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11 Mar

75 years on, Bank gets it right on inflation

General

Posted by: Kimberly and Cindy Walker

75 years on, Bank gets it right on inflation

William Watson, Financial Post 

Seventy-five years ago Thursday the newly constituted Bank of Canada took over responsibility for Canada’s currency. It was supposed to have done so 10 days earlier but British American Bank Note Co. was late with its initial delivery of cash.

Since 1935, when the Bank came into being, prices in Canada have risen 16-fold. What costs $100 now would have cost just $6.25 then. It makes you wish the banknotes had been delayed a lot longer.

Those numbers, by the way, are from the very handy inflation calculator on the Bank of Canada’s website. You don’t really want your central bank to be good at tracking inflation. You want it to be good at crushing it. The bank took about 50 years to catch on, but it’s now reasonably good at what it’s supposed to do.

To be fair, in evaluating its performance the important question is “compared to what?” Until 1935, money matters were handled by the currency branch of the Department of Finance, which handed out “Dominion notes” in exchange for gold, and vice versa, and occasionally encouraged the private banks to take on more liquidity by lending them notes against financial securities, though charging them interest of 5% for the privilege. Many banks also issued their own notes, which caused problems when the public lost confidence in a given bank.

During the Depression, elite opinion became convinced that Finance should give responsibility for money and monetary policy over to a more expert and independent central bank of the sort most other countries now had, the United States since 1913.

On July 31, 1933, Prime Minister R. B. Bennett empanelled a five-person Royal Commission-two Brits, including its chair, Lord Macmillan, two bankers and the premier of Alberta. It held its first meeting eight days later and reported 50 days after that. In a 3-2 split, with a majority of the Canadians and, politically conveniently, both bankers opposed, it recommended the institution of a privately-owned central bank. (Mackenzie King was to nationalize it in 1938.)

Just a year and two days after the commission’s appointment Parliament approved the Bank of Canada Act. There was no national productivity problem then: things got done. Two months later Prime Minister Bennett named the first Governor, Graham Towers, assistant to the general manager of the Royal Bank and a Montrealer trained in economics at McGill by none other than Stephen Leacock and seven months after that the Bank made its first transactions.

In the crisis of the last two years the Bank has ventured into what it sees as unorthodox areas of lending and investment. But it began in unorthodoxy. In 1936 it bailed out Alberta and Saskatchewan when they threatened to (and in Alberta’s case eventually did) default on their bonds. In 1938 Governor Towers took charge of the newly-created Central Mortgage Bank, which was designed to help struggling mortgage-holders. During the war the Bank supervised exchange controls and Towers did secret planning for how to keep finance going if the Nazis over-ran Britain. (Make the Canadian dollar the Empire’s new reserve currency was one possibility).

The worst inflations of our central bank era occurred in the late 1940s and the 1970s. In both cases it’s easy to sympathize with the governor of the day. During the war, Canadians lent their government hundreds of millions of dollars in Victory Bonds. Most such bonds paid 3% or less. Had the Bank done what it probably should have and raised interest rates to stem the postwar boom, the value of all those bonds would have crashed: If new bonds pay 6% what are old bonds that pay 3%? Half their original value. Towers, who had run several Victory Bond campaigns, felt a moral obligation not to destroy bond-holders’ savings. Ironically, the inflation that resulted may have induced him to leave the Bank. In 1935 his salary had been a majestic $30,000 a year. By 1955, when he quit, it was $50,000 but only $25,641 in inflation-adjusted 1935 dollars. And taxes were a lot higher.

The inflation of the 1970s is also understandable. Keynesian textbooks didn’t say what a central bank was supposed to do when a cartel jacked up the price of oil by several hundred percent. The stagflation that followed stumped policymakers. Milton Friedman’s monetarism did have a theoretical answer: keep the growth of money low and constant and inflation will be low and constant. Send a steady flow of liquidity into one end of the hose that is the economy and you’ll get a steady flow of real economic activity out the other end. It’s certainly plausible. But when Bank Governor Gerald Bouey tried it in the late 1970s it didn’t work. The hose turned out to be unpredictably elastic. Sometimes it sucked up liquidity and produced no growth. Other times just a little liquidity brought gushing growth.

Not until the late 1980s and the governorship of the, at the time, much disliked Governor John Crow, did the Bank start directly targeting inflation with a clearly defined “reaction function” (if inflation does X, we do Y: everybody got it?).

That strategy worked pretty well for two decades. Between 1990 and 2010 prices increased by only 50%. That’s not fantastic but no 20 years since 1935 have been better.

After three score years and 15 the Bank seems finally to have figured things out. Let’s all tip our hats to R. B. Bennett.