The Bank of Canada's "stitch in time"

Steve Poloz is good at economics, but not always so good at finding the best metaphor.

Greg Quinn says "Bank of Canada Governor Stephen Poloz said his “controversial” decision to cut interest rates in January could be compared to life-saving surgery for the economy and any resulting increase in household debt should be viewed as a necessary side effect."

A better metaphor would use the old proverb "a stitch in time saves nine". (If you delay stitching a tear in your jeans, the tear will get bigger, and you will need even more stitches later.) If the Canadian economy did need a cut in interest rates in January, a delay would have weakened the economy more and more over time, requiring the eventual cut in interest rates to be even bigger.

So if there are bad side effects from cutting interest rates (if stitches are necessary but costly), that actually strengthens the argument for doing a stitch in time.

Of course, if you delay stitching the tear in your jeans forever, then your jeans will die. Which is where Steve's metaphor comes back to life.

We should learn from Sweden's Riksbank's recent mistake. It kept interest rates too high for too long, for fear that cutting rates would lead to increasing debt, which meant it eventually had to cut interest rates even lower than if it had done so in a timely fashion.

(I'm still not sure whether the Bank of Canada really did need to cut interest rates in January, but if you think you probably need to cut interest rates, you should cut now. "Let's wait and see if it gets worse" is not a good strategy. And this argument for a "stitch in time" works in reverse too, if you think that interest rates probably should be raised, but are worried about the side-effects.)

Comments

[Marko]

Why not cut interest rates and , AT THE SAME TIME , restrain additional lending to the household sector. Does this somehow violate the model ?

Cannot the folks at Bank of Canada walk and chew gum at the same time? Or , more likely , do they fear that the stimulative effect of rate cuts is dependent on higher household leverage ?

[Nick Rowe]

Marko: that is actually what the BoC advocates doing. Use regulation to deter excessively risky borrowing. But the BoC is not allowed to chew gum. It does not regulate the financial sector.

There's an interesting fallacy of composition in the argument that cutting interest rates *must* increase borrowing and hence increase debt if it is to stimulate demand. That works at the individual level, but at the macro level one person's increased spending is another person's increased income, so it's possible for everyone to increase spending without borrowing more. But I set that aside for this post.

[Marko]

"...it's possible for everyone to increase spending without borrowing more."

It's possible to grow without increasing leverage if productive enterprise is being financed such that income growth exceeds debt growth , but that hasn't been happening in most countries , for quite a long while :

http://www.mckinsey.com/~/media/McKinsey/dotcom/Insights/Economic%20Studies/Debt%20and%20not%20much%20deleveraging/SVGZ_MGI_DebtV2_ex_2.ashx?mw=510

Instead the effect has been for debt to bring consumption growth forward , only to give it back when the inevitable deleveraging occurs - see , e.g. :

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2499423

"...Cuts in spending associated with debt are estimated to have reduced the level of aggregate private consumption by around 2% after 2007, unwinding the faster growth in spending by highly indebted households, relative to other households, before the financial crisis."

[TallDave]

It's surprising, and perhaps telling, that more attention hasn't been paid to how easily Canadian institutions breezed through the banking crises. They seem to have to done a remarkable job of avoiding the revolving-door mentality of American and European banking, in which the system seems sometimes to have a primary purpose of enriching lobbyists and lawyers for navigating the legal labyrinth of Leviathan they themselves construct.

[Nick Rowe]

Marko: it's true (at least for Canada) we've seen private debt/GDP ratio growing over time. Part of that is probably due to whatever caused the lower interest rates. But then the debt service ratio would fall for given debt with lower interest rates. Same with the debt/asset ratio, because lower interest rates are correlated with higher asset prices (they are the same thing really.)

You can't really tell whether it's dangerous without disaggregating, and looking at individuals on the worst end of the spectrum in terms of debt/income and debt/asset ratios.

The "bringing consumption forward" idea rests on a fallacy of composition too. For every $1 borrowed there's $1 lent. One is spending $1 more, and the other is spending $1 less.

TallDave: there has been some attention paid to it, but not enough. It's hard to figure out exactly why Canadian financial sector seems to be (cross fingers) fairly resilient over the last couple of centuries. All I can say is that the standard US narrative "Big banks bad, more regulation needed" is wrong. Canada has always had big banks, and it doesn't seem to me to have been more regulated than the US, just differently regulated. It's less fine print legalistic and adversarial, I think.

[TallDave]

Exactly Nick, and I think that simplicity is actually why more attention hasn't been paid to it -- the class of elites who promulgate complexity also benefit from it, and assiduously elide the possibility that their machinations mainly benefit themselves. Simple reserve requirements seem to be sufficient, but don't require battalions of regulators and lobbyists.

[Nick Rowe]

TallDave: we abolished reserve requirements some time back. But perhaps you meant capital requirements. Yes, those are important. But possibly equally important is seeing the regulators and the bank as sharing a common interest in seeing that the bank doesn't go bust, rather than one set of clever lawyers trying to find loopholes in the legalise, and the other set of clever lawyers trying to close those loopholes.

[Jacques René Giguère]

Nick: "The "bringing consumption forward" idea rests on a fallacy of composition too. For every $1 borrowed there's $1 lent. One is spending $1 more, and the other is spending $1 less." Are you reneging on years of "debt are our children's burden" blogging? Long live Abba Lerner!

[Marko]

"The "bringing consumption forward" idea rests on a fallacy of composition too. For every $1 borrowed there's $1 lent. One is spending $1 more, and the other is spending $1 less."

Wow. At this late date , I didn't think there was anyone left who'd still try to pass that one off.

It's especially odd since you seem to recognize the importance of disaggregating , as you noted in your statement immediately prior :

" You can't really tell whether it's dangerous without disaggregating, and looking at individuals on the worst end of the spectrum in terms of debt/income and debt/asset ratios."

Disaggregating then , if the rich are lending and everyone else is borrowing , when credit flows stop , spending by everyone else BUT the rich stops. And the rich don't spend more when they're paid back , they look for another sucker to lend to.

[Nick Rowe]

Marko: a logical fallacy is still a fallacy, even if the consequent is sometimes true for entirely different reasons, under some circumstances.

And it is much easier to make the case that it is fiscal policy that is "pulling demand forward".

[Tom Brown]

O/T: DeLong invoked you in his own defense.