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Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce

Issue 6 - Evidence

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OTTAWA, Wednesday, March 28, 2001

The Standing Senate Committee on Banking, Trade and Commerce met this day at 3:30 p.m. to examine the present state of the domestic and international financial system.

Senator E. Leo Kolber (Chairman) in the Chair.

[English]

The Chairman: Welcome to the Standing Senate Committee on Banking, Trade and Commerce. Our witnesses are from the Bank of Canada. We are honoured to have with us Mr. David A. Dodge, Governor, and Mr. Malcolm Knight, Senior Deputy Governor.

David A. Dodge, Governor, Bank of Canada: Honourable senators, I appreciate the opportunity to be here before your committee for the first time since my appointment as Governor of the Bank of Canada. I am pleased to be here with Mr. Malcolm Knight, the Senior Deputy Governor of the bank.

On this occasion, I would like to talk to you about the bank's contribution to good economic performance, our emphasis on openness and transparency, and our role in promoting domestic and global financial stability. I will then comment on the bank's view of current economic conditions, and of course discuss any issues you may wish to raise.

The Bank of Canada has a commitment to contribute to the well-being of Canadians. This means conducting monetary policy such that it fosters sustained economic growth by creating conditions favourable to rising investment, employment and incomes, and by bringing about a more stable macro-economic environment.

The unique contribution that the bank can make to good economic performance is to preserve confidence in the future value of money. This means that Canadians should be able to go about their business secure in the knowledge that their central bank will do whatever it takes to keep future inflation low, stable, and predictable.

[Translation]

The cornerstone of our monetary policy approach is an explicit inflation-control target. The current target range of 1 to 3 per cent, with emphasis on the 2 per cent midpoint, was established jointly by the bank and the government under an agreement that runs until the end of 2001. An announcement regarding a new agreement to extend beyond 2001 will be made well before the end of the year.

In a world that is subject to all kinds of shocks and with financial markets increasingly more open and globalized, monetary policy actions stand a better chance of being effective if they are more predictable and better understood by the public. That is why the bank emphasizes transparency and effective two-way communication. In this context, I would like to highlight our latest initiative to improve public understanding of the bank's actions. We have adopted a system of eight fixed dates each year when we announce decisions to change or maintain the Bank Rate and explain the reasons for our action in a press release.

For a market economy like ours to function well, there must be widespread confidence not only that money will retain its value, but also that Canada's financial institutions, markets, and infrastructure are sound and efficient. Individuals and businesses must be confident that financial claims can be reliably and efficiently created, held and transferred. This is why the Bank of Canada works closely with other federal and provincial entities to promote financial stability.

The bank focusses its attention mainly on macro financial stability issues. Our contribution includes the provision of liquidity to the financial system, the oversight of major clearing and settlement systems, policy advice to the government on the overall framework for the financial system, and collaboration with other domestic and international bodies that work on financial stability issues.

In an increasingly interconnected world, we also must - and do - work with other members of the international community to promote the development of robust national financial systems and to prevent or minimize the impact of global financial crises of the sort experienced in the 1990s.

Canada has a financial system that is recognized worldwide as being sound and efficient. To keep it that way, we must ensure that as financial markets evolve we evolve with them. The bank will, therefore, continue to work closely with its domestic and foreign partners to strengthen financial stability at home and around the world.

[English]

Mr. Chairman, let me now give you a quick overview of the economy.

Since last fall, most forecasters have marked down their projections of world economic growth for 2001 from just over 4 per cent to just over 3 per cent. While 3 per cent would not be a stellar performance, it would still be quite respectable.

In the United States, positive developments in such areas as employment and housing provide some hope that the end of the slowdown there may not be far off. The bank continues to believe that the pace of economic expansion in that country will strengthen during the second half of 2001, supported by the substantial decline in interest rates and the drawing to an end of the current inventory adjustment. The exact timing of the recovery is uncertain, however, and will depend significantly on how U.S. consumer confidence and business investments evolve.

In Canada, somewhat slower growth had been foreseen for 2001 because, by last summer, the economy was beginning to press against capacity. In fact growth eased in the fourth quarter of last year, and with data for the first three quarters revised, the level of economic activity at the end of 2000 was not quite as high as we had previously estimated. Based on recent indicators, growth in the first quarter of 2001 will be somewhat less than in the closing months of last year.

This slowing is clear in the automotive sector, where there have been production cutbacks in response to excess inventories and somewhat weaker U.S. demand. Activities also eased, albeit from extraordinarily high levels, in electronics and telecommunications, where world production has been running ahead of demand.

These three high-profile sectors naturally attract a lot of attention, especially in parts of Canada with a heavy concentration in such industries. Weakness also continues in some sectors that produce non-energy commodities. However, we must keep a real sense of perspective. There is still considerable strength in most other important areas of the economy. The latest data show that investments in the energy sector are very strong, and except for autos, retail sales are solid. In addition, activity in housing, non-residential construction, and most other service industries remains firm.

Mr. Chairman, when we weighed all of the evidence in early March, the bank concluded that there was, in the near term, room for more monetary stimulus without risking pressures on capacity or inflation. On March 6 we cut the bank rate by another 50 basis points, bringing the total reduction since January to 75 points. These lower domestic interest rates and rising disposable incomes, aided by recent tax cuts, should help to support the growth of domestic demand in Canada in the second half of 2001.

This additional stimulus to economic activity is consistent with keeping the core rate of inflation in Canada close to 2 per cent - the midpoint of our target range. We see total CPI inflation moving down to about 2 per cent in the second half of 2001, if world oil prices remain around current levels.

All in all, as we look ahead through the rest of this year and into 2002, the bank remains positive about Canada's economic prospects.

Senators, the recent volatility in the exchange rates, both in Canada and in many other countries, has generated considerable public commentary and I would like to say a quick word about that. We have been seeing a strengthening of the U.S. dollar against all major currencies, despite the marked slowdown in American economic growth. Since the rate of exchange between the Canadian and the U.S. dollar constitutes a key price in the Canadian economy, the bank recognizes that movements in the value of the Canadian dollar can be a source of concern to Canadians. I want to assure you that the bank watches market developments closely and carefully assesses the effects of currency movements on aggregate demand and inflation in Canada.

In closing, Mr. Chairman, let me emphasize two points. First, although we expect reasonable growth to resume in the second half of this year, there are risks and uncertainties attached to this projection. These risks stem mainly from global, and especially U.S., developments. Although a moderation of U.S. demand was expected, as I said before, the slowing has been more abrupt than anticipated. While we expect reasonable growth to resume in the second half of 2001, there is a question of just how quickly the necessary adjustments in production and inventories will be completed in North America.

Second, Canada's economic fundamentals are sound. In fact they are the best that they have been in nearly 30 years. Canada continues to benefit from a climate of low, stable, and predictable inflation; Canadian governments are running budgetary surpluses; Canada is running a record trade surplus; federal and provincial governments are reducing their public debt; Canada is reducing its net foreign indebtedness; and there has been a surge in investment in equipment and technology that is essential for rising productivity and improved standards of living. These strong fundamentals should operate in favour of the Canadian dollar over time.

Although consumer debt loads have increased, with rising incomes and lower interest rates, households are in a better position to service those debts. Moreover, corporate balance sheets are strong, financial institutions are sound, and credit markets are functioning well.

In summary, Mr. Chairman, I believe that Canada is well placed to weather this period of economic adjustment. Given the uncertainties, however, the bank will continue to monitor developments closely with a view to maintaining the low inflation that helps our economy to achieve its full potential.

Senator Oliver: Mr. Dodge, I congratulate you on your recent appointment as Governor of the Bank of Canada. It is a distinct honour that I know you will discharge with much thought and good judgment.

Normally, when Canadians think about the Governor of the Bank of Canada, the first words that come to their minds are inflation, inflation targets, and interest rates - will they increase or decrease? However, when you look at the mandate of the bank, and of your job, it is of course much broader. You have responsibilities beyond inflation, notably in unemployment, production output, productivity, and the value of the dollar. These are all within the scope of monetary policy.

In your opening remarks today, the only thing you said about public debt is that provincial and federal governments are reducing theirs. I will not talk about inflation or interest rates, but I will direct my questions particularly to the issue of debt in relation to both monetary and fiscal policy.

Perhaps you could explain to us, first, how you coordinate monetary policy with the fiscal policies of the federal and provincial governments. My concern is that we are not doing enough to reduce Canada's massive debt of over $500 billion. What effect is that having on our monetary policy? As you are aware, the debt has fallen relative to GDP from a peak of about 72 per cent in 1995 to 53 or 54 per cent today. This mainly reflects a rising GDP - that is, only about $30 billion of the debt has been paid down to date. That is not much. Would Canada be a more attractive place for foreign investors, and would it help you in setting and managing monetary policy, if we had made more significant reductions in our debt?

Dr. Dodge: Thank you, senator, for your question. I will not give you a complete answer to that question, as I said, on the monetary authority side, and can no longer on the fiscal authority side, as you will well appreciate.

Senator Oliver: Although you did say in your remarks today that you do liaise and work with federal and provincial governments in relation to fiscal policy.

Dr. Dodge: Certainly we do that. I will begin by going back a little and talking about liaison, and then I will talk about the future.

While it was a very painful experience through much of the 1990s, Canadians can be proud of what we collectively achieved over that period in reducing deficits, both at the federal and provincial levels. Indeed, in the early 1990s, combined federal and provincial deficits were close to 8 per cent of the GDP. We now have surpluses in the order of 2 per cent-plus of the GDP. I stress that that effort was undertaken not just by the federal government, but by provincial governments as well. That hauled us back from the nervous position that we were in in the early 1990s. Thus we have made much progress.

As for the liaison that I mentioned, the Minister of Finance and I talk frequently, not necessarily every week, but certainly at least three or four times a month. Since I have been governor, I have been in contact with three provincial Finance ministers, and when I have the opportunity to travel across Canada, I will be in touch with the others.

The bank staff remains in close contact with the Department of Finance, and certainly the major provincial ministries. We maintain close ties because, obviously, it is important that monetary and fiscal policies are made while cognizant of what other authorities are doing. That dialogue is extraordinarily important and we continue it at all levels at the bank.

Looking forward, which is important, 10 or 15 years to the time when some of us who have little hair will no longer be in the labour force, we will be entering a period when we will experience a larger percentage of our population moving out of that labour force.

In order to prepare for that period, it is quite important that all governments deal with the overhang of public debt from the 1970s and 1980s, but not all necessarily in one bite. It is important over the decade ahead that governments, as is practical and feasible, continue to reduce their levels of indebtedness. Of course, that takes some pressure off the monetary authority in terms of controlling inflation. We do need concerted policies when dealing with inflation. That is the reason for the entente between the government and the Bank of Canada with respect to inflation targets.

Senator Oliver: Is the current plan reducing the debt fast enough to satisfy the concerns that you have about control of monetary policy?

Dr. Dodge: Senator Oliver, I think that it is important that we seize the opportunities in periods of strong economic growth. The government should use periods of strong economic growth to continue to make further progress in debt reduction. That does not mean that each year the debt will be reduced by exactly the same amount, but certainly over the course of a business cycle, progress should be made. Indeed, considerable progress was made over this business cycle. I expect that considerable progress will be made in the future.

There is no specific number that one could say is the right amount of debt reduction. Clearly, the structure of government spending and taxes, for which I am no longer responsible, is extraordinarily important.

Senator Oliver: Currently, we are spending around $42 billion a year just to service the debt. You seem to be in a mode of reducing interest rates. If that were to change and interest rates began to rise by 75 basis points, how would that affect the amount that we must pay out on an annual basis to service this debt if we do not reduce it any faster than we are doing?

Dr. Dodge: Senator, it would be more appropriate to pose that question to fiscal authorities. We have tried, over the last seven or eight years, to lengthen the term structure.

As you will recall, in the early 1990s, we had a short-term structure of our debt because we had gone through this period of high interest rates and had not wanted to take on long-term debt. We have lengthened that considerably over time. Thus the Government of Canada, and indeed the governments in most provinces, are not nearly as exposed to rises in short-term interest rates as they were as recently as seven or eight years ago.

The degree of volatility in that expenditure on public debt, which was enormously high in the late 1980s and early 1990s, has been reduced considerably. They report the sensitivity in the back of the budget document each year. It was $2.5 billion dollars per point of interest; it is now $.8 billion per point.

Do not hold me to those exact numbers. However, that has been the strategy. There is a debt strategy report published each year, as you know. That is a good strategy, although with interest rates down now, some people are saying that perhaps it should not have been done. However, it was extraordinarily important, and it does mean that we are less exposed.

Senator Kroft: Mr. Dodge, I add my welcome. You follow in a long line of great public officials in your current position. I have no doubt whatever that you are going to live up to that tradition in a great way.

My question relates, not surprisingly, to the question of the relative exchange rate with the U.S. dollar. Various experts that we have had before this committee recently, and most notably your predecessor, have tended to focus on the problems of the Canadian dollar in terms of commodity prices, relative interest rates, and other elements from which a causal effect could be drawn.

Many of those issues, including the fundamental strength of our economy, would appear to have been reduced in their impact, and would appear to have given us reason to be more positive about the Canadian dollar. Yet the dollar seems to be continuing in a situation of chronic weakness. I note your comments, and I am conscious of the fact that we are talking about it relative to the U.S. dollar, and not to the rest of the world currencies with which we trade. The American economy is obviously so overwhelmingly important to us that it imposes itself on us in a way no other currency does.

I would appreciate some further comment from you on the chronic weakness of the Canadian dollar against the U.S. dollar. In view of its enormous importance to all Canadians, and to Canadian business, might we expect this to continue? Are there any indications that this will not be a continuing condition?

To save a further intervention, I will add another question. Would you comment on the implications for productivity and the Canadian economy, and on whether or not Canadian manufacturers and service industries are taking cover under the protection of a weak dollar in their exporting activities?

Dr. Dodge: This is an extraordinarily important issue and one that, as you will appreciate, occupies a lot of my and Mr. Knight's time, as it occupied the time of my predecessors.

First, I reviewed the testimony that Gordon Thiessen gave here last year. I would fully associate myself with what he said. Commodity prices, in particular non-energy commodity prices, are important.

If we go back over the last 30-year or 40-year history, it is absolutely true that, whether you do econometric modelling or whether you do things by eyeballing, the prices of non-energy commodities has played an important role in the fluctuations in the Canadian currency.

While we produce and trade much more non-commodities now, total commodities, including trade in energy-related commodities, still represent something in the order of 15 per cent of GDP. That is still a factor. The weakness in pulp prices, as I am sure you are aware, senator, does not make it terribly easy in certain parts of the country.

We have done a lot in Canada, as you indicated, to put ourselves in a much stronger position. One would have hoped and thought that through being in that stronger position, we might have seen the Canadian currency appreciate against the U.S. currency.

I cannot totally explain the reasons why that has not happened. However, the main point is that the U.S. currency per se, in these times of financial turbulence - since the peso crisis of 1995 and again since the Asian crisis of 1997 - has served as a refuge for capital around the world, first in equity markets, and then, in times of real stress, in fixed-income markets. This is not a unique phenomenon. Canada is a neighbour of the United States, so it has a greater impact on us. That has probably played the major role, certainly since 1995, in what has occurred.

Will it continue? Well, over the long haul, through keeping our inflation low, sticking to our inflation targets, running sensible fiscal policies, and through the dint and energy of Canadians investing and working hard in Canadian businesses, we would expect to see an appreciation of the Canadian currency relative to the American currency. Markets move, and they often overshoot. We have seen many instances of that. One cannot reliably predict when individual investors will move money in such a way that we will foresee that appreciation, or, rather, that we will see the relative value of the U.S. currency against all other currencies begin to decline. I will not attempt to give you a date on that, other than to say that the fundamentals, as long as we keep our inflation down, point to a stronger Canadian dollar vis à vis the U.S. unit.

In respect of the implications for productivity, that is a tricky question because one has to ask, "for whom?" Obviously, for an individual such as Ted Rogers, who has to import the equipment that he uses in his business and some of the content in his programming, the rise of the U.S. dollar relative to the Canadian dollar makes life tougher, and puts a great deal of pressure on him to be more productive.

In other industries, the decline of the Canadian dollar may offset somewhat the decline in real product prices, especially in the non-energy commodity area. It is important, however, to note that Canadian businesses strive extraordinarily hard not to just get by, but to grab market share in their particular markets and to compete around the world. It is that drive to grow and to be the best that is the fundamental basis of productivity gains. Therefore, while the change in the value of the Canadian dollar relative to the U.S. dollar affects some of the relative prices and some of the relative pressures in different industries, it is fundamentally the drive of Canadians to compete and to be the best that assures productivity gains.

Malcolm Knight, Senior Deputy Governor, Bank of Canada: I will add one point on productivity growth and its implications.

The U.S. economy recovered more rapidly from the recession of the early 1990s than our economy did, for various reasons. Beginning before the mid-1990s, they had strong increases in total investment and particularly in machinery and equipment investment. That was associated with strong technological gains and with very rapid productivity growth, which has persisted over the last four or five years in the United States. That was strong relative to all other countries. That created strong earnings growth in the United States and an incentive for investors all over the world to invest in U.S. capital. That is one of the reasons why, as you yourself said, senator, the U.S. dollar has been strong relative to all currencies. In fact, even in the fourth quarter of last year, when economic activity growth in the United States slowed down significantly, productivity growth was still over 2 per cent annually. They have been experiencing very strong productivity gains.

We have also seen quite a strong increase over the last four or five years in our levels of investment, including investment in machinery and equipment. Relative to many other countries, we believe that we are in a strong position to see future, stronger productivity gains.

Add that to the fact that the U.S. economy now has quite a large current account deficit relative to GDP - in the order of 4 per cent - whereas we have a surplus. These factors should operate in favour of the Canadian dollar over the longer term.

Senator Angus: Governor Dodge and Deputy Governor Knight, I welcome you and congratulate you on assuming these positions. I hope that you will be here often to share with us your views on this delicate economic situation that we are living through. It seems to change on an hourly basis.

Governor, I will explore with you your views on the question of consumer confidence, which I believe is a subject dear to your heart.

Please enlighten us about the term "consumer confidence" and its definition for economists and experts in the field.

Dr. Dodge: Consumers have a considerable amount of discretion in how much of their income they spend in any given year. They have less discretion than we might prefer, but nevertheless they have a considerable amount.

From a pure economist's standpoint, if consumer confidence is high, then they are likely to spend a higher fraction of their income in the current year. If consumer confidence is low, they are likely to put more of their income under the mattress or in the bank for a rainy day. While consumer households may usually spend approximately 92 or 93 cents of every dollar that they earn, and save seven or eight cents, if confidence is high, they might spend 96 cents of every dollar that they earn. If they lose confidence in the future, they may only spend 89 cents of that dollar earned. That creates huge swings in final demand.

Senator Angus: We hear much these days about the consumer confidence index. Yesterday we heard some rather optimistic reports from the U.S. - surprising perhaps - about the U.S. consumer confidence index. Do we have - and I believe we do - a consumer confidence index here in Canada? If so, what is it?

Dr. Knight: I will answer that question.

There are similar indices calculated in Canada and the United States. The one in Canada is called the "index of consumer attitudes." It came out earlier this month.

It is a survey. It asks questions such as: Do you think that this is a good time to buy a major capital good? Do you think your financial position will be better or worse in six months than it is now ? We ask consumers a set of specific questions, and on that basis, build a so-called "index of consumer confidence."

It varies a lot from quarter to quarter in Canada. In the United States, it is a monthly index. We saw a slight weakening in the first-quarter index in Canada, which was published several weeks ago. We saw a slight strengthening, but much more than the market was suggesting, in the consumer confidence index in the United States yesterday.

These are volatile movements. Both indexes remain at a relatively high level. We have seen some decline in Canada, as I said. However, on the other hand, retail sales in Canada have remained strong. Housing demand has been strong; non-residential construction has been strong.

There are some current uncertainties, and the variability in these numbers is a reflection of that.

Senator Angus: I understand that you folks at the Bank of Canada track the Canadian consumer confidence index.

Dr. Dodge: We do not produce it, but we read it.

Senator Angus: It is an important index for you?

Dr. Knight: Yes indeed.

Senator Angus: At the present time, is it in decline in Canada, in your view?

Dr. Knight: It has experienced two quarters of decline - the fourth quarter of last year and the first quarter of this year. As I said, it remains at a high level. The level is perhaps five points higher; it is around 109 currently. The number does not mean too much, but that is a little more than 5 per cent higher than it was when we had weak consumer confidence in late 1998, for example.

Senator Angus: What you have said so far is helpful. You said in your opening remarks that the overall direction of our economy and our economic well-being is a key element of your mandate. You should contribute to the economic well-being of Canadians, and basically I interpret that as maintaining the confidence levels as high as possible.

I have listened to the questions of my colleagues about the low price of the Canadian dollar, consumer debt, and automobile production, in particular. You listed several of the items that are down in Canada, including non-energy-related commodities.

The tenor of your opening, Mr. Dodge, seemed to be optimistic. I had a sense of well-being as a Canadian, listening to you. I will read to you three or four recent headlines from the last few days. "North Americans are snoozing towards disaster, economists warn" is from The Ottawa Citizen. "Market slide erodes confidence, investors lose billions, as TSE and other markets slide" was in the Hamilton Spectator. Another headline read: "Time for a wake-up call. Now is not the time to spend like there is no tomorrow, economists say." "Economists grow gloomier" was a headline in The Globe and Mail yesterday.

Are we snoozing towards a disaster? I realize that it is part of your job not only to help maintain confidence, but also not to say anything that might tend to erode that confidence. I certainly do not want to engender that kind of an answer from you. I want to put to you that Canadians are getting deeper and deeper in debt, and faster than their incomes are growing. All the data seem to indicate that.

I am only wondering if perhaps the Canadian economy is currently on shakier ground than indicated. Is future growth more in question perhaps than you are telling Canadians?

Dr. Dodge: Senator, I think we should be clear. Our job at the bank is to give the straight goods, to tell the story as best we see it. I do not think that any of us has tried to cover the fact that this current adjustment that started in the fourth quarter of last year is more abrupt than previous adjustments have been. We could discuss some of the reasons for that.

The first quarter of this year, and probably the second quarter, are not going to show good performance in aggregate. Some areas of the country, notably in Southern Ontario, where the automobile industry and production of communications and electronic equipment are concentrated, will feel the adjustment much more heavily than Nova Scotia, Quebec, Alberta, or even B.C.

We have not tried to cover that up. Even the loss of one job is painful, but we are undoubtedly going to see some people in those industries put out of work.

Our view remains very strong that by the time we get into the summer and fall, we will have reasonable levels of growth resuming. It will not be the 5 per cent that we saw last summer. However, it will be more consistent with our longer-term capacity growth, perhaps in the order of 3 per cent or 4 per cent.

That is our view. Indeed, the numbers that keep coming out have not caused us to change that view over the last three months. Some numbers are a little better, some are a little worse, but essentially they are consistent.

There are no guarantees in this world. Far be it for Mr. Knight and I to come here to give a guarantee that will be the outcome, because there are some uncertainties. That is our best view of how things are going to unfold. It will be difficult during the first half, with growth resuming beyond that.

Dr. Knight: May I add one point. It is certainly true that since consumption is a very large part of total expenditure in the economy, it is very important that we watch it closely. It is also important that policy actions be consistent with maintaining consumer confidence. If you look at the recent period, we saw, until the fourth quarter, strong growth in employment and real household disposable income.

In addition, tax cuts were introduced at the beginning of this year that will have an impact on consumer expenditure. There have also been reductions in interest rates, both here in Canada and in the United States, which will create incentives for consumers to purchase consumer durables.

These are all factors that, despite the current uncertainty, should help to underpin consumer spending as we go forward.

[Translation]

Senator Poulin: It is my turn to congratulate you, Mr. Dodge, and to thank you for coming before our Banking, Trade and Commerce Committee so soon after you have been appointed to the Bank of Canada. As you know, your predecessors maintained with our committee a strong working relation. We know that you are going to keep it that way.

This morning, we saw in The Globe and Mail an extremely interesting article saying the Americans personal debt was much higher. Could you give us the Canadian statistics and talk about the impact of personal debt on Canada financial situation?

Dr. Knight: Admittedly, household debt ratio went up gradually from the beginning of the 90s. It is really interesting to note that during all that time the household debt service ratio, in relation to their disposable income, went down. In term of inventories, it is a bit more than it was at the beginning of the 90s. Debt service is down because interest rates are lower than they were. In fact, I think debt service ratio, in relation to household disposable income, is now around 9 per cent. I don't remember exactly, but at the start of the 90s, it was more than 10 per cent.

[English]

Senator Poulin: One of my key concerns since I was called to the Senate is the growing gap that seems to exist between rural and urban Canada. According to the numbers that I received from Statistics Canada and the OECD, we can confidently say that 33 per cent of Canadians live in what we call a "region."

I compared the numbers on unemployment, productivity, and access to goods and services. Is this gap growing? What is its impact on the overall financial progress of the country, and how do you see the bank's role in minimizing the gap?

Dr. Dodge: Senator, on the first question, I do not have the numbers in front of me. However, we have seen, not just in Canada but around the world, that the new knowledge-based economy initially favoured major urban areas. That is true throughout North America. It is certainly true in Europe, and I believe it is true in most countries.

Whether that will continue or not is an interesting question. With the improved and much-reduced cost of communications, the ability to decentralize some of these knowledge-intensive activities is greatly increasing. Initially, they were pulled into the centres, but there is a potential now for them to move out. I am not sure that there is necessarily a dynamic that guarantees that difference will continue to widen over the long term.

The bank's role is to set monetary policy with all Canadians in mind, not any particular group. Sometimes this causes tensions when one area of the country is growing extremely rapidly and others are not. That is the nature of monetary union - that you develop policy for all.

We have little role to play in diminishing that gap, if you will, through monetary policy. However, obviously, we are extraordinarily cognizant of the different levels of activity across the country, whether between urban and rural areas or between different regions, as we set that policy.

Senator Tkachuk: I will speak to the disparity between the U.S. and Canadian dollars.

Mr. Dodge, as reported in the National Post on March 21, you added after your speech that day that our weak dollar could spur growth. That may mean that we do not have to go as far on the interest rate side, because the two factors set the conditions for economic growth.

Using that reasoning, would a 60-cent dollar be even better for the economy?

Dr. Dodge: The price of the Canadian dollar in terms of U.S. dollars is just that - a price. There is no "right price," but it is a price that equilibrates or flows back and forth across national borders. While I stand by what I said in Montreal, I did not in any way want to imply that a low dollar is good and a high dollar is bad. Rather, if the price of the Canadian dollar falls relative to the American dollar, in reality, relative to all currencies in the world, the decline is not as great as it appears vis-à-vis the U.S. dollar. However, if the price changes, that does have implications for the prices of consumer products here in Canada, and ultimately, of course, for the overall index.

Thus, when we have a weakening Canadian dollar, given our focus, which is always on maintaining consumer price growth in the order of 2 per cent, then it means that there is perhaps less room for us to reduce interest rates to continue to achieve a level of economic activity that is consistent with a long-term rate of growth of capacity in the country. That is what I was trying to say. I did not have the opportunity during that speech in Montreal to use as many words to explain the point as I have used here today.

Senator Tkachuk: The concern is that Governors of the Bank of Canada have come before the Banking Committee, and have responded to reporters' questions. They, I should not say, almost believe the situation that we are helpless against the American dollar. In reality, our dollar has declined since the 1970s against the American dollar, even though there have been short spurts up and down - overall it has declined. The American dollar is strong. We share a common border, and actually the difference between our countries is a line - the 49th parallel. We share equal resources and so much else with the Americans that we cannot compare ourselves to Australia, New Zealand, Bangladesh, et cetera. What policies could the bank adopt that would increase the value of our dollar? What could the bank do if it were indicated that there was concern about the dollar vis-à-vis the American dollar? What could you do? What could the bank do?

Dr. Dodge: Senator, the textbooks would say that we could raise interest rates to the roof so that everyone, everywhere in the world, would want to buy Canadian-dollar-denominated assets in order to achieve a higher return.

Textbooks would tell us that that might well have an effect over time. There have been times when that has indeed been the case.

Fundamentally, our position over time will be improved by that with which we have been struggling for a number of years. We must keep inflation down, raise our productivity, and achieve high rates of employment. As Senator Oliver pointed out, we have moved our net international indebtedness down to a level that is now certainly approaching the low levels at the beginning of the 1950s.

All of these things bode well over the long term. In the very short run, movements on the capital account will move the value of any currency around. Mr. Knight pointed out earlier that we have had capital movements from all countries into the United States, which has pushed up the external value of the U.S. dollar.

All currencies have moved down sharply against the U. S. dollar since 1995. I chose 1995 because that was the time of the peso crisis, and we have had several international crises since then. Our currency is now valued at about 64 U.S. cents. In 1995 the French franc cost 20 U.S. cents; it costs 14 cents today. In 1995 it cost 70 cents to buy a mark; it costs 45 cents today. It took 85 cents to buy a Swiss franc; it takes 58 cents today. It took $1.07 to buy a hundred Japanese yen; today it takes 82 U.S. cents.

In fact we have been less volatile vis-à-vis the U.S. dollar and have moved down less than these other currencies. It is important to note that it has been the U.S. capital account that has been driving this.

Senator Tkachuk: I can understand people putting their money in the U.S. over France, certainly over Japan, and certainly over West Germany now because of the economic challenges they faced after the reunification with East Germany. You are saying that you cannot do much at the bank. Is there anything that the Government of Canada could do to strengthen the dollar? Are we helpless?

Dr. Dodge: It is very interesting. Let us take the countries you mentioned. When Germany stepped in, in 1989, to deal with East Germany, during that really difficult period -

Senator Tkachuk: Excuse me. I only have 10 minutes. The question is, what can the Government of Canada do to strengthen the Canadian dollar versus the American dollar?

Dr. Dodge: Over the long haul, the Government of Canada can do what it has been doing, and the provincial governments can do what they have been doing. That is, both can try to strengthen the productive fabric of this country through education, appropriate investment in infrastructure, and so on. They can do it by ensuring that the public finances at all levels, federal and provincial, are, as Senator Oliver said, in surplus. A degree of surplus over the next decade is quite important. Governments can strengthen the dollar by continuing to paying as close attention as they are now to the structure and level of taxes.

We are on the right track. We are doing the appropriate things. I do not mean only at the federal level. This has been a concerted effort by Canadians and by virtually all of their governments to deal with the problem.

Senator Setlakwe: I congratulate you on your appointment. I appreciate your optimism with regard to the dollar. I have heard it said that no matter what we do, the dollar will decline because we are no longer a factor in capital investments.

Dr. Dodge: I guess we have all heard lots of things said, Senator Setlakwe. The price of the Canadian dollar in terms of the U.S. dollar equilibrates the flows.

As Mr. Knight said earlier, over the last five years, we have had either a very strong U.S. equity market, or we have had turbulence in world currency markets. The U.S. dollar, at that point, was the one place where investors could get some feeling of protection.

I do not think that what you have heard is a very good explanation of anything, quite frankly.

Senator Setlakwe: I am glad to hear that.

Senator Kelleher: I too would like to congratulate you. I am not asking you to comment, but I do not imagine you shed too many tears on leaving your former position as deputy minister of the Department of Health.

The other problem that you encounter, as you get further down the list of questioners, is that you fall victim to what we call "the bottom feeders" around here.

Dr. Dodge: You are not that, are you, senator?

Senator Kelleher: There are not too many questions left. I am going to depart a little from the discussion so far and move to another topic.

Since 1986, the federal government has, I believe almost without exception, followed the practice of presenting a budget in February, followed by tabling of Estimates. You know this routine quite well. Therefore, Parliamentarians and the people of Canada knew how much money was being raised through taxation, and how the money would be spent.

This year, we have no budget. We are relying on an economic statement developed while the economy was still operating at or near capacity. Could you comment on whether the lack of a budget and not knowing our spending commitments, or whether there will be a surplus or a deficit, impacts on the bank's functions?

Dr. Dodge: Senator Kelleher, the main purpose of a budget was to indicate additional spending or additional tax initiatives that were going to be undertaken over the coming fiscal year. Obviously, we at the bank do a lot of our own work on estimating what the fiscal side is going to look like, both for Canada and for the provinces, because that is a very important factor in the economy.

The government announced the tax regime for the current year last fall.

We know on what basis to do our estimates of revenues. On the expenditure side, we continue with the estimates that were published and with any new announcements that are made. Therefore, it does not impact very much on our ability to carry on.

Senator Kelleher: There would have to be, though, in this kind of situation, a bit more guesswork than normal. Would it not be better to operate with the maximum amount of knowledge?

Dr. Dodge: Marginally - and I say that in all seriousness, senator.We have the main parameters that we need for our task, and as long as no changes come along later, we can do our business perfectly well working from the October statements and the Estimates.

Senator Kelleher: Are there events that, in your mind, could trigger the necessity to bring in a budget?

Dr. Dodge: I believe Mr. Martin has said that he is going to bring in an update that will largely relate to the sort of business we are engaged in all the time. We are trying to gauge the impact of a changing economy on government's fiscal position, and hence the impact that the government is having in turn on consumers and other actors in the economy, and, in particular, what is likely to happen with inflation.

The fact that there has not been a "budget" during February has not made our lives particularly difficult. Finally, I know one important thing, and that is that fiscal policy does not turn on a dime, either at the federal or provincial level. We are experiencing a relatively abrupt, sharp downturn that will be followed by a relatively quick upturn. It is almost impossible for discretionary fiscal policy to have an impact. It is the structure of spending and taxation that, over the long haul, will provide the framework in which individual Canadians will become more productive.

Senator Banks: Senator Tkachuk ran out of time when he was asking you for a list of the things that the government could do to improve the value of the dollar. I wonder if you would make him happy by adding "pay down the debt" to your list.

Dr. Dodge: I told the senator that over the decade, I think that a measured program on the part of our governments to reduce public indebtedness is indeed rather helpful. However, year-by-year, one has to be a little careful. It is not a rigid formula whereby if you pay down $10 billion a year it is nirvana, but if you fall off and only pay $8 billion one year, it is bad. That is not the case.

The objective of the monetary authority and the fiscal authorities is to improve the living conditions and the economic welfare of Canadians. The dollar is a price in that system, and it has very important impacts.

We at the bank target keeping the purchasing power of that Canadian dollar stable by keeping inflation low and predictable. Fiscal authorities must focus on ensuring that the structure of spending and taxes is conducive to rising productivity.

Senator Banks: You said in your opening statement that for our economy to function properly, it needs widespread confidence that money will retain its value.

Dr. Dodge: Right.

Senator Banks: Could we take a message to Canadians today that they ought to have confidence that our money will retain its value?

Dr. Dodge: They ought to have absolute confidence that year-by-year, core inflation is going to be kept to 2 per cent, and over the longer haul, that the total CPI is going to grow by about 2 per cent. They ought to have total confidence in that. That is our job. That is the undertaking that the Canadian government and the Bank of Canada have agreed on, and as I said, we have to renew that undertaking.

The precise details of that undertaking will be defined well before the end of the year. However, that is the track that we are on and we will do everything in our power to stay on it.

Senator Banks: We can take back a confident message.

I would like to go to a different tack now. You were talking about the international movement of money. It is a wonderful thing that people can make money by speculating on currencies internationally. However, economies have sometimes been ruined in raids that have taken place.

Parenthetical to our discussion, but with respect to a potential raid on the Canadian currency by speculators, would you comment in particular on the idea of the "Toban tax," which is a tax, as I understand it, on international currency speculation? Do you think that if it ever came to fruition, Canada ought to be interested in subscribing to such an international convention?

Senator Meighen: That is not the Brian Tobin tax, is it?

Senator Banks: No, it is not. It is spelled differently.

Dr. Knight: I will answer that question.

Canada has had a flexible exchange-rate regime for most of the period since 1950. The movement to a flexible exchange rate allowed us to be practically the first country, other than the United States, to remove capital controls. The country has benefited tremendously since then from that fact.

We have a clear monetary regime, as the governor said, to maintain low and stable inflation, and that means that we have a flexible exchange rate. Countries that experience serious speculative attacks often have fixed exchange rates and have difficulty maintaining confidence in those rates. Several European countries experienced that problem in the early 1990s. It is currently happening to one or two Latin American countries. As you mentioned, it happened to Malaysia and Indonesia and other countries in 1997 and 1998.

In conditions where capital is very mobile all over the world, it is not easy to maintain a system with a hard fix of the exchange rate. That is not what we have, and we think our system works very well for that reason.

Senator Banks: Your advice would be that we should not subscribe to this tax? The Toban tax does not prohibit currency speculation, it simply taxes it.

Dr. Knight: It has been our experience that if we maintain a monetary policy of achieving low and stable inflation, and if that is credible, we are not likely to run into situations where we will have the kind of problem that you suggest, from speculative attacks on the currency.

In our situation of tight integration in production and finance with the rest of the North American economy, throwing sand in the wheels of financial movements that are necessary to firms for their production and trading processes does not seem like a good idea.

Senator Meighen: Following on Senator Angus's initiative in asking you for a basic definition of "consumer confidence," I would like to know how you define a "store of value." I will elaborate.

In economics 101 at McGill University, I was taught the usefulness of a dollar as a medium of exchange and as a store of value. Certainly, the Canadian dollar is a medium of exchange within Canada, but nowhere else that I know of.

Can you tell me what "store of value" really means? If you look at it simply in terms of its value vis-à-vis our overwhelmingly large trading partner and its currency, its value has tended to decrease rather than increase during past years, as has been pointed out by a number of senators. Is it a diminished store of value today?

Dr. Dodge: Our commitment is that we will keep inflation at 2 per cent, which means that as a store of value, the dollar today will buy about 98 cents worth of goods and services next year. It will buy about 96 cents the following year, and so on.

Senator Meighen: Is that in Canada?

Mr. Dodge: I refer to the basket of goods that Canadians consume.

Senator Meighen: I am not sure that I fully understand it. I would have to spend that in Canada in order to have 98 cents of buying power, would I not? If I tried to spend it in the United States, it would not be 98 cents, would it?

Dr. Dodge: We consider the basket of goods and services that, on average, a Canadian consumes in one year. That is the basket against which we price.

Senator Meighen: In The Globe and Mail on March 19, there were comments made by Peter Morici, I believe, of the Washington-based Economic Strategy Institute. He talked about the Fed in the United States and said that they are trying hard, but monetary policy is limited on the upside, and they have done just about everything they can do.

In Canada, an adviser to the Minister of Finance, Paul Martin, was quoted as saying that from this point on, monetary policy will have to carry us. I suppose that they are both suggesting that the ball has been passed to you. Forgive me if I overgeneralize, but your message seems to be that if the onus is on you, we should expect to keep our inflation low and continue with debt reduction on the fiscal side. In other words, "steady as she goes," and if we do that, barring some disaster, the universe should unfold as planned and we should improve, because our fundamentals are right. Is that a fair statement?

Dr. Dodge: Yes, that certainly is a fair statement. Targeting inflation provides a useful guide for what we ought to do from a monetary policy point of view. When we press against capacity, or push prices up, in Canada, then we receive the signal to tighten up and try to keep demand growing at about the rate at which we can fulfil it. That happens so that we do not have an explosion of prices.

In a period where demand is growing much less rapidly than capacity, as it has since the fourth quarter of last year, we receive the appropriate signal to act so that Canada can reach that 2 per cent inflation target. We ought to be easing monetary policy to provide a bit more stimulus.

Thus, having the inflation target actually gives guidance to the bank on its direction in terms of monetary policy. As the gap between capacity and where we are opens up, we realize that we should ease rates, which is why we have come down 75 points over the last two fixed action dates.

Senator Meighen: That leads me to my next question, which is an area that has not been mentioned. You made some favourable noises about governments reducing public indebtedness. Is that correct? No one has talked about putting more money in the hands of the consumer. If you want to raise demand levels, one way is indeed to reduce interest rates, and the other is to put more money in consumers' hands.

As the Finance Minister has told us, one way to accomplish that is to reduce taxation levels. Would you agree, and would you support taxation levels being reduced in order to put more money in consumers' hands and raise the demand levels? Is that a legitimate way to do it?

Dr. Dodge: First, it was extraordinarily good timing that Canadians have been experiencing a major tax reduction since January 1, 2001. That is undoubtedly helpful.

In general, whether on the spending or on the revenue side, it is difficult to juggle the numbers in an effort to fine-tune the stimulus that you are providing to the economy, either for investment or for consumption. Generally speaking, governments have been trying to deal with this by creating the appropriate structure of revenue collection and spending that will encourage growth over the medium term. That is extraordinarily important.

In his comments, Peter Morici said to be careful in trying to juggle things around just for the short term. If monetary authorities are doing the right thing, they will provide at least some of that movement to act appropriately. Be careful about what you try to do from the fiscal policy side for short-term purposes.

Senator Meighen: I understand. However, I also heard you say earlier that the two are intertwined - fiscal and monetary policies. There is a need to work together.

Dr. Dodge: Absolutely.

Senator Meighen: All of us have appreciated the frankness and candour with which you have answered our questions. However, your office, if I may say so, has a reputation for "putting the hand outside the window to see whether it is raining " before making pronouncements. More so than does your counterpart in the United States.

Mr. Greenspan has entered the debate quite openly. He does not call the shots in law, but he did indicate that he thought that a tax cut was an advisable step to take. He made favourable noises about a tax cut.

I am not trying to trap you or get you to say anything that you do not think you should say, but do you not think that if you believe that a tax cut is in the interests of the economy of this country, that you should say so?

Dr. Dodge: Senator, I think it is extraordinarily important for a governor of the central bank to stick to his or her knitting. We would argue that it is important to have a taxation structure that encourages economic efficiency and economic growth. I do not think that there is anyone who would disagree with that proposition.

As I said earlier, the structural reduction in taxes that was announced last fall, and that have been announced over time by a number of provinces, are extraordinarily helpful. Obviously, to the extent that governments can reduce debt-service costs over the next decade or decade and a half, that will give them more room both to reduce taxes and to meet the expenditures of us "grey hairs or no hairs" when we become a larger fraction of the population. That is extraordinarily important. It gives everyone confidence that things are well managed.

I am not here today in my old capacity, when I did come in front of you to talk about taxes. In fact we had quite a number of sessions around a similar table on that issue. I am now on the monetary side, and I think I will just leave it at that.

Senator Meighen: Mr. Greenspan is too, and I hope you will follow his example.

The Chairman: Governor, almost everyone has a follow-up question. If we were done by 6:00 p.m., would that be okay with you?

Dr. Dodge: Yes.

The Chairman: Everyone will ask one question, please, because it takes at least 5 minutes per question, which means a further 45 minutes.

By the way, if you want to forego your question, that is fine.

Senator Oliver: My question is about inflation. One of the things that concerns me about your entire presentation is that you have basically said that the cornerstone of everything you are doing in terms of monetary policy is inflation control.That is a shock to me.

You say that the inflation controls that will be the cornerstone of your policy as governor are the same as for the previous governor. You said that the present policy will run out in 2001, and that an announcement regarding a new agreement to extend beyond 2001 would be made well before the end of the year.

I have always been of the impression that Governors of the Bank of Canada have an obsession with inflation at the expense of many other things that are important to our economy. What would be wrong with the Canadian economy experiencing 4 per cent inflation, for instance? What would that do to employment and the unemployment rate? Why are you so fixed on this inflation rate of 1 per cent to 3 percent?

Dr. Dodge: I will begin, and my colleague will carry on while I get another cup of coffee as the price of staying until 6:00 p.m.

It is the anchor of our policy for several reasons, senator. First, over the longer haul, in order for financial markets, indeed all markets, to function efficiently in the allocation of goods and services and to generate the sort of growth in productivity that leads to growth in incomes for us all, there has to be confidence that they can use, to use Senator Meighen's words, this unit of account, and that that unit of account in fact is a solid ruler and not a rubber band. We have observed across time and space what happens when that confidence is lost. It is not pretty. Indeed, we have to only think back to the experiences of the 1970s in our own country.

Senator Oliver: What would be wrong with 4 per cent inflation?

The Chairman: One question only.

Dr. Dodge: What is the number that one picks? Is it zero, is it 2, is it 4, is it 22?

The answer is that a number very close to zero is probably the best. There could be debate about whether "very close to zero" means one, two, or two and one-half. There can be debate on that sort of range. We have been doing much technical work looking at that. We will be sitting down with the government in the very near future to review it.

It is also clear that when one gets up to larger inflation targets, not disinflation targets, there is greater uncertainty. Remember that when we started off, they were called "inflation reduction targets." A number of other countries that are coming down from very high rates of inflation are trying to get their rates down. Those higher numbers leave a greater degree of uncertainty.

If one wants to have the maximum certainty, one needs a low number with which one sticks. If you are asking me if there is a big difference between one, one and one-half, two, or two and one-half in terms of the quality of the results and the functioning of markets, the answer is, probably not much. When one starts to get up into numbers that are a little higher, although still well into single digits, the experience is probably not quite as good around the world. My colleague is the expert in looking around the world.

Dr. Knight: I do not know how much I can really add to what the governor has said. Let me make several points.

It is not an obsession with prices. We only have one policy instrument, so there is only one objective that we can achieve with our monetary policy in the long term. We do have a responsibility to the Canadian people to maintain stability in the value of money.

Ordinary families must make plans for savings over long periods of time. They must predict the cost of sending their kids to college and of retirement. If people do not have confidence in the value of their savings in the future, it is hard to make those kinds of plans.

Maintaining low and stable inflation is a crucial element in maintaining good economic performance in a real sense. It makes economic decisions a lot less confusing.

As the governor has said, it is not a question of the differences among various low inflation rates. We saw in Canada in the 1970s and the 1980s that higher inflation rates tended to become unstable. I must say that my experience from working in a large number of countries is that those with high and unstable inflation rates get poor economic performance in terms of long-term growth. We do not want that.

Senator Kroft: My question is directed at both Messrs. Dodge and Knight, as economists as much as in your present jobs. I am struck by the language that you use. The word "abrupt" is mentioned often.

I watched Mr. Greenspan's appearance before a similar committee hearing for a couple of hours. In my mind, and I think often in the public mind, "abrupt" is close in meaning to the word "surprise." I do not know if they are synonymous.Perhaps it is an economist's word for surprise.

My question is about mechanics. Based on the power of computers and information gathering strategies that we have now, hopefully we are getting smarter. With the ability to gather, organize and study data, we should have more capacity to predict.

Are we progressing significantly with our models? How great is your confidence in your ability to predict today, compared to what it might have been 5, 10, or 20 years ago? Are we getting better at predicting? If we are, then it would seem to follow that the decisions that we make based on those predictions should be more reliable.

I would appreciate your comments.

Dr. Dodge: I will start, and then I will leave the hard lifting to my colleague here.

Let me deal with the word "abrupt" first. We saw in past slowdowns that changes in sales and orders took quite a while to produce changes in output and employment. In the 1970s or 1980s, or the recession of the early 1990s, we found that while sales and orders fell off, it took 1, 2, 3, or 4 months before firms reacted and began to adjust their production. It took even longer for them to adjust their employment. When a downturn came, things slid down with a big inventory overhang that took quite a while to work off.

Recessions tended to be, to use current language, "U-shaped," or even banana shaped. We know that firms react faster today. When Senator Angus does not walk into Wal-Mart to buy things, it is reflected right away in Wal-Mart's orders to its suppliers. The suppliers, as soon as they see those orders fall, react much more quickly to reduce their employees' working hours and their inventories of parts and raw materials.

The process of adjustment has been tremendously compressed. It happens very rapidly. People can get caught quite quickly by these changes.

Second, corporations and chief financial officers, and indeed small businesses, are much more conscious today than they were 15 or 20 years ago of the need to adjust quickly to maintain earnings. Indeed, many of our economist colleagues out there as analysts in the stock market punish any CEO or CFO who does not react extraordinarily quickly.

We all thought 18 months ago that there would need to be something of an adjustment. When an adjustment comes, it seems to come very quickly.

I will use the example of automobiles. We have seen a sharp adjustment in the overhang of automobiles in January and February 2001. One might hope, actually, that that inventory cycle will be considerably shorter than it has been in the past.

We are seeing a painful and quick adjustment being forced on telecommunications suppliers for the same sorts of reasons. That is what I meant by "abrupt."

On the other hand, when Senator Angus goes in and buys that thing from Wal-Mart, right away that is going to be transmitted to the supplier, who will have to jack up production. That will have its effects quickly back along the line, which is why a lot of us have said that we think that this adjustment is likely to be V-shaped rather than the more traditional U-shape.

Using the word "abrupt" has a fairly specific rationale. It stems from what we believe is an understanding of a rather different process that exists in the economy.

Having taken the easy question, I will turn to my colleague for the more difficult one.

Dr. Knight: I guess the governor has just defined a "store of value" as a place where Senator Angus can find lots of things to buy.

I think that the question is an excellent one. It is one that we confront every day. We believe that in following a policy of maintaining stable inflation since 1991, we have helped to give Canadian business people and households more certainty about the stability of their money. That helps them have greater certainty about what their incomes and assets will be over time. That is an element of increased certainty.

At the same time, as the governor said, we are living in a world of constant, very rapid innovation, not only in the financial markets and in high-tech, but even in industries which have been traditionally thought of as low-tech. Inventory management has become much more effective than it was even a few years ago.

Fundamental uncertainties are created, and we as central bankers must try to assess the implications. We must assess the implications for demand, output, and employment. It is not an easy job.

We have many models and we work very hard on them. They help us, but as the structure of the economy changes as a result of all this innovation, it is hard for the models to keep up. Although the objective of monetary policy is clear, and does help to give an increased sense of certainty and to make better economic decisions, the process of making monetary policy is complicated. It is particularly complicated at times like these. We have gone through a period of fairly strong, steady growth for some years. Now the situation looks like it is changing and everyone must reassess what that means.

Senator Tkachuk: Governor, I did not intend to cut you off when you were telling me about those other things, but we only had 10 minutes and I wanted to get your answer to what a government could do to halt the fall of the dollar.

We have had the same message from former governors of the Bank of Canada - that we have a strong economy and the fundamentals are good - but the dollar keeps dropping. Our governments are doing all of the things that you said they could do, and our dollar continues to drop. I have my own ideas about the reasons, but they are not important to this area of the discussion. Through it all, as the dollar has dropped, the message from the Bank of Canada has been that we have many issues to deal with and sooner or later it will improve.

When will you become concerned about the dollar? What if it dropped to 60 cents or 59 cents? We are accustomed now to the 60 threshold, and before that there was the 70 threshold. Would the bank be forced to take any action, or will you say that everything is being done that can be done and let it slide? When will you become concerned?

Dr. Dodge: The United States is running a current account deficit of about 4 per cent of GDP, and that has many around the world worried. Their net international indebtedness is up to about 13.7 per cent of GDP. If they continue to run at this rate, they will be at levels where a number of other countries, including Canada, have found themselves in great difficulty. Without some adjustment in that area, we worry that in the future, we will have an adjustment of an extraordinarily sharp magnitude in the U.S. dollar that will be difficult for all of us to cope with.

I worry that we have a U.S. dollar that, relative to all of its trading partners, including Canada, is riding sufficiently high that we will not see the kinds of adjustments that we need in the United States. Indeed, we may end up with many political pressures in the United States to act in a way that would be quite harmful to the world economy overall. That is because U.S. producers are being priced out of world markets by the extremely high U.S. dollar.

As I look ahead, I am nervous about the major economy in the world running such a large current account deficit, relying so heavily on capital inflows from outside of the country, and not experiencing the sort of adjustment that allows U.S. producers to adjust appropriately.

In world terms, and after all we are citizens of the world whether we like it or not, we are not concerned that the economy will collapse tomorrow. However, it could be worrisome unless we see some sort of adjustment process.

From the point of view of domestic policy, it is fair to say that none of us were unhappy with Canada's position before the Mexican peso crisis at about 73 or 74 cents. The peso crisis took us down a step from that. The Asian crisis took us down another step, and these are actually quite discrete steps. None of this really has anything to do with what every Canadian touches and feels - individual productivity, job satisfaction, et cetera.

We certainly do not take any comfort from the fact that during this period of international crises we seemed to be "knocked down a peg" and have not recovered from it.

The assertion that we are happy about this is absolutely not true. There would be a price to pay if we increased interest rates to 12 or 15 per cent in order to create an influx of short-term capital. That price, in terms of employment and economic growth, is one I do not think we would be willing to pay. In fact we are not even sure that it would work.

[Translation]

Senator Poulin: My question is more personal, without being indiscret. "Trust" is a word that keep coming in our discussion today. We can understand from your explanations how complex a good monetary policy must be when you want to keep your goals.

You have been deputy minister in the departments of Finance and Health - two departments which Canadians have a lot of concerns about - you are now Governor of the Bank of Canada, where we have two schools of thought concerning its independance. We all know our boat is sailing on stormier seas than ten years ago or so. Our condition is not so easy and Canadians need to trust both the Bank of Canada and our federal government. There is a need and a desire. As governor, what kind of a working relation will you have with the government? How will you direct your staff to work with government?

Dr. Dodge: We are all interdependants, whether it is the Bank of Canada with the government of Canada, or with Canadian provinces, other central banks, business communities, here in Canada or within international business community. The interdependance is real and that means we must have freedom when we exchange ideas. It is absolutely necessary that I should be able to state frankly our opinion and that our colleagues in the Bank of Canada could do exactly the same.

If we do not try to colour things, if we have a frank and intense discussion, it can lead to better policies, whether monetary, fiscal, economic or social. That is the way I would like to proceed. I am absolutely certain my colleagues would do the same.

[English]

Senator Angus: Governor, this is somewhat related to the confidence issue, and Senator Poulin talked about that too. I would like to take you for a moment into the world of irrational exuberance. Like it or not, and agreeing or not with predecessors in your office and elsewhere, it seems to me that there is a very distinct relationship between monetary policy and the financial markets. Never before have we seen the consumer confidence index in the U.S. go up by 8 points, as it did yesterday. The Dow went up to 260.3 points. Confidence was brimming in the consumer-investors' minds. Then by noon today, it was down by more than it had gained yesterday.

It is scary out there. I am sure that I am not telling you anything you do not already know. A large percentage of Canadians, much larger than it used to be, is investing in the markets. They are in mutual funds. It is all there for us to read.

Focusing on confidence, and on the monetary policy that you advocate, what is the relationship today, in your mind, between the markets and monetary policy? Is there anything you could do to alleviate this roller-coaster ride that we are on?

They were expecting monetary policy to go down 50 basis points. Mr. Greenspan sets it at 50 instead of 75, and the market goes down 300 points. It is mind-boggling. Wealth is being erased from the records, and people are scared.

Dr. Dodge: Senator Angus, that is a good question, and I wish that I could give you an equally good answer. All I can say is that all central banks, monetary authorities, and regulators are asking the same question.

Over the last 10 years, there has been a tremendous development of new financial instruments, a tremendous reduction in the costs of transactions in the market, and an explosion of information available in real time to a very large number of actors. Markets at the micro level have become much more efficient. The cost of transactions is down and the information availability is up.

We could return to Senator Meighen's instructors at McGill, and even at McGill they might have got this more or less right. We have always known that markets work better with improved information. We have seen that with all those improved efficiencies at the micro level, the macro level is measured by volatility. We have had increasing volatility day-to-day, and week to week, through this entire period.

This is the first time that we have seen a big, deep market like the New York Stock Exchange move 3 per cent or 4 per cent in one direction one day, and 3 per cent or 4 per cent back in another day. We have had crashes before with drops of 3 per cent, 4 per cent, or 10 per cent. However, we have not had this sort of hyper, day-to-day volatility.

I think that many authorities, and Mr. Knight can answer this better than I, are struggling with that particular issue. That is not quite the irrational exuberance that you were talking about that drove the NASDAQ up to over 5,000. However, this volatility is somewhat disconcerting, as you say.

Most stocks owned by Canadians are held indirectly through contractual savings plans. Most people, although not all, are savers. They are putting money aside for the future, either the near future to buy a house, or the far future to retire. People are not so concerned about what happens from one day to the next. If you are, you are probably in the wrong market. Indeed, we have some good Canada Savings Bonds that avoid that volatility.

A lot of that washes out over the long haul. Consumer household spending has been relatively insensitive, despite what all of our friends on Wall Street and Bay Street say. Out on main street, expenditure is relatively insensitive to those movements.

Spending is sensitive to expectations about employment and about income. To the extent that those market disruptions feed through into big declines in employment or income, we will see action.

Senator Setlakwe: You did mention, Governor, the currency crises that were a result of the weakening of the peso and what happened in Asia. Were it to happen again, would we react as we did the last two times, or would we do something to stablize our currency if it started to affect us?

Dr. Dodge: I will let my colleague talk about Japan in particular, because the relationship between the yen, the U.S. dollar, and now the euro, formerly the Deutshmark, was a little different from that between either the second-tier currencies like ours or the Australian dollar, or between the emerging market currencies and the U.S. dollar. Mr. Knight is the person who really understands these movements.

Dr. Knight: Japan has had major structural problems in the financial sector that go back a decade. There have been a lot of false starts in restructuring.

We had a situation in the spring and summer of 1999 when the yen appreciated very sharply against the U.S. dollar and other currencies. That did not seem to have many "knock-on" effects on other countries. The yen has weakened sharply against other currencies in the last month or so. This is certainly a reflection of the uncertainties that exist in the economy.

Part of the problem in that particular situation is that economic activity has been weak for some time. The government has been trying to stimulate the economy with strong fiscal stimuli for three years. The result is that public debt levels are quite high, and the strategy seems to have reached the end of its effectiveness. It is not an easy situation to deal with from the point of view of macro-economic policy. Structural measures are needed.

In a number of other economies that you referred to, the problems have been concentrated in the banking and financial systems. Based on independent analyses by, for example, the International Monetary Fund, Canada has a financial system that is judged to be one of the strongest and best regulated in the world. The kind of crises that you are talking about are restricted to those countries that tend to have serious structural problems, particularly in that sector.

Senator Kelleher: Two quarters of negative growth is the traditional definition of a recession. Are we now in a recession, or dangerously close to a recession, or do the so-called "traditional" definitions no longer apply in this up-and-down economy?

Dr. Dodge: That is an arbitrary definition that economists have actually used for quite a while. It is as good a definition as any. We are not in one now.

Senator Kelleher: Are we in danger of slipping into one?

Dr. Dodge: While the first half of the year will be rough for Canadians, we do not believe that it will show negative growth. We are rather positive about the second half of the year, as I said.

The fourth quarter had roughly a 2.5 per cent relative annual growth rate. We were probably a little worse than that in the first quarter of this year, but only a little. We will probably be in that range and continue from that percentage point.

The word "never" does not and cannot exist in our lexicon. However, if you are asking for our best judgment, no.

The Chairman: I will ask a question on behalf of Senator Banks.

Mr. Allan Greenspan was a good professional saxophonist. Governor Dodge, do you by any chance play the saxophone?

Dr. Dodge: No, I do not. You would not want to hear me play the saxophone.

Senator Meighen: Governor, my question has to do with the inflation control target. I believe that you said something a minute ago about a second-tier currency. What is the definition of "second-tier currency"? I was not clear about that.

Dr. Dodge: There were three major currencies in which a lot of trade was denominated: the yen, the U.S. dollar, and the Deutschmark. Now we have the euro. There are a number of other important currencies that are not top-tier, and in that group are the Canadian dollar and the British pound.

Senator Meighen: I have a question on inflation control.

The Chairman: That is a second question.

Senator Meighen: I indicated that my question is about the inflation control target. Governor, what conditions would permit you, or encourage you, in your negotiations with the government to try for closer to 3 per cent? In other words, to change the current emphasis, which is around 2? Senator Oliver asked you a similar question. What conditions would lead you to do that?

Dr. Dodge: This is an analytical question. As you know, there are some analysts out there whose analysis leads them to believe that an operational target would be something closer to 3 per cent, and there are others who believe that it would be closer to 1 per cent. There is always the potential for bias in the consumer price index, so zero might not actually be zero as we currently measure it. However, there are many analysts who would say that, effectively, zero is the right place to be.

These are rather tricky technical issues. There is good reason for some technical debate. Every central bank feels more comfortable with a figure closer to zero rather than farther away from it. If we look at the targets that have been used, the 1 to 3 per cent encompasses most of them. Therefore, 2 is not a bad number in that game. One and one-half might not be a bad number in that game, but I do not think that 3 or beyond, certainly from the range of experience we have and from a technical point of view, would be the answer.

Senator Angus: Governor, I would like to ask you if globalization of the capital and goods markets, which has accelerated and is very real today, has a major impact on how you carry out your mandate. The U.S., as we have seen, is so strong in this regard, and it seems that in a global sense, many economies might be prevented from slipping into recession because of the strength of that U.S. economy. However, I worry about the converse - if the "R word" comes into sharp focus in the U.S., will that drag other countries like ours, that have good fundamentals, into a recession? What are those implications for you?

Dr. Dodge: Strong U.S. demands have been very helpful to Canada as we have tried to deal with some of the problems during the 1990s. It obviously has been extraordinarily helpful for a number of Asian economies, for Mexico, and a number of Latin American countries. There is absolutely no question about that. If the U.S. domestic demand weakens, then that will be a negative.

At the same time, you cannot continue to expect the United States to run current account deficits in the order of 4 per cent. That does not compute over time. Is domestic demand strong enough in the rest of the world to absorb some of what I think must in the end be at least a relative decrease in the role of the United States as a world engine of growth?

Our view is that we have done a lot in Canada to get ourselves into a position where we can absorb that. Indeed, of all countries with a very large trading relationship with the United States, we are probably the best positioned to deal with it. We have a close trading relationship with the United States; therefore we may have a lot with which to deal.

It will not be an easy ride for some of the Asian countries that produce a lot of the actual equipment such as the chipboards, the chips, and all that stuff. Europe is more insulated because a relatively small fraction of its economy is generated from trade with the United States.

We are now certainly in a much better position to ride out a slowdown in U.S. demand than we were even as recently as three or four years ago. However, will it hurt us? Will it hurt others? It is not very helpful.

The Chairman: Thank you very much. On behalf of the committee, I would like to offer our sincere thanks for a wonderful performance from the governor and the senior deputy governor. We appreciate the time and the courtesy you have extended to us, and I hope we will see you again in the not-too-distant future.

The committee adjourned.

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