Krugman and Canada

In my last post, I said Canada was one of the developed countries that weathered the current global financial crisis better than the United States, because Canada had a more effective financial regulatory system.  Yesterday, Paul Krugman, in an op-ed column entitled "Good and Boring", said Canada is a country which did it right and is an important role model of stability from which we need to learn.

Canada has an independent Financial Consumer Agency and Canada sharply restricted sub-rime lending.  Krugman characterizes the Canadian banking system as boring, because they kept banking safe by strictly limiting banks' leverage while the United States, since Reagan, has lived dangerously on the path of deregulation.  Canada limited the process of securitization.  In the United States the process of securitization was unfettered and became a cash cow for banks to make ever increasing risky bets with other people's money rather than a means to reduce risk by spreading it.

Krugman takes issue with Paul Volcker's assertion that the "... crisis lay in the scale and scope of our financial institutions --- in the existence of banks 'too big to fail' ", because there are only five banking groups in Canada and they are all "too big to fail".  Krugman is not correct in his assessment of Volcker.  Volcker has consistently said derivatives were not only misused but possibly unnecessary financial innovations.  He has called for regulatory reform and breaking up banks which inappropriately combine commercial retail banking with investment/trading banking.  In that Volcker has used the phrase "too big to fail", he is as sloppy as most commentators and media.  As Joseph Stiglitz has repeatedly said and which I have explained for months, the issue is not size or just banks but whether any financial institution of any size without respect to whether it is a big bank, small bank, insurance company, mortgage company, hedge fund, equity investment group, or some other shadow banking firm is systemically dangerous.

In as much as the so-called currently proposed "Volcker" Rule uses the phrase "too big to fail" while keeping the financial system, in actuality, just as it is, Mr. Krugman would be correct in his criticism.  "Too big to fail" is a bogus , if not purposefully misleading, concept which deflects the public from the need to regulate systemically dangerous financial institutions of any size.  In 1998, a single hedge fund, Long-Term Capital Management, came very, very close to causing a systemic failure.  And the United States made no attempt to correct that crisis with financial regulatory reform.

Krugman also is not correct in his assertion that Canada proves that keeping low interest rates over a long period of time does not aggravate and lengthen the recession (I also believe it keeps unemployment high).  In fact, Canada has had a more active intervention with the use of their overnight rate and it has been at a higher rate, 25 basis points as opposed the US federal funds rate of zero to 25 basis points, for a shorter period of time.  Krugman does not believe the Fed lowered interest rates too low too fast.  I do not agree.

Here is a comparison of the Federal Funds Rate and the Canadian Overnight Rate:

6/30/05                                   3.25                                                  2.50
7/9/05                                                                                              2.75
8/9/05                                     3.50
9/20/05                                   3.75                                               
10/18/05                                                                                          3.00
11/1/05                                   4.00                                               
12.6/05                                                                                            3.25
12/13/05                                 4.25                                 
1/24/06                                                                                            3.50
1/31/06                                   4.50
3/28/06                                   4.75                
4/25/06                                                                                             4.00
5/10/06                                   5.00
5/24/06                                                                                              4.25
6/29/06                                   5.25
7/3/06                                                                                                3.75
7/10/07                                                                                              4.50
9/18/07                                   4.75
10/31/07                                 4.50
12/4/07                                                                                               4.25
12/11/07                                 4,25
1/22/08                                   3.50                                                     4.00
1/30/08                                   3.00
3/4/08                                                                                                  3.50
3/18/08                                   2.25
4/22/08                                                                                                3.00
4/30/08                                   2.00
10/8/08                                   1.50                                                      2.50
10/21/08                                                                                              2.25
10/29/08                                 1.00
12/9/08                                                                                                1.50
12/16/08                                  0 - .25
1/20/09                                                                                                1.00
3/3/09                                                                                                    .50
4/21/09                                                                                                  .25

The Fed has made its quantitative easing nest and will have a much more difficult series of exit strategies to execute if they are to sustain even a slow recovery which is why the recession will be long and drawn out and unemployment will remain high.  How difficult will it be to exercise monetary policy to control inflation and output gaps in a slow recovery with high unemployment?

The United States must learn from Canada as well as Australia and France.  The United States needs an independent Consumer Financial Protection Agency, transparent derivatives markets, regulation of securitizations, a modern version of Glass-Steagall separating commercial retail banking from investment/trading banking, and financial regulations which limit, if not prevent, the existence of systemically dangerous financial institutions of whatever size and regardless of whether they operate in transparent daylight or the shadows.


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