Born of the Great Depression, the Bank of Canada has found new relevance, 75 years later, in averting another. As Canada emerges, surprisingly strong, from what many had feared would be at least a Great Recession, the governor of the bank, Mark Carney, credits its interventions in large part for sparing us the worst of the financial crisis.
In an interview to celebrate the bank’s 75th birthday, Carney said one of the lessons of the near-collapse of global finance was the crucial part that central banks play in the smooth running of financial markets, especially in a panic. “The need for a lender of last resort, and not just a lender but a liquidity supplier of last resort, was made absolutely clear by the crisis.”
The corollary lesson: markets are not always self-correcting. Having worked in capital markets for many years at Goldman Sachs, Carney says he acquired “both a respect for [markets] and a skepticism of them. You know, I’m not a market fundamentalist. There are periods of excess in both directions in financial markets and it’s important to recognize that.”
Not that that’s exactly news: bubbles, panics and crashes are as old as capitalism. Rather than the revolutionary new world of finance that many commentators predicted would emerge from the crisis, Carney sees a reaffirmation of some age-old truths. “I think we’ve relearned some pretty basic lessons about financial regulation and the importance of having enough capital to support credit activity, the importance of liquidity, the need for good market infrastructure, relative transparency, clarity, etc. And so in many respects things haven’t changed.
“What has been brought a little more to the fore has been a question that has not yet been resolved at all, which is: what, if anything, can be done about some of the—given human nature, given the nature of financial markets—inherent procyclicalities in financial markets and in the economy?” By “procyclicalities,” he means the tendency for markets to chase themselves off their long-run equilibrium values for a time, in self-reinforcing spirals. The herd instinct, in short.
Some of that, he concedes, was driven by regulation—the very regulation that was supposed to stabilize markets. For example, the “Basel II” standards, agreed upon by the world’s central banks as a baseline for national regulations, set out how much a bank can lend in proportion to how much capital it has on its books. Problem: the higher the value of the capital, the more the bank is permitted to lend. So the higher asset prices rise, in response to the easier availability of credit, the more banks are encouraged to lend. Conversely, in a crash, when credit dries up, the same standard encourages banks to lend even less.
That’s one of the questions Carney and his fellow central bankers will be taking up at the June meeting of the G20 in Toronto. Another is the role played by monetary policy in financial crises, both as cause and cure. Carney believes Canada’s long experience with inflation targets, to which the bank and the Finance Department are jointly and publicly committed, was one of the reasons we escaped from the crisis comparatively unharmed. People knew that the bank had a good record of keeping inflation from straying too far below or above its two per cent target. So fears of deflation were never really a factor here.
Still, long experience of relatively stable inflation may also, oddly, have contributed to the crisis, by making investors less conscious of risk, less fearful of the proverbial Black Swan—what’s known in the literature as “disaster myopia.” Carney says he thinks “there is still a case to be answered about the implications of a period of low, highly predictable [interest] rates feeding procyclical behaviour in asset markets.”