Fleishman Hillard: The Political View

Today’s calendar holds three interesting things: 1. The players in the Canadian ABCP market are moving towards a final resolution;  2. The Bank of Canada is making an interest rate announcement this morning; and 3. Today is the beginning of the holiday season. So I thought it would be worth exploring the concept of moral hazard in today’s posting.

First, a primer on cause and effect in economics:

1. Potential GDP versus actual GDP: GDP is the measure of the total productivity in Canada. Potential GDP is the level of economic activity that is reasonable and sustainable given our resources and workforce. When actual GDP is higher than potential GDP, it means the economy is overheated, and we are producing goods and services at an unsustainable level. This results in too much money chasing too few goods.
2. Inflation: Too much money means the price of things go up. Economists believe a little inflation is a good thing. People should have an incentive to spend money – if something cost more tomorrow, we should buy it today. The Bank of Canada has a target range for inflation of one to three per cent.
3. Interest rates: The Bank of Canada has one lever to pull to keep inflation in the target range: the overnight rate. The overnight rate is the rate banks lend to each other, and this is set by the Bank of Canada. To slow down the economy, raise interest rates.
4. Exchange rates:  An exchange rate equalizes the purchasing power of two currencies. Things like Big Macs, and personal loans should cost the same to residents in different countries. Exchange rates act as buffers between countries, and changes in exchange rates reflect changes in comparative economic strength.

That’s it. That is the traditional model for macro-economics and monetary policy.

So – moral hazard.  Moral hazard occurs when there is lack of consistency in accountability and consequence. “Too big to fail” is the catchphrase that captures this concept as it relates to the recent financial crisis, as the US government stepped in to support the mortgage insurers and investment banking firms, through emergency funding and support of hastily constructed transactions. Finance is based on the risk/ reward relationship. Risk isn’t risk if we do not pay the penalties. In typical, and laudable, Canadian style, we struck a balance. Many investors were hurt by their inability to access money invested in the supposedly safe investments, but the ABCP products were restructured in a way that did provide a way out. Short term notes were exchanged for long term debt. Not great, but not bad. It looks like the penalties for a $30 billion problem will amount to about $200 million; certainly a lot of money, but less than expected. The bigger danger – as correctly pointed out by a client last week – was the legal precedent this sets. Is this type of resolution now broadly acceptable?  Are other investors at risk? Do we have to restrict derivatives to standardized exchange-traded products?

When we meddle in a system, we create unintended consequences.

As I write this, the announcement has come out that the overnight rate is to remain at an all-time low of 0.25 per cent. In an effort to create stability and prevent panic, earlier this year the Bank of Canada committed to keeping rates unchanged until mid-2010. The Bank noted that weak exports were caused by a strengthened dollar – but remember that exchange rates are a consequence and buffer, not a cause to be cured by monetary policy. November’s housing starts were released yesterday, and are the highest level year- to-date. Low interest rates will cause bubbles in interest-sensitive businesses (similar to the temporary effect ‘cash for clunkers’ had on the automotive sector).  What will the Bank do when inflation gets outside its target range but it has promised to keep rates low? How will the Bank respond when the rate it sets is low, but the rates that the Canadian banks lend out at continue to rise? Will cheap money bring back leverage? Will the Bank try to manage exchange rates?

While we need to continue to moderate the dramatic effects of recent events, we need to understand the trade-off we are making between taking responsibility now and irreversibly changing our core model in the long run.

Happy holidays!