Flaherty/Carney vs. Bankers

As discussed previously, Jim Flaherty and Marc Carney will be meeting with Canada's major banks to discuss tight credit conditions. Flaherty/Carney contend that the Banks have more than enough capital to satisfy risk management requirements and therefore should be lending more in order to stimulate the economy. The Banks in turn argue that they are already lending at a prudent level and that tight global credit conditions and elevated default risk are to blame for lower loan volume and the higher cost of capital.

What does the data say? Let's have a stroll through the weeds.

The table below shows the year-over-year change in loans to individuals from table C7 of the Bank of Canada's Banking and Financial Statistics:

		Loans to Individuals
		to purchase securities	autos	renovations	total
2007	I	5%	5%	12%	9%
	II	6%	4%	12%	9%
	III	8%	5%	15%	9%
	IV	1%	7%	17%	13%
2008	I	0%	8%	20%	15%
	II	1%	10%	24%	15%
	III	1%	26%	30%	16%

Thus far, personal loans have continued to increase, at least through the third quarter. I would guess that auto loans and borrowing for renovations will fall off in Q4 2008, but clearly banks are not withholding credit from households.

On the other hand, private business lending has fallen year-over-year by about 2%. Not too dramatic considering tight credit conditions throughout 2008. The table below shows lending activity to some important Canadian sectors:

		Loans to Canadian Businesses
		Financial	Mining	Energy	Forestry	Const.	Mfg	Total
2007	I	28%	128%	41%	-13%	18%	-3%	17%
	II	37%	172%	50%	-12%	15%	1%	13%
	III	33%	65%	38%	-10%	16%	-6%	14%
	IV	83%	9%	21%	-7%	20%	-2%	14%
2008	I	35%	12%	0%	0%	19%	0%	12%
	II	23%	-6%	-28%	-8%	18%	-5%	4%
	III	7%	-14%	-17%	-8%	13%	-6%	-2%

Not surprisingly, lending to commodity producers fell dramatically in the second half of 2008 and lending to weak, over-leveraged, or disappearing manufacturing and forestry sectors continued to decline. Construction and real estate development loans were strong until the third quarter, but I would expect lending to that sector to slow in Q4 and into 2009.

So who does the data side with in this argument? I'd certainly like to see the Q4 data, but absent that, it seems that the banks are already lending where they should, and cutting back in sectors where there is enhanced default risk due to a deteriorating economy.

Until I hear a better articulated argument from either the BoC Governor or the Finance Minister, I'll side with the Banks.

You know you're an economist when...

You get this for Christmas...

.....and are thrilled about it - Thanks honey !

Light Holiday Blogging

Hi everyone - blogging will be light over the holidays. A big thanks to everyone that has taken time to stop by and read what I have to say. I'll try to post a few things if the mood strikes or if I can be torn away from shoveling snow, wrapping presents, or drinking egg-nog. Merry Christmas!

US Credit Expansion?

Following yesterday's post regarding Canadian bank lending, a commenter directs me to the following chart of total bank credit for all US banks. He notes that lending is still increasing in spite of the credit crisis.


It is interesting that lending, in aggregate, always increases - even through severe recessions (early 70's and 80s). However, the most interesting thing to me is the anomalous behaviour of credit in the current recession. The data shows a dramatic flattening of credit followed by a sudden spike. What could explain the behaviour of this data?

In response to the "credit crisis is a myth" hypothesis, researchers at the Boston Federal Reserve note (convincingly) that the recent changes in aggregate loan data can in part be explained by the fact that banks used to securitize loans but are now increasingly being forced to bring loans onto their balance sheets:

During crises, bank balance sheets expand for a number of reasons. First, one consequence of the credit crisis is that loan "securitization," the business of packaging various loans (home, business, auto and other) into assets for investors, has become more difficult. Accordingly, banks have had to keep the loans.

The authors further note that weak financial conditions mean more companies tapping existing lines of credit:

Second, during this and other times of financial weakening, companies increasingly rely on their existing loan commitments and lines of credit. This is because general liquidity dries up and commercial paper markets become strained.

This could explain why we are currently seeing increased loan volume in spite of bank failures and a massive build-up of reserves. The entire article is worth reading: http://www.bos.frb.org/bankinfo/qau/wp/2008/qau0805.pdf

Is pressuring banks to lend a good idea?

So the Finance Minister has given Canadian banks a deadline to increase lending and Bank of Canada Governor Marc Carney is scolding them for "hoarding" capital. This strategy of leaning on banks is intended to open credit channels and reduce borrowing costs for Canadian businesses. This could be effective if , as the actions of the BoC and the Finance Minister seem to imply, Canada's credit market problems are due to a lack of liquidity rather than heightened risk aversion.

I don't know whether banks are indeed hoarding capital or merely behaving how prudent banks are supposed to behave, ie. rationing credit at a time when default risk is high. Following the work of Bernanke and Gertler and Bernanke and Blinder, perhaps the widening credit spreads we are currently observing in debt markets are due to increased agency costs - that is, costs due to adverse selection, moral hazard and monitoring - arising from an adverse credit shock. Therefore, it could be that banks are behaving exactly the way they should and pressure to lend, especially from government authorities, is not warranted and may even be irresponsible in the long-run.

Should the rest of Canada care if the the Big 3 fail?

The Ontario Manufacturing Council (OMC) released a report yesterday (completed by the Centre for Spatial Economics) that showed that the complete failure of the Big 3 in Ontario would mean the loss of about 580,000 jobs in five years. A 50% reduction in Big 3 output would translate to approximately 300,000 jobs lost. Now, while the OMC and the Ontario Government were careful to stress that these losses would be felt across Canada, the report shows that 90% of the job losses would occur in Ontario alone.

That Ontario could lose over half a million jobs in one of its most important industries and the Canada wide effects would be only 60,000 jobs lost over 5 years seems incredible. Moreover, the 580,000 number is the high-end of the estimate and from what I can tell, that scenario assumes that foreign car makers do not set-up in Ontario to replace lost domestic production.

So should the rest of us (non-Ontarians) be calling for a bailout or would the failure of the Big 3 merely cap the long downward spiral of Ontario manufacturing? That is, has the rest of Canada decoupled from Ontario? Recent trends in unemployment rates seem to suggest so.


However these trends may be deceiving. A lot of employment in the West has been a product of the commodity boom, and therefore recent trends may represent a cyclical rather than a structural change. Moreover, the economy is in a particularly fragile state and a shock of this magnitude, even if it seems to be localized in Ontario, may have other adverse effects. Hmm...does this mean I've talked myself into an auto-bailout?

Welcome to the Liquidity Trap

I guess its time to put our traditional monetary models on the shelf for awhile as we are now in the world of quantitative easing.

Somehow markets view a historically low fed-funds rate, and a dramatic shift in the primary monetary policy instrument as a sign to celebrate rather than as a signal that the economy is in a very bad place and will be there for long time- Dow up 360; S&P up 45; TSX up 262.

Revised BC Forecast

I've been thinking a lot about how BC may be impacted by a Canadian recession and how that impacts my forecast. Here are the relevant facts:

1) Canada is almost certainly going to be in a recession to start 2009. If standard models for the transmission of US shocks to the Canadian economy hold, a 4%-6% decline in US growth could translate to 1.2%-1.8% decline in Canada - on top of softening domestic demand. These shocks should hit BC through inter-provincial and US export channels.

2) According to BC Stats, inter-provincial exports account for about 16% of BC GDP, with most of the trade occurring with Ontario and Alberta. In the 1990 recession, BC exports declined about 2% and in the 1982 recession exports declined close to 11%.

3) International exports account for 28% of BC GDP. In the last US recession, these exports fell 5%. Moreover, key BC export sectors - mining and forestry - are in serious trouble.

This all sounds really awful - perhaps too awful to produce 1.3-1.4% growth. Taking the above into consideration, my revised forecast says that without VANOC stimulus, the BC economy would likely slip into a recession, posting growth of -0.2%. With VANOC spending, and its indirect effects, growth should be bumped up by 0.4%-0.5%.

Therefore, the revised forecast is 0.2-0.3% - 2010 saves the day! (just kidding, no hate mail please).

Firing Blanks

The US Federal Reserve convenes its two-day meeting today to deliberate on the direction of monetary policy. Expectations are for a cut of 50bps, which would bring the fed-funds rate to a historical low of 0.5%.

Given that most of the normal channels through which monetary policy works (eg. housing, credit, investment) are either severely jammed or completely broken - there will likely be no material stimulative impact from a rate cut. Moreover, the effective funds rate has been trading at below 50bps for quite some time, and it is still unclear how the decision to pay interest on reserves has impacted the usefulness of the fed-funds rate as a policy instrument (see here for an excellent discussion).




There also may be significant risks to cutting rates , most prominent, (as Tim Duy notes) of which is a disorderly adjustment in the US dollar. A falling dollar, along with massive borrowing associated with bailouts and a coming stimulus package, could send interest rates higher as countries demand higher compensation on US government debt (though this hasn't happened in the past couple of years, despite a weaker dollar and massive borrowing). Moreover, as global trade deteriorates, there may be none of the typical stimulative trade effects normally associated with currency depreciation.

What are the risks if they don't cut? Who knows. Uncertainty is scary and markets are too fragile not to deliver on expectations which is why the Fed will continue towards the zero bound with their hands firmly gripping the monetary spigot.

Dr. Taylor’s Monetary Tonic

A Taylor rule ( named for John Taylor of Stanford) is a somewhat mechanical rule for monetary policy that suggests that an optimal policy should minimize the variation of inflation around its target and output around its potential. Its general specification is:

r =r* + β(π- π*) + γ(y – y*), where values with a *are steady-state or target values.

Even though the Bank of Canada is mandated solely to keep inflation near its target of 2%, it is not surprising that it responds to an output gap as well since an economy growing above potential is inflationary. An estimated rule reveals weights on the inflation and output gap of 1.88 and 0.38 – awfully close to the values of 2 and 0.5 suggested here: http://www.bankofcanada.ca/en/res/wp/2002/wp02-1.pdf. These estimates show a much heavier weight on excess inflation than on output, about what we should expect from an inflation targeting central bank.

Taylor rule for the target rate tracks the average quarterly overnight rate fairly closely, though suggests that the Bank should have started cutting earlier and more aggressively

UPDATE- Nick Rowe asks where the broken line comes from in the above graph - It represents my forecast (guess) at the future path of the output gap and inflation. Needless to say, i'm expecting inflation to not be a problem and for growth to disappoint to the downside. I've also added a second red broken line to show the Taylor rule path for the overnight rate based on the current BoC forecast (MP from Oct. 23). Thanks Nick.

r = r* + β(π- π*) + γ(y – y*), where values with a * are steady-state or target values.

Even though the Bank of Canada is mandated solely to keep inflation near its target of 2%, it is not surprising that it responds to an output gap as well since an economy growing above potential is inflationary. An estimated Taylor rule reveals weights on the inflation and output gap of 1.88 and 0.38 – awfully close to the values of 2 and 0.5 suggested here: http://www.bankofcanada.ca/en/res/wp/2002/wp02-1.pdf. These estimates show a much heavier weight on excess inflation than on output, about what we should expect from an inflation targeting central bank.

A Taylor rule for the BoC target rate tracks the average quarterly overnight rate fairly closely, though suggests that the Bank should have started cutting earlier and more aggressively.

UPDATE- Nick Rowe asks where the broken line comes from in the above graph - It represents my forecast (guess) at the future path of the output gap and inflation. Needless to say, i'm expecting inflation to not be a problem and for growth to disappoint to the downside. I've also added a second red broken line to show the Taylor rule path for the overnight rate based on the current BoC forecast (MP from Oct. 23). Thanks Nick.

Onward to the zero bound!

Wow. 75 basis points! I'm not sure whether to read this as the BoC trying to get ahead of the curve or if Marc Carney and Co. are seeing some really bad data on the horizon.

from the press release:

While Canada's economy evolved largely as expected during the summer and early autumn, it is now entering a recession as a result of the weakness in global economic activity. The recent declines in terms of trade, real income growth, and confidence are prompting more cautious behaviour by households and businesses.

It will be interesting to see the forecast revisions in the Monetary Policy Update in January.

A Modest Proposal for Statistics Canada

I have a problem with Statistics Canada. I’ve been known to curse the awful labyrinth that is CANSIM but nothing fills the swear jar quite like having to PAY for data.

Now, I know that some readers of this blog will have old grad school friends who work at Stats Can, and I don’t mean to insult them. I know StatsCan has a great reputation internationally, and I’ve worked enough with international data enough to attest to the quality of StatsCan’s work.

My firm doesn’t use enough data to justify paying Haver Analytics or the Conference Board or another data provider for an annual subscription. Therefore, when I need data, not only do I have to go through roughly 6000 confirmation screens before getting it, I have to pay the ridiculous sum of $3 per series. That is, if I want a time-series of the unemployment rate by province and the national rate, I have to pay $33. If I want to add employment numbers, the participation rate or any other series – it quickly adds up. Sure I can expense these costs, and yes I could build my own database and update it each month as data comes out, but I shouldn’t have to. If I want the same data from the US – it’s free. If I want it from the EU – it’s free. UK – free. Australia – free. Get the idea?

So, a modest proposal for StatsCan – Carve out a core set of macroeconomic data and post it free of charge. Use the FRED II database as a guide. I don’t know how expensive this would be, and I know that an organization that hasn’t laid anyone off since Joe Clark was Prime Minister isn’t especially adept at cutting cots – but please find a way.

End rant – back to economics a little later.

Short and Mild?

Private sector and Bank of Canada forecasts imply that the Canadian economy will experience a brief and mild recession, spanning perhaps the fourth quarter of 2008 to the first or second quarter of 2009. How do these forecasts compare with past recessions? Check out this graph from the Parliamentary Budget Office:


Is it likely that a Canadian recession will be only slightly worse than the 2001 slowdown given a protracted and painful recession in the economy of its largest trading partner? I'll call it now - Bay Street will be revising its forecasts substantially downward in the next couple of months.