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Monetary policy in a period of financial chaos:

The political economy of the Bank of Canada in extraordinary times

Presented at the Political Economy of Central Banking conference,

Toronto, May 2009

Marc Lavoie and Mario Seccareccia
Department of Economics
University of Ottawa

July 2009

“Although quantitative easing is now referred to as an unconventional monetary policy tool, the purchase of government securities is, in fact, the conventional textbook approach to monetary policy…. In practice, most central banks have chosen to conduct monetary policy by targeting the price of liquidity because the relationship between the amount of liquidity provided by the central bank and monetary aggregates on the one hand, and between monetary aggregates and aggregate demand and inflation on the other, are not very stable.” (Bank of Canada, 2009b, p. 26).

The Bank of Canada thus feels compelled to recall that monetary aggregates are very badly correlated with price inflation, and that base money is also very badly correlated with the money supply. To provide excess bank reserves, as recommended by Monetarists, central banks must decline to sterilize its liquidity creating financial operations or it must conduct open market operations by purchasing assets. As pointed out by Deputy Governor John Murray (2009), “All quantitative easing is, by definition, ‘unsterilized’. Although this is correctly viewed as unconventional, it closely resembles the way monetary policy is described in most undergraduate textbooks, and is broadly similar to how it was conducted in the heyday of monetarism”. Murray misleadingly insinuates that such a technique has been implemented before, namely during the 1975-1982 monetarist experiment in Canada. What can really be said is that quantitative easing is an attempt to put in practice what academics have been preaching in their textbooks for decades from their ivory towers. It is merely monetarism but in reverse gear. While monetarist policy of the 1970s was implemented to reduce the rate of inflation, current monetarist quantitative easing is being applied to generate an increase in the rate of inflation.

As a result, the claims of quantitative easing are just as misleading as the claims of monetarism of the 1970s and early 1980s. Bank of Canada officials claim that “The expansion of the amount of settlement balances available to [banks] would encourage them to acquire assets or increase the supply of credit to households and businesses. This would increase the supply of deposits” (Bank of Canada, 2009b, p. 26), adding that quantitative easing injects “additional central bank reserves into the financial system, which deposit-taking institutions can use to generate additional loans” (Murray, 2009). In our opinion, these statements are misleading and indeed completely wrong. They rely on the monetarist causation, endorsed in all neoclassical textbooks, which goes from reserves to credit and monetary aggregates. It implies that banks wait to get reserves before granting new loans. This has been demonstrated to be completely false in the world of no compulsory reserves in which we live since 1994. In any event, even before 1994, as argued by a former official at the Bank of Canada, the task of central banks is precisely to provide the amount of base money that banks require (Clinton, 1991). Banks do not wait for new reserves to grant credit. What they are looking for are creditworthy borrowers.

Quantitative easing is an essentially useless channel. It assumes that credit is supply-constrained. It assumes that banks will grant more loans because they have more settlement balances. Both of these assumptions are likely to be false, at least in Canada. With the possible exception of its impact on the term structure of interest rates, the only effect of quantitative easing might be to lower interest rates on some assets relative to the target overnight rate, as these assets are being purchased by the central bank through its open market operations. It is doubtful that the amplitude of these interest rate changes will have any impact on private borrowing or on the exchange rate. Indeed, in Japan, which has had experience with zero interest rates for many years, quantitative easing was pursued relentlessly between 2001 and 2004, but with no effect, as “the expansion of reserves has not been associated with an expansion of bank lending” (MacLean, 2006, p. 96). Indeed, officials at the Bank of Japan did not themselves believe that quantitative easing could on its own be of any help, but they tried it anyway as a result of the pressure and advice of international experts. As Ito (2004, p. 27) notes in relation to the Bank of Japan, “Given that the interest rate is zero, no policy measures are available to lift the inflation rate to positive territory… The Bank did not have the tools to achieve it”.

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