Question

What happened during Canada's post-financial crisis?

Answer 1

Oil prices continued to surge during the first months of 2008, and the Canadian economy was at first little affected by the US recession: employment and output continued to expand. But the US financial crisis in the fall of 2008 affected global financial markets, and Canada was not exempt from its effects. The collapse of the prices of oil and other Canadian commodity exports compounded the effects of the financial crisis, and the Canadian economy fell into recession in October 2008.

Canadian Policy Responses to the Recession of 2008–09

Stabilization of Financial Markets

The immediate priority of policy-makers in the United States and other countries was dealing with banks and other financial institutions that had suddenly become insolvent. Financial institutions play a key intermediary role in the economy, and governments acted to minimize the disruptions caused by bank failures. Banks that were sufficiently large were considered “too big to fail,” and had to be bailed out. Indeed, the fact that banks were aware that they were too big to fail produced a moral hazard problem: the belief in an eventual rescue by governments encouraged large banks to engage in risky behaviour.

Canadian policy-makers were spared this problem. Though all of the “Big Six” chartered banks — National Bank of Canada, Royal Bank of Canada, Bank of Montreal, Canadian Imperial Bank of Commerce, Bank of Nova Scotia and Toronto-Dominion Bank — were considered “too big to fail,” Canada’s regulatory regime prevented them from engaging in the sort of risky behavior observed elsewhere (see Bank Act). In particular, Canada’s banks were obliged to maintain lower debt-to-equity ratios than most of their counterparts abroad. Higher debt-to-equity ratios offer the possibility of higher profits rates, but highly leveraged banks are also more vulnerable to negative shocks to the value of their assets. After the 1985 collapse of Northland Bank and Canadian Commercial Bank, Canadian regulations were further tightened (see Estey Commission). Partly because of this stronger regulatory environment, Canada’s banks were not in danger of insolvency in the crisis.

Instead, the immediate priority of Canadian policy-makers was to restore stability and liquidity to financial markets (see Stock and Bond Markets). While Canadian investors and financial institutions were not as exposed to the sort of losses seen in the United States, Canadian holdings of asset-backed commercial paper dropped sharply in value. (The term commercial paper describes short-term, unsecured loans that companies issue in order to finance their accounts and inventories. They are usually sold at a discount but pay out at full value.) In order to avoid the sort of “fire sale” price collapses observed elsewhere, Canadian authorities persuaded investors to accept and write off short-term losses. In addition, measures such as the Insured Mortgage Purchase Program (IMPP) allowed banks to exchange illiquid mortgage assets for bonds issued by the Canadian Mortgage and Housing Corporation (CMHC). Since CMHC debt is backed by the federal government, these assets were more readily accepted as collateral for short-term lending. This exchange did not affect the government’s risk exposure to the mortgage market: only mortgages that were already insured by the government were eligible for the IMPP.

Monetary Policy

The failure of Lehman Brothers made it clear that the scale of the financial crisis would soon affect the real economy. On 8 October 2008, the Bank of Canada — in concert with other leading central banks — reduced its target for the overnight rate from 3 per cent to 2.5 per cent (see Interest Rates in Canada). This action was followed by a series of rate cuts until the Bank’s policy rate was reduced to its lower bound of 0.25 per cent on 21 April 2009. (The Bank allows a 0.25 per cent deviation above or below its target rate, so a target of 0.25 per cent implies a lower bound of 0 per cent; see Bank Rate.)

Since the Bank of Canada could not reduce its policy rate any further, it felt obliged to make use of “unconventional” monetary policy instruments. Other central banks, including those in the United States and United Kingdom, had also reached the lower bound of their policy rates and began to use unconventional monetary policy tools. The reduction of the interest rate to its lower bound in Canada was accompanied with a “conditional commitment” to maintain the Bank’s policy rate at its lower bound until the middle of 2010. This was the extent of Canada’s experience of unconventional monetary policyinstruments; unlike in the US and the UK, the Bank of Canada did not see fit to engage in quantitative easing.

Fiscal Policy

The Conservative government of Stephen Harper remained in power with an increased minority after the federal election of 14 October 2008. During the campaign, the Conservatives promised to keep the federal budget in balance, and its fiscal update of 27 November outlined measures to restrain spending in order to avoid going into deficit. Subsequent economic and political developments — including an attempt by opposition parties to form a coalition government — forced the Conservatives to back away from this position. The Harper government introduced a budget on 27 January 2009 that included a two-year stimulus program, mainly on infrastructure spending.