IV. The Deficit and Social Welfare Reform--Putting Capital Back to Work:

Minister Martin's two discussion documents stress the common thread of policy reform that links his pre-budget consultations with the ambitious social policy reform exercise that has been undertaken by Human Resources Development Minister Axworthy. Indeed, many Canadians suspect that the real social policy changes will in fact occur as a part of the federal budget--through deep preemptive cutbacks in the Unemployment Insurance program and other measures. And we, too, see that the reform of social welfare programs will indeed be an important element of any successful effort to gain control of Canada's looming debt crisis. The problem is that Minister Axworthy has overlooked the most important and expensive of Canada's social programs, and the one that most needs to be reformed if our fiscal house is indeed to be put in order.

By far Canada's largest "social" program is the welfare program we have established over the past 15 years for financial investors and bond-holders. This year the federal government will spend something close to $40 billion in interest payments. This exceeds the total spending by the federal government on all of the social programs considered in Minister Axworthy's discussion paper: unemployment insurance, child tax benefits, transfers to the provinces for welfare and post-secondary education, student loans, and others.

Thus it strikes us as astounding that so much public and political attention(22) has been devoted to an attempt to shave--at great social and economic cost--perhaps a few billion dollars from our social security programs, all in the name of fiscal responsibility and the creation of a "healthy" business climate. At the same time, the much larger drain of public funds in the form of interest payments to generally well-off investors is ignored, virtually taken for granted. If the goal of the social reform exercise, as many of us suspect, is to reduce government expenses, then attention must be turned toward this much larger drain on public finances. But equally, if the goal of the reform is to reinvigorate the incentive to work, to create jobs and economic growth, to reduce dependency on public handouts and revive the dignity of real production--then for all these reasons, too, we should turn our attention to the greatest welfare scandal of them all: our welfare program for investors.

With real interest rates on purely financial investments so consistently high over the past 15 years, investors have become lazy and dependent on easy public money. Why take on the risk and effort of developing new products, buying machines, hiring and training workers, and marketing, when a real return of 6 percent or more can be earned by purchasing a risk-free government bond? Reducing interest rates would help to put capital back to work in a real job: production and employment, instead of clipping interest coupons.

It is not often that we agree with Mr. Frank Stronach, the President of Magna International Inc. But on this subject even he is in agreement with our concern that high interest rates are undermining real economic growth and innovation. He recently asked "Why would you pour a foundation, buy machines, hire employees, if you can make as much money buying bonds?"(23)

Moreover, lower interest rates would also help to address the demand-side problems that in reality are at the root of the crisis in our labour market and our social security network. By stimulating real private investment as well as personal consumption spending (which not coincidentally has remained relatively weak through the present recovery), lower real interest rates would do much to enhance output, employment, and growth.

In general we disagree quite forcefully with the implicit (and at times explicit) theme running through Minister Axworthy's discussion paper: namely that the availability of social security has somehow sapped Canadians of the motive to work. But in this case, his analysis is perhaps quite appropriate, as we illustrate in Figures 8 and 9.(24) Figure 8 summarizes the rise of the financial welfare system over the past 35 years, in the form of climbing real interest rates. Figure 9 shows the flip side of the coin, with respect to the real "work" of capital. It plots net private investment in Canada (excluding depreciation), as a share of GDP. With such easy public welfare around, the actual work of capital--its contribution to economic growth in Canada--has diminished steadily.

Minister Martin's discussion papers are filled with jargon about fiscal discipline, innovation, and productivity--but unless we put capital back to work in this country, there is no realistic prospect of either controlling our debt crisis or rejuvenating economic growth.

V. Alternative Monetary Policies for Debt Control:

The conventional response to all of the foregoing might acknowledge the key role that lower interest rates must play in reducing the deficit, and might even acknowledge the role of interest rates in engineering our debt crisis. But then the typical economic "expert" will throw up their hands (all three of them!) and bemoan that interest rates are entirely beyond our control--there is nothing we can do about them. Interest rates are set in "free", "efficient", "globalized" financial markets. They reflect the real economic forces of "thrift" (on the part of lenders) and "productivity" (on the part of those who wish to borrow capital). Canada cannot hope to isolate itself from these rational, global forces, and hence we must live with what the financial institutions offer us.

Firstly, we reject the implicit assumption that financial markets and institutions are some type of inexorable, universal force which somehow holds the world economy within its irresistible power. Our financial system is a social institution, which was set up to perform certain concrete functions: collect and allocate financial resources, and exert some discipline over the use of those resources, in the interests of economic efficiency. If this institution is no longer fulfilling its stated purpose in a socially beneficial manner, then it must be changed.

There is nothing written in stone about how we must organize our currency and financial systems. If the debt crisis is indeed a national emergency, and if (as indicated above) it is impossible to solve that emergency without altering economic outcomes currently dictated by capital markets, then we have to be prepared to do precisely that. In a national emergency, everything must be on the table.

Let us examine more concretely the claim that we cannot do anything about the interest rates that financial markets dictate to us. Canada's interest rates are set by a "free market" process involving the government and a handful of powerful financial investors. If we try to alter the outcome of this process, by forcing lower interest rates, then it is conventionally argued that two things will occur:

i) these investors will not lend the government any more money, in essence going "on strike"; and

ii) financial investors will take their money and leave Canada, by selling government bonds in a panic sale on the re-sale market, hence uncontrollably driving down the value of the exchange rate.

By examining concretely the dimensions of this problem, we can suggest concrete solutions:

i) the market-determined "auction" system of setting interest rates needs to be re-examined;

ii) the government needs to meet a greater share of its borrowing needs through alternative financing mechanisms; and

iii) the current unregulated system of foreign exchange needs to be reformed.

This is not the place to map out a comprehensive alternative vision for Canada's monetary system, although we list a few concrete suggestions below. Our top priority is to stress that we must start to build up the political will-power to intervene in the so-called "free market" of global finance in order that it begins to operate more in the national and social interest. The Finance Minister's implicit assumption that we have to just accept the dictates of the speculative financial system is counterproductive and disempowering in this regard, given that his own deficit arithmetic proves that some sort of intervention to bring down interest rates will be required.

Here are the directions in which we suggest the federal government start to move, so that our entire economy might one day be less at the mercy of the unpredictable and self-interested whims of the global financial system:

i) Return to the direct regulation of interest rates: Instead of the quasi-market "auction" system that we presently have, according to which financial institutions are given free reign to in essence dictate the short-run interest rate, return to direct administrative management of the interest rate. This is how interest rates used to be set in Canada, and how they are still set in the U.S. This would remove Canada's short-run interest rate from speculative spikes of the sort we experienced earlier this year.(25)

ii) Use Canada Savings Bonds and other more stable financing instruments: The government's reliance on the savings of its own citizens has declined dramatically in recent years. When average Canadians buy a savings bond, they do not watch the speculative foreign exchange and bond re-sale markets on an hourly basis to see if they can make a quick speculative profit by gambling on changes in asset prices. They look at the promised return on the bond, and if it seems adequate (it is almost always higher than what commercial banks offer on savings accounts) then they are satisfied with a fair return.

Yet in its rush to embrace financial market deregulation and globalization the government has ignored the savings potential of its own population. As indicated in Figure 10,(26) Canada Savings Bonds now account for only a tiny share of the government's outstanding debt. This type of public borrowing (in the form of war bonds) played an important role during another great national emergency in Canada (World War II), and could be invoked again. The Ontario and Saskatchewan governments are pursuing promising initiatives in this regard at the provincial level.

Particularly worrisome is the corresponding rise in the government's reliance on very short-term commercial financing vehicles,(27) which are especially vulnerable to speculative pressures from the large financial institutions. The use of T-bills to finance the government's debt is akin to financing a home mortgage through a pawn shop.

iii) Borrow from the Bank of Canada: When the economy is operating vastly below its potential, but when the private financial system is stubbornly and irrationally moving in a contractionary direction, then a responsible government has no choice but to inject liquidity directly into the economy through the Bank of Canada. There is nothing out of the ordinary about the government meeting a share of its financing needs from the central bank; Canada has done it successfully in the past, and could do it successfully again today.

Of course the monetarists at the Bank of Canada and the financial analysts will raise a hue and cry about the government "monetizing" its debt, to the great pain and hardship of the powerful financial speculators who make their living off the manipulation of wealth rather than from actual production and employment. But this is not the issue. All debt is monetized. All debt becomes an entry in someone's chequing account. The real issue is who gets to control the terms of that monetization. At present this control is ceded entirely to private profit-making institutions--who may decide, for example, to monetize debt when the economy doesn't need it,(28) but decide not to monetize debt when the economy does need it (such as at the present). We demand that this financial priming of our economy start to occur more on the basis of social cost-benefit decision-making (instead of the private profit-seeking cost-benefit decision-making of the banks). Relying more on the Bank of Canada (at least during recessionary times) to finance government deficits would be one important strategy in this regard.

iv) Inject credit directly into the economy: There are additional means, other than using the Bank of Canada as a deficit-financing vehicle, by which the government could directly stimulate economic activity in depressed times. This would allow the government to sidestep the constraint posed by the globalized financial system, which is presently demanding that we keep our interest rates very high (and hence the supply of new credit very low) even though the economy clearly needs lower rates.

One promising proposal in this regard is the suggestion of the Canadian Labour Congress that Canada establish a national, publicly-sponsored industrial investment bank. This institution would be granted normal banking powers to create credit, with the aim of financing new real investment projects in key Canadian industries--financing which would otherwise be rationed or overpriced thanks to speculative developments in private capital markets. The initial financing for the bank could come from the Bank of Canada, or from special taxes levied on the counterproductive speculative behaviour of private financial institutions (such as a turnover tax on foreign exchange transactions which are unrelated to real trade or investment flows). Subsequent credit would be leveraged exactly as for private banks, according to the fractional reserve banking system.

v)Place controls on foreign exchange speculation: The key fear that lower interest rates could spark a collapse of the Canadian dollar is rooted in the speculative behaviour of a few powerful financial wealth-holders. They would sell off Canadian assets not because of any problems with the fundamentals of Canada's economy (which are widely recognized as being extremely strong), and their foreign exchange transactions would have no relation to real trade or foreign investment flows. They would be intended, rather, to make a quick capital gain profit off of a movement in relative asset prices--much as real estate speculators rapidly turn over properties during times of rising or falling real estate prices. Average Canadians, who earn and spend most of their money in Canada, have no interest in this international asset casino; it is only the wealthy and the large financial institutions who care about how their portfolios will measure up after they have been converted into U.S. dollars in a bank in the Turks and Caicos Islands.

It is extremely difficult to attempt to damp this speculative behaviour, of course, given the intense and instantaneous electronic integration of financial markets. But if the operation of these global markets has become so removed from real economic efficiency considerations that they stand in the way of orderly economic development, then they must be reformed. All countries imposed controls on international capital flows during World War II and the first decades of post-war reconstruction; if we indeed face a national debt emergency, then we must be prepared to do the same thing again. Some ideas which would be worthwhile considering here would include a turnover tax on financial foreign exchange transactions, compulsory waiting periods for financial foreign exchange transactions that could be invoked during periods of turbulent speculation,(29) or reductions in the share of registered Canadian pension funds that can be invested abroad.

vi) Be prepared to accept a temporary fall in the dollar: It is unlikely that even this attempted re-regulation of foreign exchange markets could fully insulate our foreign exchange market against speculative attack from global wealth-holders, if a genuinely pro-growth monetary stance were to be adopted in Canada. But what would be the real consequences of the resulting fall in the dollar? Wealth-holders who measure their net worth in U.S. dollars would lose, but this does not affect the vast majority of Canadians--who are concerned with production and employment opportunities at home, not the size of their foreign asset portfolios. The competitiveness of our products would be further enhanced, real investment(30) and employment would likely increase, and Canada would experience an export-led economic boom. The exchange rate under these circumstances could not stay artificially depressed for long. Once the financial speculators had finished their feeding frenzy, in essence completing vast one-time transfers of wealth amongst themselves, then the real fundamental determinants of Canada's exchange rate would reassert themselves, and the exchange rate would return to something closer to its equilibrium level.

We should learn from the recent experience of the U.K. in this regard, just prior to their withdrawal from the European Monetary System. The central bank spent billions of pounds of public money trying to defend the exchange rate (money which went directly into the pockets of financial speculators playing this no-lose numbers game); the effort collapsed, the pound depreciated, the real U.K. economy was strengthened by this, and the currency has subsequently recovered.

vii) Inflate to the level of our trading partners: Finance Minister Martin and others like to boast about Canada's "enviable" inflation performance,(31) noting that our inflation rate is the lowest in the industrialized world. Is this performance really so enviable, however? Far from sparking new investment thanks to "enhanced confidence in the value of Canadian money", the policy is strangling investment and economic growth before it has a chance to get going, thanks to high interest rates and stagnant demand conditions. In fact, the most obvious consequence of the Bank of Canada's campaign to single-handedly eliminate inflation seems to be an increase in real interest rates here, since nominal rates have not responded to the decline in inflation here. This would only be surprising to the most naive of textbook supply-demand economists: Canada's nominal interest rates have never fallen below those in the U.S. for extended periods, so reducing our inflation rate below that of the U.S. cannot but leave us with higher real rates.

The folly of the Bank of Canada's strategy is now obvious. The alleged negative economic impact of slow inflation on the real economy is infinitesimal compared to the long-run harm of permanent stagnation and artificially high interest rates. We should abandon the 1-3 percent inflation target (which we are currently overachieving, anyway), and instead target the inflation rate in the U.S.

viii)Cooperate with other countries to reform capital markets: It is extremely difficult for any single country to impose useful forms of social regulation over private capital markets, although the preceding suggestions could have important positive impacts. But instead of throwing up our hands as if the global financial system were some supernatural, inexorable power, we could instead start to work with other countries to try to implement international structures which would channel financial markets into more socially useful endeavours. In particular, some form of cooperation with other smaller industrial countries--all of whom, it was shown above, have been hit hard by the financial speculation that was unleashed by the U.S. Federal Reserve earlier this year--would be especially useful in the long run.

VI. High Interest Rates and Canada's Controlled Recession:

The preceding section listed eight specific suggestions as to how financial markets could indeed be brought under a relatively modest regime of social regulation, in order to bring down real interest rates and push Canada's economy out of its morass of permanent stagnation and exploding debt. But we are highly sceptical that the Finance Minister and the Bank of Canada will heed this advice--not because it is impossible to lower interest rates, but because they do not want to lower interest rates.

This is because the sudden, dramatic, permanent increase in interest rates that was experienced beginning in 1981 is not a "normal" result of the functioning of "free" financial markets. It rather has been the key weapon in a deliberate strategy to slow down the pace of economic activity, undermine the economic bargaining position of working people, and shift the distribution of income strongly in favour of wealth-owners. It is the key instrument in a deliberate effort to engineer a "cold bath" for the economy: a more-or-less permanent, controlled state of recession.

The interest rate is not determined by the supply of and demand for capital.(32) In a monetary economy, there is no pot of golden coins, collected thanks to the thrift of savers, which is then allocated in market-clearing fashion to the most deserving borrowers. In a monetary economy, credit is created by the banking system. The price at which that credit is created is determined institutionally and conventionally, depending on the structure of financial institutions, the relationship between creators and demanders of capital, and the structure of income distribution in society. Higher interest rates establish a higher hurdle rate of return for new investment, resulting in a net shift in the distribution of income towards capital; they also shift income from real industrial investors and entrepreneurs to financial investors and wealth-holders. Finally, and most importantly, high interest rates slow down the pace of economic growth, holding the economy back from its capacity frontier, and reestablishing a permanently high level of unemployment, which serves to undermine workers' bargaining position in negotiations over wages and working conditions. This serves to further shift economic power and income from working people to employers and wealth-holders.

The results of this controlled recession in Canada have been startling and effective, albeit extremely painful for the vast majority of Canadians. Since the monetarist palace coup in 1981, the average real short-term interest rate in Canada has increased by almost 600 percent: from an average of 1.1% between 1950 and 1980, to an average of 6.1% from 1981 to the present. As mentioned above, the average real interest rate paid on the federal debt doubled during the same period: from 3.87% between 1950 and 1980, to 7.66% since then. The average unemployment rate rose from 5.3% between 1950 and 1980, to an average of 9.8% since then. This has undermined wage growth (which has lagged far behind productivity growth since 1981, resulting in a steadily declining labour share of output). But the total share of capital in national income (including after-tax corporate profits, plus interest and investment income) rose from 11.1% of GDP during 1950-80, to 13.8% since 1981.

This whole exercise was clothed, of course, in the language of "wrestling inflation to the ground". But the evidence is now abundant that inflation is not the key concern: redistributing income and power to employers and wealth-holders is the key concern. How else can we explain the deliberate continuation of real interest rates of 6 percent in an economy with virtually zero inflation, falling unit labour costs, and an output gap of at least 10 percent? How else can we explain that the modern stock market tends to decline whenever good economic news (such as lower unemployment or faster growth) is announced? It is because wealth-owners realize that their long-run economic interests are being well-served by this deliberate policy of controlled recession. While the reigns can be loosened to some extent (especially once labour has been disempowered by long-run unemployment, the erosion of social programs, and the implementation of a "flexible" labour market), the stock market does not want economic growth getting out of control.

Somebody has to say that the emperor has no clothes. Canada's fiscal crisis cannot be solved until we abandon this deliberate strategy of controlled recession.

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