BoC May Use Inflation to Spur Demand

By Ryan McGreal
Published April 07, 2009

CTV reports today that the Bank of Canada is considering inflation as a tool to spur an economic recovery:

With economic recovery still looking shaky, the next move by the Bank of Canada may be to just start printing money.

The price can be high: devaluation of the loonie and run-away inflation down the road.

But with economies running on empty, central bankers are inclined to focus more on solving the mess at hand than theoretical messes of the future.

Holy printing press, Batman: what could they be thinking?

It turns out that this actually makes sense, given that the global economy is stuck in a liquidity trap.

To explain: central banks respond to garden variety recessions by lowering interest rates to increase liquidity, and this works every time. The problem we're in is that this is no garden variety recession, having been caused in large part by a catastrophic collapse in the unregulated 'shadow banking' sector after the housing bubble collapsed.

Interest rates are already rock bottom and central banks can't set a negative interest rate, which means central banks' ability to respond to the recession by cutting rates is really constrained.

One way around this is to increase the money supply and create inflation. That way, the central bank can lower the nominal interest rate until the real interest rate is effectively below zero, thus breaking out of the liquidity trap.

It sounds crazy, let alone highly unorthodox for an institution exclusively dedicated since the early 1990s to maintaining price stability. Yet it's hard to argue with the logic once the alternatives have been considered.

Paul Krugman has written a more technical explanation featuring the Japan's liquidity trap in the 1990s if you're interested. He concludes:

The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible - to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.

This sounds funny as well as perverse. Bear in mind, however, that the basic premise - that even a zero nominal interest rate is not enough to produce sufficient aggregate demand - is not hypothetical: it is a simple fact about Japan right now. Unless one can make a convincing case that structural reform or fiscal expansion will provide the necessary demand, the only way to expand the economy is to reduce the real interest rate; and the only way to do that is to create expectations of inflation.

Last week, Bank of Canada Governor Mark Carney's remarks on the shadow banking system seem to suggest that he broadly shares Krugman's analysis of this economic crisis. His entire lecture is well worth reading, but the following passage is particularly apropos:

Just as banks began doing what markets traditionally did best, there was an explosion in highly specialized products that required monitoring and continuous access to funding liquidity. More and more of the traditional functions of banks - including maturity transformation and credit intermediation - were conducted through a broader range of intermediaries and investment vehicles, which have been collectively referred to as the "shadow banking" system. Shadow banks included investment banks (in other countries), mortgage brokers, finance companies, structured investment vehicles (SIVs), hedge funds, and other private asset pools.

The scale of these developments was remarkable. During this decade, banking assets grew enormously, to anywhere from one and a half times to six times national GDP in Canada, the United States, the United Kingdom, and Europe. In all countries besides Canada, much of this growth was financed by increased leverage.3 In the final years of the boom, when complacency about access to liquidity reached its zenith, the scale of the shadow banking system exploded. The value of SIVs, for example, tripled in the three years to 2007. The growth in financial activity and the increasingly complex array of financial players have prompted a dramatic increase in claims within the financial system, as opposed to between the financial system and the real economy, which created risks that were difficult to identify and evaluate.

Financial institutions, including many banks, came to rely on high levels of liquidity in markets. In the United States, the total value of commercial paper rose by more than 60 per cent and the ABCP market by more than 80 per cent in the three years before the crisis. In essence, the shadow banking system practiced maturity transformation without a safety net - that is, it was wholly reliant on the continuous availability of funding markets. The collapse in market liquidity that began in August 2007 crystallized these risks.

The regulatory system neither appreciated the scale of this activity nor adequately adapted to the new risks created by it. The shadow banking system was not supported, regulated, or monitored in the same fashion as the banking system. With hindsight, the shift towards the shadow banking system that emerged in other countries was allowed to go too far for too long.

Perhaps Carney also shares Krugman's analysis of how monetary policy can get us out in the short term and buy us some time to put together sensible regulations that will contain the shadow banking system.

Ryan McGreal, the editor of Raise the Hammer, lives in Hamilton with his family and works as a programmer, writer and consultant. Ryan volunteers with Hamilton Light Rail, a citizen group dedicated to bringing light rail transit to Hamilton. Ryan wrote a city affairs column in Hamilton Magazine, and several of his articles have been published in the Hamilton Spectator. His articles have also been published in The Walrus, HuffPost and Behind the Numbers. He maintains a personal website, has been known to share passing thoughts on Twitter and Facebook, and posts the occasional cat photo on Instagram.


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By beancounter (registered) | Posted April 07, 2009 at 23:37:00

Perhaps what we need is some sensible regulations to restrain the actions of central banks, especially the Federal Reserve System.

Much has been said during the current economic "meltdown" about the failure of laissez-faire capitalism. One has to ask though what central planning has to do with a laissez-faire econonomic system. Central planning is what a central bank does. I don't need to list the countries which used central economic planning that resulted in a great deal of deprivation and suffering for their populations.

At least the former communist countries' central planning was done at the behest of their governments. In the U. S. monetary policy is set by a consortium of private banks with only the chairman appointed by the government.

President Woodrow Wilson signed the Federal Reserve Act but later realized his mistake and said "...what have I done?"

Henry Ford said "It's a good thing the average folks don't know anything about the financial system in this country or we would have a revolution next Monday."

Ron Paul, a former presidential candidate, has spoken and written extensively about the Fed and has advocated its abolition. Perhaps we should seriously consider this solution and restore a system of real, honest and sound money, instead of money that is created out of thin air.

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By LL (registered) - website | Posted April 12, 2009 at 01:21:53

This is class war, whether or not it causes growth to resume. Engineering inflation amounts to taking value away from working classes by reducing the purchasing power of their wages.

Just like the bank bailouts. Make working people pay for ruling class screw-ups.

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By LL (registered) - website | Posted April 13, 2009 at 22:48:09

What makes you think wages will go up? A huge part of neo-liberalism has been to attack real wages.

And another thing: your last point sort of acknowledges that a growth economy cannot be sustained forever. So how does your goal of regulated capitalism fit in with a steady state - and thus sustainable - economy?

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