Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 13 - Evidence, November 5, 2009
OTTAWA, Thursday, November 5, 2009
The Standing Senate Committee on Banking, Trade and Commerce, to which was referred Bill S-203, An Act to amend the Business Development Bank of Canada Act (municipal infrastructure bonds) and to make a consequential amendment to another Act, met this day at 10:34 a.m. to give consideration to the bill; and to study the present state of the domestic and international financial system (topic: global economic crisis).
Senator Michael A. Meighen (Chair) in the chair.
[English]
The Chair: I call this meeting of the Standing Senate Committee on Banking, Trade and Commerce to order. Today, we are continuing our examination of a private member's bill, Bill S-203, An Act to amend the Business Development Bank of Canada Act (municipal infrastructure bonds) and to make consequential amendments to another Act.
This act was introduced in the Senate on January 27 by Senator Grafstein, a colleague and a former chair of this committee. According to the bill's summary, Bill S-203 would:
[Translation]
[...] amend the Business Development Bank of Canada Act in order to provide for income tax exemptions for municipal bonds to finance infrastructure projects.
[English]
Today, we are fortunate to be joined by Jack Mintz, Director and Palmer Chair in Public Policy at the University of Calgary, who is also the former president and CEO of the C.D. Howe Institute. Dr. Mintz has been invited to share his views about public finance-related aspects of the bill and about public financing of infrastructure more generally, if he so wishes.
As we all know, Dr. Mintz is a highly-respected economist and public intellectual. In our second hour — which will not be a full hour since Dr. Mintz has another commitment and must leave at 12:20 p.m. — we would welcome any thoughts he might have about the causes and consequences of the global financial and economic crisis, and about what actions Canadian policy-makers should take, as well as areas that could be usefully investigated by this committee as a result of the economic crisis.
Before asking you to proceed, Professor Mintz, I will tell you who is around the table. We have Senator Harb from Ontario, Senator Peterson from Saskatchewan, Senator Oliver from Nova Scotia, Senator Gerstein from Ontario, Senator Greene from Nova Scotia, and I am from Ontario. Our deputy chair, Senator Hervieux-Payette from Quebec, should arrive shortly.
That being said, do you have an opening statement and a few comments? Following that, would you be available for questions afterwards?
Jack Mintz, Director and Palmer Chair in Public Policy, University of Calgary School of Public Policy: Yes. Thank you very much, Mr. Chair. It is a pleasure to address this committee once again, as I have done a number of times in the past. I will specifically deal with the issue of tax-free municipal bonds, an issue which has been brought up in the past in Canada. One government even tried using it. I would like to reflect on the issues around it, and whether it is the best public policy that we could actually use in this country.
Bill S-203's proposal to commit municipal governments to issue tax-free municipal infrastructure bonds is following a road paved with good intentions but is the wrong road nonetheless.
Enabling municipal governments to issue tax-free municipal bonds is, in my mind, poor public policy for three reasons. First, governments should not encourage a particular form of financing or public expenditures at the municipal level. If the tax exemption allows municipal bonds to be priced lower, effectively the government is providing a subsidy for debt. This could encourage some municipalities to over-extend themselves, requiring the province to assume risks if municipalities become financially troubled. It is not sensible to subsidize municipal indebtedness and spending since other forms of finance, including taxation, are equally important.
Second, in an economy exposed to international capital markets, the benefits of the tax exemption would largely go to investors, typically in higher-income classes, who would seek to hold such bonds, rather than the municipalities. Foreign investors play an important role in determining bond prices, and international markets will not have the tax exemption since their country will tax the interest income received by their residents holding Canadian municipal bonds. The exemption would, therefore, not result in a remarkably lower bond cost since international investors will not benefit from the exemption. Taking comparable taxable bonds, a difficult task for sure, less than one-half of the tax exemption benefited municipalities, with respect to provincial tax-exempt municipal bonds issued in Ontario.
I would suggest that estimate could be generous since the provincial guarantee would have provided lower cost of funds, anyway, and some of the benefits are eroded by dealer transaction costs. In fact, the Province of Ontario now provides support to municipalities using its provincial credit worthiness, allowing for lower interest rates charged on taxable bonds.
Third, political accountability is a much-treasured concept in that the government's spending money should be responsible in levying taxes on existing and future taxpayers rather than depend on financial support from upper-level governments, which have to tax their voters instead. Why should residents in Halifax, for example, subsidize bonds issued by the City of Toronto?
The federal-provincial tax exemption for municipal bonds undermines political accountability. Even worse, by encouraging indebtedness, the risk is picked up by the province, which is ultimately responsible for municipal affairs.
What I wrote in June 2002, almost seven years ago, in a National Post article still applies today. I will quote what I wrote then:
Exempting interest paid on municipal bonds from income tax, a policy adopted in the United States, is also bad economics. Even Mel Lastman, Toronto's mayor, not afraid to ask provincial governments for handouts, criticized this approach and for good reasons. Why would we ever want to encourage debt finance so governments will leave our future working population with greater tax liabilities than they now face? After all, the same taxpayers will in two decades have a host of programs to pay for including public health care and pensions to support the elderly. Municipal debt shouldn't be another bill left to our children.
Further, economic evidence is pretty conclusive that tax-free municipal bonds are a highly inefficient means of delivering support to municipalities. Study after study in the United States have shown that a significant share of the tax benefits accrue to high-income investors, who pay no tax on interest, rather than to municipalities that have more favourable borrowing cost. In fact, over 40% of the benefits accrue to investors (never mind bond dealers through transaction costs) rather than to municipalities. Given that non-resident owners are not exempt from paying tax on these bonds, it is likely that the Ontario municipalities would benefit far less than what has been shown by U.S. experience. It would be a lot cheaper for the province to pay a subsidy for each dollar of debt issued by the municipality.
It is far better to consider two other ideas. The first would be to give municipalities access to low-cost debt ratings of the province, as has been recently done in Ontario. Provinces are already involved with municipal finance, and they have the mechanisms to minimize any risks arising from municipal indebtedness.
The second would be for municipalities to be given wider taxation powers, as in other countries. This, however, is an issue that would be left to the provinces to decide.
I believe expanding municipal taxation powers is the best option since it provides room for more creative taxation by municipalities. It does not reward indebtedness in an expensive way, and it ensures political accountability.
That concludes my remarks.
The Chair: Thank you very much. We have been joined during your presentation by Senator Ringuette from New Brunswick, Senator Hervieux-Payette from Quebec and Senator Frum from Ontario.
I know there will be a number of questions. After we have exhausted our questions on the issue of municipal bonds, I hope you will expand a bit on lessons to be learned or areas to be investigated pursuant to the financial crisis that we hopefully have lived through but may still be living through.
Senator Harb: Would it be possible for Professor Mintz to also make his presentation on the global economic crisis now? In that way, we can ask questions on both issues.
The Chair: I will let Dr. Mintz answer whether he is prepared to do that.
Mr. Mintz: I should leave it to the chair of the committee to determine how best to conduct the discussion. Sometimes mixing two issues can be a bit confusing. However, perhaps there are not many questions on tax-free municipal bonds. As you know, I do not mince words.
The Chair: Senator Harb, I do not see much correlation between the two issues.
Senator Hervieux-Payette: I agree with that. I think that we will deal with the issue of municipal bonds quickly because Dr. Mintz was quite explicit about the advantages and disadvantages.
I agree with you, Dr. Mintz, on the benefit to municipalities of having the credit ratings of their provinces. I do not know why they are not doing it.
If they were authorized to borrow money, what debt ratio would you recommend so that they will not endanger the future generation, will not go bankrupt and will not create big problems? People in Quebec now believe that all municipal debts are covered by the government. It is not that clear. They issue their debts, and the bigger cities are on the market. I believe that we must look at the administration before we buy municipal bonds.
There is probably a good balanced approach that could be taken if they were authorized to borrow, rather than always asking the provincial government. What would you consider to be a balanced approach in terms of their taxation power and debt ratio?
Mr. Mintz: This is a subject I wrote about in a paper for the World Bank, and I would be happy to share it with you if the committee would like to have it. It was authored with Michael Smart at the University of Toronto a few years ago, and it deals specifically with these issues.
In my view, it is quite appropriate to use debt for infrastructure if it is done wisely, and it is an important issue. I am not talking about bridges to nowhere. I am talking about infrastructure spending that has an impact on the economy. If you spend money on infrastructure that helps grow the economy, it is not wrong for some of the burden to be shared with future taxpayers and not with the current taxpayers. The difficulty, of course, is that current taxpayers have voting powers now and future taxpayers do not get to vote at this point, and current taxpayers have all the incentive to push the costs off to the future. You need to put some constraint on that.
In fact, I argue that there may be some sort of constraint on the amount relative to infrastructure spending that one would like to put in place. In fact, that is the sort of issue that Michael Smart and I discussed in this paper.
Another important idea, which a number of provinces are now doing, is to have real capital budgets that identify infrastructure spending separately. Another idea would be to balance the operating budget, which would include a depreciation charge on infrastructure, and then use some debt, but not all debt, to finance infrastructure. It may be 60 per cent of the infrastructure spending, two thirds or some other number. However, one could reasonably approach the issue in that way.
Senator Peterson: Thank you for your presentation. On infrastructure debt, would you separate debt that had a return through a user fee from other debt for building a bridge for which there is no fee, or example?
In your solutions, you spoke of wider taxation powers. Could you give us some examples of what that would include?
Mr. Mintz: On the first question, you have a good point that some infrastructure projects could be funded with user fees over time, such as tolls on roads. If you are creating revenues specifically attached to the infrastructure projects, they can accrue to governments to help cover the ongoing costs, including interest expense on debt, and that could allow you a higher debt ratio for infrastructure spending. That judgment would have to be made project by project. I do not think there is any clear rule there.
You raise the important point that user fees could help cover some of the interest expense on that debt in the future. However, we must remember that it is future people who will be paying the user fees to cover the costs.
On your second question about wider taxation powers, Tom Roberts and I wrote a piece about three years ago for the C.D. Howe Institute in which we went through that exact question.
I would argue that municipalities are afraid to put property taxes on residents. In fact, in some provinces, the biggest complaints about underfunding of municipalities come from the municipalities that do not like to impose a property tax on their residents. There is some room to use more property taxation in Canada in some jurisdictions. Alberta and Ontario are two that I would identify with respect to that. Of course, some hardships are involved with property taxation, particularly for the elderly and low-income individuals, but property tax credits could help offset some of those costs.
One of my concerns about the property tax system is that we have excessive taxation on non-residential property as well as multi-residential property, which tends to be apartments that are used by lower-income Canadians. In this country we tend to hit businesses and low-income Canadians harder with property taxes than single-home owners, which includes, in many jurisdictions, condominiums, although there are some differences across the provinces with respect to regulation.
I do not think that relying on the property-tax base is appropriate. Cities today have a number of demands, and it is appropriate to have some sort of tax that does not create major distortions in the economy but, at the same time, provides some help to municipalities and more ability to use creative tax policy to help fund their services.
My proposal is not a sales tax. In fact, I think a sales tax would be the wrong way to go. The U.S. examples are bad examples. Retail sales taxes in the U.S. are under a great deal of pressure because of certain constitutional issues involved with states collecting taxes for other states. In fact, in California, a recent proposal has come out with the full elimination of the retail sales tax in California, as well as the corporate income tax. It will be substituted with a new consumption-based, value-added tax on business accounts.
I think sales taxation is the wrong way to go. The story that came out this morning suggesting a sales tax in Toronto would be a bad idea. You also cannot create a value-added tax at the municipal level. Differential rates would cause a lot of evasion and problems in the system. It is simply not possible to do at such a small jurisdictional level. It is difficult enough to do it at the provincial level — though, in Canada, we are making it succeed — but it is a virtual impossibility at the municipal level.
That leaves my favourite proposal, which is to bring in, what I call an "earned income tax". It would effectively be on the payroll and earnings of individuals. It could be collected through the tax collection agreements for personal income tax in Canada. It could be levied at a certain maximum rate as the province decides. It could also be made progressive. People will not be too sensitive to moving homes as a result of this tax compared to moving goods or their consumption. This tax would be less distorting as a result.
An alternative that Richard Bird and I have suggested in the past, which this California commission has adopted in their recommendations, is to consider what I call a "business value tax." It would be applied to businesses on an accounts basis. It would apply to their revenues and allow for deduction of the costs. I think it is too hard for municipalities to do that. However, if there was a province-wide business value tax that could be shared by the municipalities, it could be considered.
Those are the options I think are worth considering. However, we certainly need to have a very careful and measured debate on these issues as, at one time, we did have sales taxes in Canada. Of course, some jurisdictions have income taxes. However, they have been abolished for a long time. People are not ready for that. We need to have a serious debate about taxation powers. In my view, this will be left to the provinces to decide in the end because much variation exists across Canada. There is no one-size-fits-all that is appropriate.
The Chair: We have been joined by Senator Massicotte from Quebec.
Senator Harb: One witness who appeared before us a few weeks ago mentioned that his concerns about the bond issue. He felt that there would be no takers. He commented that 90 per cent of the pool of funds already in the market is non-taxable, including pension and other funds.
You are saying that only about 10 per cent is there. Therefore, we are not talking about much money.
Do you share that opinion? If so, tell us about it.
Mr. Mintz: I am not sure I fully share that opinion. Looking at the breakdown of instruments available in Canada, you tend to find that foreign investors account for about 40 per cent of the market. Pension funds and Registered Retirement Savings Plans, RRSPs, account for another 40 per cent. The remaining 20 per cent is individuals.
It is a big market out there. It is quite possible that if you have a tax exemption for municipal bonds, a number of individuals would be very willing to hold these bonds. This is especially true in the high-income groups, as every economic model would tend to show, because they pay high rates of tax on their interest accounts. Of course, the introduction of tax-free savings accounts may actually damper some of that impact. I suggest there would be some take-up of these bonds. I do not think that would be a significant issue.
The bigger question is how much municipalities get lower interest rates associated with their debt if the tax exemption was provided. Once you take into account who is really holding securities at the margin — to the extent that pension funds, RRSPs and foreign investors play a role — then you can make an argument that there would be little savings experienced by municipalities. Most of the benefits will go to the taxable investors who decide to purchase these bonds.
Senator Oliver: My question has been largely answered by your response to Senator Peterson.
Nonetheless, when you were giving your opinion on tax-free municipality bonds, you made it clear that you think it is extremely poor public policy because it is a subsidy for debt. You went on to explain what you meant by that.
My question was that if we cannot use interest income-tax-exempt municipal bonds, what you would recommend. You answered that you would like to see an earned income tax.
It seems to me that there are two problems with that. First, the current government would like to find ways to reduce tax rather than adding more tax to individuals and corporations. Your proposal does the opposite. If individuals and corporations had more money free, they could invest in the economy, stimulate the economy and it would lead to more growth.
Second, many municipalities encompass much of rural Canada. Much farm land and other lands would be hard to tax on an earned income tax basis. What do you say about that, given the nature of many of the municipalities and rural Canada?
Mr. Mintz: Your point about rural Canada is correct. An earned income tax would not apply to interest dividends and capital gains. It would only apply to self-employment income and payroll that individuals receive. I did the analysis that you suggest in looking at the rules of an earned income tax.
Senator Oliver: You did or you did not?
Mr. Mintz: I have done the analysis by province, but not by rural versus urban. You are absolutely right; those issues would have to be looked at carefully. That is why I said that this is not something I would jump to immediately. The same applies to sales taxes. Can you imagine small rural areas trying to impose a sales tax? That is a virtual impossibility. A value-added tax is even crazier as a result.
I am sympathetic to your point of view. Other factors would have to be considered. Which province you are in makes a very big difference as many differences exist across the provinces on some of these questions.
With respect to your point about taxation, as you know, I have always been very concerned about the level of taxation in Canada over the years. We have made remarkable progress in 15 years under both Liberal and Conservative governments to bring down the tax levels that had built up during our deficit-fighting years. Recently, going into this global recession, Canada had a great balance sheet going into it because of all the smart economic policies undertaken in the past 15 years. Therefore, hats off to all governments, both federal and provincial, for doing that.
The municipal level has an issue with the constraints they have over taxing powers. Some taxes are better than others. Property tax is not a bad tax to have at the municipal level. It is easier to run and simpler. Perhaps other areas could be expanded, such as user fees and so on. For example, Alberta had very little reliance on user fees when I did my study three years ago and could expand their use of that to help finance municipal services. Again, these issues vary significantly by province. It may be that some provinces would rather go the route of adding a new tax for municipalities. Other provinces may not want to do that. Those are questions for voters to decide ultimately in terms of what they want.
We have to remember that tax-free municipal bonds have a fiscal cost. Lower taxes would be collected at the personal level. Some cost will be associated with that; it must be picked up somehow. Either we raise taxes on others, or we have to cut spending to ensure that we balance the books. You cannot look at that as a free lunch either.
The Chair: Does anyone else wish to question Mr. Mintz on that matter? It seems your views have come across loud and clear, Mr. Mintz, and also your elaboration of other possibilities that might prove useful to municipalities.
With your agreement, perhaps we could shift gears now and ask you to help the committee as it is doing some preliminary work to try to identify an area for an in-depth study on matters falling out of the economic crisis. Any comments you would care to make on the causes and consequences of the economic crisis and on areas that might prove fruitful for this committee to delve into would be appreciated.
Mr. Mintz: Thank you. I was not planning to give a long presentation on this. In fact, I could probably speak for an hour on the subject, if I wanted to. I have given many speeches recently on subjects related to the financial crisis that we had, as well as the economic fallout that occurred because of what happened last year.
If you asked me who is at fault or what happened, my view is that almost everyone is at fault. I think that that governments, especially in the United States, and some remarks could be made about the United Kingdom and Ireland as well, and a few other governments that loosened regulations, made it very easy for people to buy homes on very little credit, with very little down payment. That certainly exacerbated the problem that occurred. There is no question that the sub-prime mortgage problem that occurred in the United States, which grew out of government regulations and changes in law that occurred in the last part of the Clinton years, had a significant impact on the growth of credit risk in the housing market. There is, in my view, no question that that was one of the reasons that it occurred, but it was not the only thing.
Also a belief existed on the part of lenders and borrowers that housing prices would continue to rise and that there was virtually little credit risk. Lenders, thinking that they could pass the risk around the world through structured products, thought that they could make the risk go away. As a result, their decision making had very faulty premises because they were based on models that did not capture properly some of the institutional features of capital markets and were therefore terribly wrong, but everyone believed in them.
Borrowers were at fault because they put themselves in a position where they could easily lose a house should there be a rise in interest rates. As a personal point, my mother and father, who went through the depression in the 1930s, would never put themselves in the position that borrowers did in the United States of taking on far too much mortgage debt relative to their income such that if there were any revision of interest rates upwards or if they lost a job or whatever, they would have also lost their home. The problems were just as much the fault of borrowers as they were of lenders who pushed this low-cost credit on many individuals.
Central bankers were at fault because they said that we have monetary policy targeted on inflation and have eliminated business cycles, and people had a strong view that there would not be any problem at all in financial markets and that interest rates would stay lower. In my case, listening to many bond funds coming in and doing presentations on various endowment committees that I sat on and other things, they kept on talking about the fact that interest rates would never go up, that inflation has been handled by central bankers and that basically things are just great now in the world economy. Central bankers themselves also believed in much of that. I am sure some people questioned what was happening and whether it would result in a problem or not, but by and large most people — and I will include myself — did not understand fully the implications of this major problem that occurred in the way that we had perceived risk in markets.
Today, I would argue that we have not learnt the lesson at all. In fact, we now seem to think that if we put risk on to the taxpayers and governments, that somehow the risk will go away. That risk still exists. In fact, today we now have governments undertaking significant amount of risk absorption from the private sector, and we cannot believe that that risk absorption will go away at all.
That is a bit of my perspective on what happened. Certainly, when we had Asian growth and the push up of commodity prices around 2004, we could see interest rates rising in Europe and in the United States, we saw the housing market starting to turn sour with inventories building up, prices starting to decline in 2007, and the rest is history in terms of the trillions of dollars that were lost as a result.
As a committee, I suggest you study some of the lessons. First, it is important to understand the role of financial regulation underlying all this and what actions will be needed with respect to financial regulations to ensure that at least some of these risks that developed in financial markets will be handled or properly priced in financial instruments so that it will not happen again where the world sees a systematic risk that takes place that hurts the whole world economy at one time. That is certainly one area of study that I think will interest you.
Luckily, in Canada, we have had a better banking system; some people will say, due to better regulation, due to bankers, and maybe they were stupid a few years ago, but they look pretty smart today. We have been able to have a more sound banking system, and that has been true in some other countries where the banking system was not as much under threat. However, once we had the systematic risk running through the whole global economy, even our own banks were challenged as a result. Some areas are worth examining there, and I have some other views we could take up in the question period about what I believe should be the framework for financial regulation in the future.
The second point I think you should look at is the growth in government deficits and in debt in Canada. As I mentioned earlier, we have had a good balance sheet going into this global recession where both our federal and provincial net debt went down to 28 per cent of GDP, which was actually pretty good. In my view, we have undertaken an economic stimulus that was relatively timely, relatively temporary and did not build long-term costs into our deficit numbers. As a result, even though we do have more debt piling up now, which will rise into percentage points in the 30s, our net debt ratio, as a share of GDP, will be somewhere in the 35-per-cent range eventually. I do not think that we have a serious or as serious a problem compared to the United States, where they have had a failing economic stimulus that was neither temporary enough nor timely enough to deal with what was a much deeper recession that has occurred in the United States so far.
What are the implications of all this? There are two issues. One is the implications for federal finances over the next several years and the pressure that will be put on the federal government with respect to some of the spending envelopes that are critical to Canadians, including health and education. These are also areas that are important at the provincial level. In fact, my bigger concern over deficits is not so much at the federal level as it is at the provincial level. Ontario now has a $24.7-billion deficit, Alberta has close to a $7-billion deficit and many of the other provinces have significant deficits as well. Some of them may be in a situation of having a structural deficit. At the same time that they are dealing with these difficult deficit situations, they will be cutting back expenditures in areas such as infrastructure and education, which are important critical elements to growth in the Canadian economy.
We will have to think about how federal and provincial governments can coordinate themselves with respect to their goals in trying to ensure that productivity is maintained in the future through the important public programs that play a critical role in areas such as public capital spending and education.
Of course, we all know that health care eats the lunch of everyone else at the provincial level. It is the most significant expenditure, so the health care issue will also be very much on the table. That will put pressure on the federal government to look at the transfer payments it gives to the provinces as a result. That is the second area that will have to be dealt with as part of the fallout to this global recession.
There are probably some other aspects that one can talk about, but the third one that we will have to think carefully about is our trade policy in the future, and our relationship with not just the United States but with countries around the world.
We have had a view in Canada, because of our close relationship with the United States, that it was very important to fix our trading relations with the U.S. this past decade. We have made some baby steps to do that, in my view — positive steps, but not major ones. Now we have an even more difficult Congress and president to deal with on trade matters. Attention will have to be given to that issue because trade will be still very important for Canada.
We are also seeing the continuation of a shift of economic resources to emerging countries, particularly in Asia, but also one can include Brazil and Latin America. This significant shift in economic power to other parts of the world means that Canada also has new options that it should be considering. I do not think of this as a way of diversifying trade. I look at this as opportunistic policies that could be adopted and, in fact, help us in our own relationship with the United States.
If we have a credible alternative, it makes it easier to negotiate with other partners. If you have no alternative, then your trading partner will beat you up nine times out of ten at a negotiation.
One of the things we need to do is to ensure that we develop some other markets in the world that clearly give an important alternative to Canadian businesses, so that in any negotiations and discussions that we have with other countries around the world on trade policy, people will understand that Canada has options. Those options are viable ones, and if they do not want to play ball and have free trade, or at least trade that is to the advantage of both of us, then we have an alternative with a country that is also looking for those type of advantages.
The European Union trade negotiations occurring right now and our need to think more about what we can do vis-à-vis Asia and maybe Brazil are some areas that we need to think about as we try to move forward with our trade policy. Again, it is another area that is useful for your committee to look at as well.
That is the end of my comments on these issues.
The Chair: Thank you very much, Dr. Mintz. That provides much food for thought and questions from the members.
On your first point of financial regulation, if you look at the financial crisis and look at Canada, as you said, for a number of reasons, we have come through so far in pretty good shape. Do you see any need for increased coordination among regulators within Canada? If so, who do you see taking the lead in that — the Governor of the Bank of Canada, the Office of the Superintendent of Financial Institutions, OSFI, or some other group?
Second, much of damage we suffered came from outside our borders. It seems that the way to deal with that is through international regulation. Historically, our friends south of the 49th parallel have not been keen on abdicating sovereignty to international bodies. What hope do you hold for increased international regulation, if indeed you share the view that that would be helpful in preventing another global economic crisis?
Mr. Mintz: With respect to coordination amongst our regulators within Canada, there are two aspects to that. One is coordination within the federal government, where you have a number of different people who are involved with regulation of financial markets. The other aspect is coordination between federal and provincial governments, given that provinces play a role in certain aspects of financial regulation as well.
Therefore, there are two issues that one might want to look at quite carefully in terms of the differences between that and what might be required in the future.
With respect to federal regulation, I am of the view that probably the best approach to consider is pretty well what people are talking about and, in effect, what has happened in the past: having a formal committee that would be composed of the major regulators at the federal level who would sit together. Then the question is who would chair that.
In my view, it has to be the Minister of Finance who must be ultimately responsible for financial regulation at the federal government level. Therefore, it would be his designate — that could be OSFI or someone else — who would chair that committee. I am not of the view that the Bank of Canada should have that responsibility, in part, because I believe it is important for the Bank of Canada to continue to be focused on monetary policy and issues around that. I know that financial developments have a significant impact on monetary policy; and the bank had to come in very importantly with its role of the last resort to assist banks when necessary. However, overall, a number of different policies were undertaken in Canada that were not just in the Bank of Canada's purview but in other parts of the government and that were critical. As long as we ensure that the regulators are talking to each other, the committee concept is the right way to go in terms of coordination within the federal government.
That leaves coordination between the federal government and the provinces. A national security regulator has been discussed. Maybe we should be thinking more about financial regulation that is coordinated, not just with respect to security regulation, within the federal-provincial context.
That is a thorny issue. However, I have been impressed, for example, by Quebec and the way that Quebec has developed its financial regulatory system in the past number of years, which is quite different than what has evolved in other provinces. We need to have some more discussion about both the content and structure of financial regulations in Canada.
With respect to international regulation, I think that is much tougher to do. However, we do have important bodies now that do facilitate coordination amongst the different parties at the international level. Countries have different approaches in how they want to regulate their institutions, but when it comes to the major institutions operating globally, some thought could be given to capital adequacy ratios and other areas that are appropriate in terms of regulation that could be attempted at the international level.
It will be much tougher to do that. In my view, given what we did in Canada, where we had both regulations and behaviour by banks that was much more prudent compared to what happened in the United Kingdom and United States, we have to ensure that our system is as sound as possible. However, it is clear that when we have a global problem , the financial crises that occurred, when, for example, banks were no longer lending to each other, we had to act and did so with other countries.
We have to ensure that we have the institutions at the international level that facilitate coordination as much as we can achieve. However, in my view, it will not be easy to do at the international level.
Senator Harb: Thank you very much, Mr. Mintz, for your presentation. I have a few questions to ask you, starting with the interest rate.
During previous recessions, in the 1980s and 1990s, interest rates were quite high for the duration of the recession. The argument presented by the government and the banks was that what they wanted to ensure that consumers lived within their means and did not spend money that they did not have.
This recession has been interestingly different, and I would like your comments. In 2004-05, interest rates started going up; the argument of the federal bank was that the economy was heating up, and they wanted to cool it down — fine. Suddenly, a 180-degree turn happened when the economy soured and the interest rate went down to zero in the United States.
The correlation between the two is quite interesting: In this recession, governments on both sides of the ocean are telling consumers to spend and spend more. Does that make good economic sense? How far can you go in terms of pushing the consumer to spend money, in some cases money they might not have?
Mr. Mintz: You are asking a very important question, senator. I have written something about it in one of my op-eds a little while ago. This view that saving is bad and consumption is good is based too much on a Keynesian macro-economic theory that has, as its underlying premise, the concept that the only way to buoy up economic demand is to get people out to consume more and that savings is a complete leakage to the economy. Therefore, when people save more, we have less consumption and less economic activity. There is something to that with the current malaise.
Part of the problem in the United States has been the extremely low savings rates and, as a result of that, the amount of huge indebtedness that they have to the rest of the world where they have to rely on other countries holding their debt as they issue piles of it over the coming years. For example, Japan has a debt-to-GDP ratio that is extremely high. I forget the number, but it is well over 100 per cent and is on track to move to 200 per cent of GDP in the not too distant future as their deficits are quite large.
The big difference between Japan and the U.S is that the savings rates in Japan have been 30 per cent of GDP, allowing their interest cost to be very low. Japanese interest rates are in the range of 1 per cent. They have been able to finance a large amount of their debt with their savings. Japan will experience pressure in the future because of the size of their deficits. Some people argue that Japan could end up with a current-account deficit, which means that they will have to borrow from the international market to finance Japanese consumption. They have had a very high debt-to-equity ratio for many years, but their savings has softened some of the problems that one associates with that. The foreign indebtedness relative to GDP is a bigger problem. The Bank of Canada model in predicting exchange rates has always had foreign indebtedness as a share of GDP as being one of the factors that affects the Canadian dollar. The greater the foreign indebtedness is, the lower the Canadian dollar. The Canadian dollar has performed better because we have reduced our foreign indebtedness since the early 1990s.
The United States is going in the opposite direction now. That is why I am of the belief that, over time, given the large deficits in the United States, by 2014 the accumulating debt will make the United States look the same as the Canada of 1994. They will have a significant problem because of their low savings rates, and because of that, they will be even more dependent on Chinese and Middle Eastern sovereign funds and other funds to supply the debt or funding needed to purchase their debt. Of course, these countries might decide not to hold American debt and opt to hold other assets.
In The Wall Street Journal this morning, India announced that they bought gold, and, of course, gold prices went up yesterday. Part of the reason was to move India away from the American dollar. We will see a continuing decline in the American dollar as a result. On some of these issues, Canada is in much better shape than the United States. Part of this committee's deliberations is to understand the future prospects of the United States, its fiscal prospects, its monetary policy prospects and the implications that that could have for the Canadian economy, which can be quite serious for us to deal with.
Senator Harb: My next question deals with the market economy. We are a capitalistic society. When we have a trade in commerce crisis, we always have the winners and losers. In this particular case, we know who are the losers. Can you tell the committee who are the winners?
Mr. Mintz: Do you mean the winners from the economic fallout?
Senator Harb: Yes. When someone loses in a market economy, someone else wins. I want to know who are the winners.
Mr. Mintz: When we have a downturn, there are not many winners. In an aggregate sense, total economic activity declines. Some people will bear a bigger economic brunt. In particular, those who become unemployed face the biggest problems as a result. A few winners have resulted from the current economic malaise. Even in the United States until recently, a growth could be seen in health care employment, not a decline. Of course, at some point, governments do not have the money to pay for all the bills, and they begin to look at where they can cut costs in the health care area. In the United States, some decline has taken place in that area.
In a sense, the Canadian winners have been government employees to date because of the fiscal stimulus that required more people to be employed by the government. We have also seen increases in health care and education. More students are going back to the university and college systems, creating more demand for education programs. They have been some of the winners in the system. As governments have taken on large deficits at the provincial level, we are beginning to see that they will not be winners any time soon. Certainly, we are seeing some fiscal restraint, which will affect the public sector as well.
To be honest, I would say that there are not many winners when the economic downturn is a big as the one we have experienced. Generally, everyone is worse off because they have less income to play with and governments have less to play with from tax revenues. As a result, everyone loses.
Senator Harb: You mentioned that public sector employees might be the winners. However, many pension funds, including public sector plans, have lost billions of dollars. You might want to consider that in this particular recession, unlike any other, we do not have financial regulation or proper rules by which to play the game. We can blame China all we want, but the problem was not in China; it was in New York at the stock exchange when they refused to allow the government to introduce regulations to govern some financial activities. Everyone was a loser because, as we were told during our visit to New York, everyone was bidding on the way up, and no one was bidding on stocks on the way down. If people had been bidding on the way down, we would have had more winners.
The Chair: Maybe the winners are simply the lesser losers.
Senator Hervieux-Payette: I have a question that pertains to the future about less government intervention but some changes in law. By that I mean, for instance, the role of individual shareholders — all Canadian citizens — your 20 per cent of individual shareholders who lost tremendously, not just with their pension but personally. They have lost in both places: Their pension fund is lost, and they have lost, as well. Those are their savings for the future.
I was wondering if you could see a way that we could give more power to the shareholders. The shareholders of the pension funds have no say in where the money is being invested. We will certainly consider revising our legislation on pension funds. However, I do not see that we have any clout as to where our pension fund will go, and you have zero clout as a shareholder. The board has a fiduciary role for these people. These people have no say as to what is done with their money.
Do you have any comments or have you written an article recently about empowering the shareholders so that we are less frustrated because we have a say, not what is happening on at the stock exchange —that is another game — but that, if we ever fill in the proxy to vote, that it has some meaning. Right now, I feel it is not even worth filling them out because I know we do not have a say in this. Actually, it is going counter to the spirit of the law, in that shareholders should be the ones benefiting from both the board decision and the management.
Mr. Mintz: I will first start with reminding people of a book written many years ago by Albert O. Hirschman on exit versus voice. There are two ways to exert power over someone. One is to try to get more voice in what they do. The way you to think of it in a corporation would be to get on the board of directors, or at least having more direct influence on managers in that way. The other is exit, where you sell your shares, which is the alternative.
In the case of corporations, of course, obviously selling shares is one thing that shareholders can do. That creates a great deal of pressure on management because managers themselves will have their own pay, as well as their reputation, attached to the success of their company. Therefore, to the extent that we ensure that executive compensation is tied to long-term consequences of the corporation and not only to immediate results, I think that does a great deal to align the interests of the shareholders with management. Of course, if shareholders do not like the way the company is organized and pays their executives — the methods for which are fully disclosed and should always be — they can decide that they do not want to be part of that corporation and not hold those shares. We should let the discipline of the market work, particularly with respect to stocks.
A more interesting question is about pension funds; we need to look more carefully at how they are governed and how they operate. They have captive owners. Once you are in a pension fund, unless you actually leave the pension fund by quitting your job and maybe transferring it to a locked-in RRSP, you are stuck with a pension fund and what it does. That is completely different than the shareholder in a corporation who at least has one out, which is to sell shares and not be part of that corporation at all.
The question has become how we reward pension funds in this country. Take defined benefit plans, for example; they have taken on a large amount of risk in their investments. A study done by the Organisation for Economic Co-operation and Development, OECD, came out last summer, and Canada was the third-worst performing pension fund sector in the world. The average loss of pension funds — I think they are both public and private — in Canada was minus 18 per cent during the recession. That was the third worst on average. By the way, the Americans were even worse than that. This was just the average loss that was 18 per cent.
Why was that? They were holding a large amount of risk, private equity and those things. The question is how we end up compensating managers and pension funds. One of the problems I have with pension fund funding, particularly with defined benefit plans or hybrid plans — where there is some guarantee for the benefit — is that pension funds do not have to hold a reserve if they cannot pay up with respect to the required benefit. Therefore, in some sense, the investment returns during the good years that pension funds were getting was an overstatement of how well they were doing because, at the same time, they were imperilling the ability to cover the guarantees that they have with respect to defined benefits that they pay to workers.
We need to look more closely at pension plan governance in this country because people are trapped with the way pension funds are governed. Of course, a significant risk could be imposed on governments as a result. First, with public pension funds, deficiencies due to their funding mean that the governments have to make up for those deficiencies. Any type of government-sponsored plan will put taxpayers in the position of facing significant risk associated with that defined benefit plan, and taxpayers will have to make up for the shortfalls. Significant defined benefit plans in the public sector, of course, as was noted by Senator Harb, have significant deficits, and governments are now making up for the shortfalls in those deficits. Again, it goes back to how much risk you want to undertake with the holdings in that pension fund and the guarantees that pension fund has.
On the private side, governments, as well as taxpayers, could end up facing risk where a pension fund gets into serious trouble. As in the case of Nortel workers, people suddenly do not have the pension that they thought they had because Nortel was put into a position of underfunding the pension fund altogether.
In the United States, they try to deal with that by having a guarantee fund that the government set up, but that creates a moral hazard risk in that it encourages pension funds to take on more risk as a result. I have a colleague by the name of Norman Neilson at the University of Calgary who recently published a paper in the United States who showed that the Ontario pension funds took on more risk compared to other provincial funds in Canada because of that pension guarantee. Therefore, we have to be very careful about policy in this area and how far down the road we go with governments absorbing the risk involved.
One final point I would like to make is with respect to what other countries do with their defined benefit plans. One of the companies I was involved in had five pension plans that they had to deal with around the world: in the United Kingdom, Ireland, another in Canada, another in Netherlands and one in Norway. The Norwegian plan never had a deficit problem; it was always fully funded. That was because the Norwegians had a regulation, of which I cannot remember the details, that forced them to hold mainly bonds to fund future obligations. As a result, the Norwegian plans were hardly ever in a deficit position, and we never had to talk about deficit funding for those. If you have to hold mainly bonds to fund future obligations, then you will have a serious problem with the contribution costs associated with that plan. The Norwegian plan actually cost more money as a result.
The main point is that we can reduce risk, but we have to be willing to pay for the costs associated with that.
Senator Hervieux-Payette: Thank you. I fully agree with your second point about empowering the shareholders. It occurred to me that, of course, they hold annual meetings that the shareholders would be invited to attend. If it was done with new media such as the Internet, giving shareholders the ability to ask questions, it would make the meeting proper, but when the meeting is taking place 500 kilometres away, the shareholders know that they do not have much say.
Publishing the names of shareholders could be envisaged for the future. It should normally be in the public domain, so I think we could move forward to give them more say. If an individual sells his or her shares, I do not think it will make a big difference the next day. However, if a fund sells a block of shares, it makes a difference.
My last question is about the future. Once the patient has recovered, the economy is balanced and we are moving forward, yet facing the competition you spoke of from Brazil, Russia, India, China and maybe others, how will we finance the new economy? How will we get the pool of money needed for the commercialization of everything that is being researched?
The University of Calgary is doing fabulous research in nanotechnology and in many other areas, as are others throughout the country. The government is investing the people's money in tax credits for research and development as well as in exploration in other sectors. We put a large amount of money into these initiatives, but we never recover it when a company is sold to foreign investors. We see that in information technology. When they come to the last phase, the company is taken over by foreigners because they have the cash to continue the operation. We have invested a great deal in the company through R&D and lose total control. Sometimes they walk away with the technology and no jobs are left in Canada.
We have invested billions of dollars in research and development in many sectors. How can we help build the new economy without leaving them with no source of funds when they are close to commercialization?
I will leave that with you. We have to consider the future for the graduating students. We are the most educated population in the world. How will we ensure that when we finance companies, a return for Canadians and the commercialization takes place here?
Mr. Mintz: You raise a very difficult question with which many people have been struggling, and I do not think anyone has come up with a magic bullet. However, I would argue that some of the policies we have undertaken over the past number of years are making it easier to keep the value added that one gets from research and development in Canada rather than it going elsewhere.
In fact, over 10 years ago, when I looked at this issue as chair of the technical committee on business taxation, we came across a number of labs in Canada that were collecting royalties for R&D that was done in Canada. They were receiving the research and development tax credit, but all the spin-off jobs were in the United States and elsewhere. We were getting little value from the research and development tax credit that we used in Canada to spur research. At least, we were not getting as much value as we could have.
That is why, at that time, we argued for significantly reducing taxes on businesses. In fact, in 1998, Canada had the highest corporate income tax rate amongst all OECD countries, but it also had one of the highest marginal effective tax rates on capital in the world. As a result, although we had all those tax credits and support for R&D, many of the facilities were elsewhere because there was no point in putting the value-added activities in Canada.
I would suggest that, with the changes that have occurred since 2000 in our business tax structure, we are making it easier to get more commercializing of research here by at least having more manufacturing and other types of activities, including business services, use that research and development.
I want to make one other important point that I think is critical, and this is a problem we sometimes have in looking at research and development. Research and development is really good and very important for product development, but to get products to the market, we need another side of innovation that the official definition of research and development in the OECD does not include. That is all the other factors that are important in order to get goods and services to the market, which includes the way you service your customers, the marketing you use and so on.
Canada has two important disadvantages that make commercialization of research difficult here. First, we have a relatively small domestic market and sometimes manufacturers like to be close to their big product demand. Therefore, they tend to put more of those types of operations closer to the big market. Also, we are distant from major markets as well, which creates a bit of a problem.
Trade policies are very important to help with commercialization. Policies that look beyond the research and development activity, that try to reduce government-induced costs, regulations, taxes and such things can also help create more value added in Canada. I think we have been going down that road, and it will be interesting to see the statistics over time.
Looking at Ontario as an example, even though it is having a major challenge with manufacturing, not all manufacturing is doing badly. Some very strong sectors in the Ontario economy include finance, some of the high-tech industry and some of the natural resource sector. We still have major natural resources in Canada. Major developments are being undertaken now, including Shell gas in British Columbia and the oil sands in Alberta. I understand that even Quebec might have natural gas in the future. New technologies are being used to develop deposits that were once impossible to reach. Huge amounts of innovation are happening there as well as the creation of value added.
It all goes back to the fact that businesses operate in a global world. They will put different parts of their production in different countries depending on what is most advantageous to them. To the extent that we keep a competitive position in Canada in many of the things we do, and I would argue that, in doing that, we have made important strides in the past decade that put us in a better position to attract higher value-added jobs.
I agree that it is important to do that because we do not want to graduate students just to have them move to another place in the world where they can use their good training. Ireland not only invested heavily in education but also ensured that they had a regulatory business structure that attracted many multi-nationals to their country. Until recently, they were able to reverse a long-term historical outflow of people to the rest of the world because there were inadequate jobs in Ireland. Ireland was an amazing development miracle from the late 1980s, until recently. Now they are having their challenges due to the global rescission, but they went from being a poor cousin in Europe to being one of the richer cousins in a very short period of time. That was due to some smart policies, policies to educate the population and policies to attract jobs to the Irish economy. They ended up with immigration to Ireland as opposed to having people emigrate from Ireland.
That is the way we have to think in Canada to take advantage of commercialization and research. It is not only the little things that will do it but also the bigger things as well.
Australia is another good example of a country that has been able to successfully lever off its resources and create a number of industries. Of course, Australia has been doing very well not just because of the resource sector but also other industries as well, particularly in services and manufacturing. It is not perfect; however, they also have the advantage of the Asian market now, which is the fastest growing market in the world.
Senator Gerstein: Dr. Mintz, at some point our efforts to stimulate the economy in Canada have to be phased out. How will we recognize when the time has come to phase out these stimulus measures? To put it another way, what signs should we be looking for to see that the economy is becoming self-propelling?
Mr. Mintz: That is actually a very difficult question. It is the hardest question that I believe is facing both the Governor of the Bank of Canada, as well as the Minister of Finance. That is because you do not want to move too quickly in certain areas such as raising interest rates or cutting back. You need to get some growth going in, but, at the same time, you do not want to wait too long because you could build up inflationary pressures that could have other important impacts on the Canadian economy for longer-term development. That is a difficult tightrope to walk at this point.
In my view, the Canadian economy still has considerable excess capacity, in that we will not have inflationary pressures at least for another year. At the same time, we will have to take off that fiscal stimulus that has been put in this year and next year, and it will have to be basically timed out. If you look at the fiscal stimulus that we adopted in Canada at the federal level, it does have that attribute. Most of it will disappear after next year, especially all the infrastructure spending. It is a use-it-or-lose-it attitude; if the provinces and municipalities do not have projects that take advantage of it before the end of next year, then it just will not be available.
With our Employment Insurance, the expansion of generally most of it has been temporary, and it will also come off. That may be a bigger challenge because I am not sure that unemployment rates will go down as quickly by the end of next year. There will be some pressure to keep some of that employment insurance support in the system to help people coping with a lack of jobs, particularly in certain areas of Canada.
The other parts of the stimulus, such as the homeowners' tax credit, will definitely be phased out. The one thing that was permanently put into the system is the expansion of the personal tax exemptions that were introduced in the economic stimulus and that will not be disappearing. In fact, that will continue on over the years. That was actually a permanent tax cut that was brought in last year.
When you look at the overall package — I forget the total percentage now — most of it will come off next year, which is probably about the right timing for the Canadian economy. The bigger problem will be the political pressure to keep spending up, and I think it will be important for governments to be focused on the deficit. Most Canadians are of the view that letting the deficit rise this past year was appropriate public policy. It was an exceptional time, but we need to get back to controlling our fiscal finances in a prudent and responsible manner. That attitude will take place amongst the population, and they will require it of their governments.
As I mentioned, the one pressure point I would be concerned about is the fiscal deficits and, in fact, structural deficits of the provinces that have now clearly come before and that they will have needs in infrastructure, education and health care spending. That is a big part of their budgets — in fact most of it — and a significant problem will be how to fund that in the future, while at the same time tax revenues may not be sufficiently buoyed up as a result.
How to deal with the fiscal balances between federal and provincial governments and the needs at the provincial level to fund some of the expenditures will be the biggest challenge down the road as we move forward. At the same time, we do not want to see exceptionally rising tax levels or inability to deal with deficits that could lead to more debt as a result. Those will be the bigger issues to deal with on a going-forward basis.
To return to your point about when to stimulate, it will take probably a couple of years before unemployment will start tracking downwards in an important way. The bounce-back of the stock market always precedes the growth in the economy and greater employment numbers. However, given the temporary shock we had in Canada and the ability of the business sector to deal with that, I am confident that in about a year's time, we will have to be looking at some restraint. I would suggest that right now both monetary and fiscal policy are on the right track. By next year, we will have to see some changes in both fiscal restraints and in interest rates going up to deal with what could be the start of a rise in the Canadian economy. Part of that will be driven by Asian developments, where commodity demands will rise and international prices for commodities will rise; and, of course, Canada is a significant beneficiary of that type of change that will happen worldwide.
Senator Greene: I would like to ask you a general and futuristic question about pensions. Pensions are a problem now. There are huge unfunded public liabilities. Many of the private plans are in trouble. While we do not know how the economy will look in about 10 years, we do know that the demographics will not be kind to pensions. We can take many steps now to fix what we have, but it seems to me that 10 years from now, 10 years and more, the problems will be quite large; large to the extent that we should begin to look at more creative solutions. I do not know what those are, but it seems what we are doing now may not be adequate, no matter what the state of the economy.
Mr. Mintz: First, on pension plans, I would suggest that we have to remember that there is a whole retirement income system in Canada that is very well integrated. When we talk about defined benefit plans — which have a very different nature from defined contribution plans, where defined contribution plans are an investment risk that is imposed on the pension holder and what they receive in the end will depend on how well that plan performs — it also applies to group RRSPs and RRSPs in general and everything else in that category.
I take it your question is a concern over defined benefit plans particularly, which became underfunded in 2008. I would suggest you look at the DBRS report that came out just a few months ago, where it showed that many of the plans are not doing that badly at all and, in fact, are not that severely underfunded. With the growth back in the stock market, I think they have gone back to their level.
That does not mean that we do not have issues involved. In fact, my biggest concern as a public policy analyst has been the flight away from defined benefit plans to other types of retirement income programs that are available to individuals.
In some cases, moving away from defined benefit plans is not a bad thing from the point of view of the economy because defined benefit plans have been used as part of labour negotiations to retain workers. In the case of someone who moves from their job — I can tell you about my own personal experience with that — you tend to leave great deal of money on the table.
That is because, under a defined benefit plan, the employer puts in less money at the beginning of the plan when the employee is young but puts much more money into the plan toward the end of the working life of the employee. That type of plan is a way of trying to retain good employees in your labour force.
The movement toward defined contribution plans, RRSPs and group RRSPs, adds more flexibility in labour markets, and that may not be a bad thing in itself from that perspective. On the other hand what has happened with the movement away from defined benefit plans is that more is imposed on individuals. Individuals have human capital risk with respect to the uncertainty of whether they will be able to keep a job or not and the money they are working with now, their earnings that go into investments to provide retirement income; they have more difficulty diversifying risk.
The value of defined benefit plans has been to shift the risk away from individuals who have more difficulty holding it to other parts of the economy, whether it is a corporation or a government. In the case of the latter, of course, the Canada Pension Plan is an example, but it is also true with public pension plans as well.
I believe one of the big public policy issues is to think more about the sharing of risk involved with the retirement income and the ability of having those types of plans available to help people deal with retirement risk so that they can be sure that they can have a certain sustained level of consumption after they retire.
By the way, people tend to consume less after retirement than they do during working life, and their replacement income does not have to be nearly as large. Even though we use the number of 70 per cent, that number does not come from anywhere. It is just a presumption that you need retirement income at 70 per cent of your level of working income. Work has been done, for example, in the United States that has shown that actually you need about 50 per cent of your income at retirement not 70 per cent. In fact, a significant body of literature looked at that as a result.
My biggest concern is about defined benefit plans. We know legal issues exist that have led to many companies deciding basically to keep them slightly under funded because this way, if there is any wind-up, the company must bear the risk — the deficits anyway. However, all the surpluses, or a significant part, go to the workers. Many companies now, for risk reasons, tend to keep the funds a little under funded. They are not necessarily the ones in trouble, but the main point is many companies have decided, at least in the past with more flexible labour markets, to abandon defined benefit plans.
In the past several years, we have seen examples of companies that have gone back to defined benefit plans because they see the oncoming labour shortages and the need to keep good workers as well as treating their workers fairly and having those plans for that reason also.
I am very concerned that we ensure we have a regulatory framework that supports defined benefit plans in the private sector because that is an important issue to deal with in the future.
Senator Oliver: I appreciated many of the remarks you made today on the financial crisis, and many of them have been very intriguing. You began by talking about the financing of private homes and the sub-prime mortgage crisis in the United States. You went on to talk about some of the legislative changes in the last years of the Clinton administration. After that, you very quickly talked about some of the problems with structured products.
It is my view that things that were happening with some of these structured products are what drove us into this recession. I would love to hear from you more about some of the things that you think went wrong there. For instance, I am talking about securitization and some of the new derivative products being sold globally and so on, and the fact that people did not know. The expression that you used earlier was that one of the main occurrences is the way we perceive risk in the markets. That goes to the structured products.
I would like to hear more from you about how evil and uncontrolled some of them were, and what, if anything, you would recommend about some of these structured products.
Mr. Mintz: Structured products, such as asset-backed securities, mortgage securities and so on, are not necessarily a bad thing. They allow for risks to be diversified over a larger number of different securities and populations. That helps lower the cost of risk. In itself, in my view, there is nothing wrong with the structured product as a way of trying to develop mechanisms to reduce the cost of risk and lower costs, as a result, that borrowers face. That could be a good thing for an economy if you can do that.
The problem I felt though is that the structured products did not have the right pricing of risk because they were ignoring certain risk. This goes back to the models used by many people in the financial markets. I went through an analysis of these models, and they tend to be based on analyses done by economists in the 1990s. Economists like to use very particular assumptions when they develop theories. Some of those assumptions were the same as a world without taxes, a world without transaction costs and a world where credit risk goes away; not particularly modeled appropriately.
The pricing of those structured products was based on these models, which were effectively incorrect. They ignored what I feel are some of the important institutional features of capital markets that could affect the pricing. Of course, while things sort of roll on where life is not changing too much, it may not matter to a certain degree, but as soon as something is more abrupt, as we saw with higher interest rates occurring in 2004-05 and the development of large housing stock inventory in the United States and falling housing prices, then all of the sudden the models that did not incorporate credit risk very well did not lead to the right pricing of the structured products.
You are right that structured products led to the global recession in the sense that they were sold internationally. Therefore, any risks in the United States were passed on to other parts of the world as well. We saw it in Canada with asset-backed commercial paper, which was our problem. In Europe we saw, in the summer of 2007, a German bank going under because of structured products that it was holding from the United States.
The difficulty with financial regulation in the future will be how to ensure that people price risk properly and do it in a way that you get the correct and prudent behaviour that is in markets. That is why I think it is more along capital adequacy ratios, et cetera, that we have to do it.
Let me make the point that the framework in financial markets is that you want to ensure people have trust and confidence in financial markets. The way you do that is that you must have the good players separating themselves out from the bad players. They do that by the actions they take in financial markets that indicate that they are exhibiting the appropriate behaviour and that the bad traders and bad players in the market end up not looking very good. We do that through covenants. There are many things institutionally that we put into markets that allow that separation; debt covenants and other things such as that.
The role of government regulation is to ensure that you enhance that separation of the good from the bad. Otherwise you will get a breakdown of markets, as we saw last year. That has severe impacts on the world economy. Government regulations that actually make it easier for bad players to mimic good ones actually undermine confidence and trust in financial markets.
Let me give you examples. If you have deposit insurance that is not risk-related, then bad players can come in, issue all sorts of deposits, and they can be investing in very risky assets. In the end, it is the taxpayer who picks up the cost of that. That is why I think deposit insurance should be risk-related and premiums should be based on the risks being held by financial institutions in terms of their assets and activities.
If we put in policies such as bank bailouts, as we saw recently, where you keep the same management team and you do not make any other changes, then you are creating a moral hazard problem in the future and keeping some of the bad players around rather than punishing people who mess up. In the United States, the bank bailout was necessary, as it would have created a whole contagion of failures if the government did not support it in some way. It is important that any bank bailout should require a complete change in management or absorbing the institution in another institution, which is what happened to Bear Stearns and a number of other companies. Those are the sorts of actions that should be taken.
The key point is that the financial regulations should make it more costly for the bad players to try to mimic the good ones to separate them out in markets.
Senator Oliver: That would be done through a form of regulation. Do you care to comment on the steps that the G20 is looking at taking in relation to some of these products?
Mr. Mintz: Some of the steps being discussed, such as credit default swaps having a certain reserve similar to the requirement of an insurance company for their insurance, make a great deal of sense. In fact, that would be consistent with my framework for good financial regulation. The bigger issue with financial regulation is how far down the road you go in who you include in the financial regulatory framework. Clearly, everyone agrees that banks are important to include, and other large financial institutions should be included as well.
Going back, capital adequacy ratios make it easier for the good players to separate themselves out from the bad ones. If they do not have a sufficient amount of capital, it makes it too easy for the bad ones to come in and take on risks that are inappropriate.
Senator Peterson: I have one comment on the asset-backed commercial paper. I do not think it is a matter of good players and bad players; it was that the bond ratings were all glowing, and I do not think anyone knew it was in the basket. There was a great deal of toxic debt in there, such as credit card debt. That was a tragedy that some of the good players — as you called them — ponied up and made good on the things they had sold, but others were hurt badly. I would hope that regulations should stop something similar to that. That should not be allowed, and I would hope, in your financial regulations, that that would be overseen by someone, maybe OSFI.
Mr. Mintz: With respect to the asset-backed commercial paper incident, I would disagree with you a little on that. Some people did understand the risks involved with them. In fact, it was very clear that the banks may not have had to back-stop asset-backed commercial paper sold in Canada, and they did not hold it. Many people were either misinformed or held them as corporations. In fact, quite significant corporations did so and, as a result, ended up with asset-backed commercial paper that was quite inappropriate.
What did happen, of course, goes back to these economic models. The pricing of that was triple A because people believed the models that were underlying it, including the bond-rating agencies, the central banks and the traders themselves. Therefore, we were all fooled because of that, but not everyone was fooled. Some companies did not hold the paper at all, and they did not. They made the right decision.
I would argue that what we did with asset-backed commercial paper, and the way we responded to it did not help the market at all. It undermined the functioning of the market. We effectively bailed out people who made bad decisions. We froze the market and said that we did not want to apply market rules, which meant people would have to take a hit on their earnings. As a result, we froze the market, and now people are holding paper that will take a long time to get repaid, and we removed the liquidity from that paper.
I am not convinced we responded to that issue in the best way. I would argue that we undermined markets by letting some of the bad traders off the hook, in a sense, for some of their bad decisions.
The Chair: Colleagues, and on your behalf, may I say to Dr. Mintz that this has been an enlightening morning. We have all enjoyed the discussion very much. If you will pardon the expression, we are very much in your debt and hope we can call upon you another time. We very much appreciate your willingness, on relatively short notice, to meet with us today. Thank you very much on behalf of us all.
(The committee adjourned.)