Central banks: Given too much credit

Our monetary policy may be seriously flawed.

The Big Five banks recently caught hell from customers when they declined to pass along all of the rate cuts that the Bank of Canada has offered up through this financial crisis. With the central bank’s key rate at a record low of 1%, many Canadians are angry to see mortgage rates hanging in above 5% — and the Canadian Bankers Association has received a record number of complaints as a result.

But with the downturn deepening into a global crisis, we shouldn’t be surprised that commercial banks have been stingy with the central bank’s largesse. In fact, it’s exactly what we should expect in this kind of recession.

In his recently released book, The Origin of Financial Crises, London-based money manager George Cooper highlights what he thinks is the fundamental flaw in North American monetary policy. Cooper traces the current malaise back to the philosophy of the U.S. Federal Reserve under Alan Greenspan, who pioneered an interest-rate-setting policy that ignored the amount of credit creation going on in the economy. Instead, the bank would react aggressively to slower growth by cutting interest rates quickly and deeply, but then would refuse to raise rates and cut off credit creation when the economy expanded and an asset bubble formed.

This “asymmetrical” approach to interest rate policy resulted in one layer of credit expansion piling up on another over a 25-year period, creating a debt bubble that now seems to be stretched to its limit — a fact that follows on the idea that the credit creation cycle can only run so far before you run out of room for more rate cuts. It’s the point we now seem to be at, and that Cooper defines as one in which it is “impossible for the central bank to encourage more private sector borrowing; private sector lenders refuse to pass on the central bank’s lower interest rates and borrowers rein in spending to pay off debt.”

The only thing the government can now do to encourage another round of growth is to offer up stimulus spending of the type just delivered in the federal budget. But as for another round of rate-cut-led growth, well, that’s done.

“I think this is a different type of downturn than we’ve seen over the last couple of decades,” says Cooper. And that’s kind of worrying. Cooper goes on to say that we now have no choice but to apply stimulus to save the economy. “It’s a matter of saving and preserving our installed industrial capacity,” he says. “But the better plan would be to avoid getting to this point in the first place.”

No kidding. But how would we do that? According to Cooper, we could engage in what he calls symmetrical central banking. “Central banks need to return to their core purpose of managing the credit creation process,” he says. “Excessive credit expansion should be fought with the same vigour as is used to fight excessive credit contraction.”

He points to the European Central Bank, which takes into account the amount of credit being created when it makes its interest rate decision, something the Fed has famously refused to do. “North Americans have always belittled the importance of those who say you don’t need to take account of credit creation,” says Cooper. “They say, ‘Why are you hanging on to that relic?’ Well, this is why we held on to it: you don’t get these big bubbles.”

Avoiding the big bubbles is an idea that seems to be gaining attention. In a recent speech to the Toronto Board of Trade, Anthony S. Fell, the former chairman of RBC Capital Markets, said, “We are at the end of the 25-year debt super-cycle,” and “this downturn might be bigger than many people are thinking as a result.” Fell also suggested the Federal Reserve needs to begin to intervene and pop asset bubbles. “We would be better off having more frequent but moderate recessions than the big one at the end.”

Cooper agrees. “Sure, taking credit creation into account and controlling asset price inflation would mean lower growth overall,” he says. “But at least we wouldn’t be in the position we’re in now.”