Thursday, July 16, 2015

Stephen Poloz's Zen Moment

This is an extended version of what appears on

To cut or not to cut, that is the question. And fortunately for Bank of Canada Governor Stephen Poloz, it was a pretty easy question. A lagging US recovery, China's downturn, lower oil prices and “bad weather” all contributed to this interest rate cut. “I wouldn't describe it as a close decision,” he told the press, “It's a decision where we had a number of trade-offs on the table. It requires a lot of deliberation and a lot of inputs, not a mechanical decision. Not even close.” But whereas Poloz admitted to feeling comfortable at the end of 2014, now there was a bunch of crap heading for the ceiling fan and that interest rate cut was Canada's only way of taking cover.

Poloz is known for his metaphors but the above is mine. Poloz used the parable of the big oak tree to compare “analysing vulnerability” in the economy. The big oak tree is only a risk if there's a branch that could break off and fall into your neighbours house. In Poloz's mind, cutting interest rates must have been like sawing off that branch. He may have successfully mitigated some potential risk, but in doing so he didn't bother with any long-term consequences. He may have sawed off that branch so it wouldn't fall into the neighbours house, but by cutting without thinking ahead, the branch fell right into the neighbours house.

I hope that's clear, because a lot of what the Bank of Canada says isn't. Poloz is a fan of Greenspeak but sometimes we get moments of incoherent clarity such as: “When other things are equal, a lower currency will be a stimulus to the economy.” When asked if China's slow-down could affect Vancouver's housing market and potentially the broader economy, Poloz crept back to his Greenspeak with a definite “I don't know” and “I won't speculate” sprinkled on top.

Ever since Poloz took over as Governor, he's used “forward guidance” to talk the Canadian dollar down to 77 cents as of this writing. This prompted one journalist to sarcastically thank Poloz for more expensive US vacations to which Poloz shrugged, suggesting that Canadians vacation in Canada instead. Somebody at the PEI Tourism Board must have been lobbying the Governor's office all last week because Poloz made several references to how great PEI was and how everyone should go there.

But what about that US recovery? That imaginary scenario where the Fed successfully raises interest rates without bankrupting the US federal government?

“What happened [earlier this year] of course was the US economy had this fallout, part of it was the weather... some of it may be fundamental.”

When Poloz says some of it may have been fundamental, he probably means some non-existent inherent destructive feature of capitalism. I'm sure he doesn't mean the fundamental monetary paradigm he's been working with. Weather took a prominent role over these other “fundamental” issues. Just like the old Soviet planning authorities who blamed their own incompetence on the weather, Canada's central banker is blaming poor business conditions on poor climate. Funny, that's never been an issue in Canada before. Poloz blamed PEI's lack of productivity on a late Spring. No word yet on business-destroying government red-tape, excessive taxation or an insane monetary policy crafted by a Board of Directors with no objective knowledge on what the price for borrowing money should be.

Instead Poloz reminded us that simple, mechanic, “narrowly defined” economics is not helpful. But earlier in the press conference, he seemed to give a simple, mechanic, “narrowly defined” answer as to why cutting interest rates isn't just pouring more gasoline onto the fire that is household and consumer debt. “Lots of mixed views on this,” Poloz answered. He explained how “interest rate relief” means different things for different people. He reiterated his stance that those heavily in debt will use the low rates to get out of debt and those without debt will use the low rates to get into debt, and that grows the economy because why not?

Actually, Poloz's zen moment in yesterday's economic fallacy variety hour came as he explained what interest rates were and why low ones were beneficial. It was that simple, mechanic, “narrowly defined” language that explained how interest rates allow businesses to keep track of their books over time. If a Chinese company is buying raw materials in 2013, processing them in 2014, and then selling them to Canadians in 2015, it can't ignore the time factor. Various expenditures and revenues will change, money that paid for the materials and for the labour in the previous years has a higher market value than the money received from consumers in the present so businesses discount the later money. Interest rates help determine the appropriate discount to apply so a business can look at its books in the long-term and determine whether they're really making a profit or not.

This correct understanding may have been what prompted Poloz to say that an “interest rate lift off in the US” would be welcomed since it was “consistent with a more positive outlook on the US economy.” And indeed, the higher the rates the more present-oriented businesses will be. If production is long, requiring a number of inputs, raw materials, labor and time before a final product can be sold, and the interest rate is high, the less profitable the project will be. Higher rates hinder entrepreneurs with long production processes because, when interest rates are set by the free market, higher rates indicate a lack of sufficient funds. In a high interest rate environment, consumers are spending their income in the present and thus there aren't any additional funds to finance long-term projects.

That's why, according to Poloz, it's essential to manually lower interest rates. Low interest rates give entrepreneurs the go-ahead to begin longer production processes by making those investments appear profitable. Like other prices in the economy, interest rates act as signals to guide entrepreneurs to invest scarce resources efficiently, and in a way that is compatible with consumer demand. An interest rate, when left alone, will tend to equate the quantity of loans demanded with the quantity being supplied. If people decide to save more of their income, there's more supply for loans on the market and interest rates will fall accordingly. But Poloz didn't bother mentioning this part. He stopped short of explaining how you need actual capital to have capitalism. By manually lowering rates, Poloz is making it appear as if there are more loanable funds then there are.

The end result should come as no surprise to readers of this blog. “Good consumption numbers,” says Poloz, will “close the output gap” by 2017 and keep inflation on its 2% target. See? Nothing to fear. Nevermind the fact that one of these days some entrepreneurs with longer-term projects will be physically unable to continue their operations. Nevermind that there aren't enough savings to finance all this “investment” or that we may be squandering scarce resources in an unsustainable manner. That's simple, mechanic, “narrowly defined” economic thinking. Best to think of some metaphor or parable to explain why the central bank's price controls are superior to free markets.

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