FINA Committee Meeting

STANDING COMMITTEE ON FINANCE

COMITÉ PERMANENT DES FINANCES

EVIDENCE

[Recorded by Electronic Apparatus]

Thursday, May 28, 1998

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[English]

The Chairman (Mr. Maurizio Bevilacqua (Vaughan—King—Aurora, Lib.)): I would like to call this meeting to order and welcome everyone.

As you know, the order of the day is pursuant to Standing Order 108(2), which is the consideration of the Bank of Canada's monetary policy report of May 1998.

I would like to take this opportunity to welcome the governor, Mr. Gordon Thiessen, and also deputy governors Charles Freedman and Paul Jenkins.

As you know, you may have some introductory remarks, and thereafter we will engage in a question and answer session.

Welcome, Governor.

Mr. Gordon Thiessen (Governor, Bank of Canada): Thank you very much, Mr. Chairman.

I must say that my colleagues and I are always pleased to appear before your committee following the release of our semi-annual monetary policy report, as it gives us a chance to discuss with you a range of economic and monetary issues. But I must say more generally that our semi-annual report and our sessions with you provide an opportunity for us to account for our actions and the results of those actions.

Before I turn to our recent monetary policy report, I would just like to say a few words about the objectives of monetary policy. In February 1998, the government and the Bank of Canada jointly reaffirmed that Canada's monetary policy can best contribute to good economic performance by remaining focused on inflation control. Keeping inflation low helps businesses and individuals to make sound economic decisions, and it helps to moderate cyclical fluctuations in incomes and employment. The February announcement extended our 1% to 3% inflation-control target out to the end of 2001.

[Translation]

Let me remind you that monetary policy has its effects on the economy with long lags. For that reason, decisions about policy actions to achieve this target for inflation control have to be forward-looking and thus are based on projections of an uncertain future.

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[English]

Since the release of our previous report last November, there have been an unusual number of unanticipated international and domestic developments, and these have had important economic and financial consequences for Canada. I'm speaking here of developments such as the extent of the crisis in Asia, the declines in primary commodity prices, and the persistent weakness in the Japanese economy. At home, there were the strikes by Ontario's teachers and the postal workers, and then there was the January ice storm. All of these had an effect on our economy.

In the United States, on the other hand, the economy has been substantially stronger than expected, including upward revisions to estimates of the first-quarter growth in the U.S. economy, which were made available this morning.

These developments have resulted in a higher-than-usual degree of uncertainty surrounding the economic outlook. When we add up the effects of all these events and look forward, we see the economy continuing on a solid growth path, although not quite at the same rapid pace we saw in 1997.

Despite the effects of developments in Asia, our economy is being supported by a very vigorous U.S. economy and by accommodative monetary conditions. We see inflation remaining inside our 1% to 3% target range.

[Translation]

While the uncertainty surrounding the outlook is greater than normal, the risks appeared balanced to us when we wrote this Report this month. Since then, there have been some signs of greater momentum in the economy, but they are not yet sufficient for us to revise our overall view.

[English]

This outlook, however, implies that the economy would reach a level close to full capacity during the course of 1999, and as we noted in our report, this path for the economy suggested to us that the recent range of monetary conditions would be broadly appropriate during the next six months, in the absence of further shocks.

Let me stress to you that this is a judgment we make about the level of monetary conditions that currently looks appropriate. This judgment is designed to provide Canadians with a perspective on the future, but if economic or financial shocks hit us from the outside or if the economy has more or less momentum than we can see at this time, we will of course reassess that judgment.

Let me also remind you that when we talk about monetary conditions, we are talking about the combined influence of short-term interest rates and the exchange rate for the Canadian dollar. Given the degree of economic uncertainty there is currently and that is likely to persist this year, monetary conditions may fluctuate over a relatively wide range, as they have recently.

[Translation]

Beyond the next six months, if the underlying momentum of the economy remains as strong as we currently anticipate, less-stimulative monetary conditions would be called for as the economy approaches and achieves full capacity.

[English]

I want to emphasize to you just how important it is to ensure that our economy reaches full capacity in a smooth and sustainable way. What we've learned over the past 25 years is that taking risks that could set off an inflationary boom means taking the risk of falling into a recession that would inevitably follow. It is by keeping the current economic expansion on a non-inflationary and therefore sustainable path that we are going to get the best gains in incomes and employment that our economy is capable of producing.

Thank you, Mr. Chairman. We are open to your questions.

The Chairman: Thank you very much, Governor.

We'll begin with Mr. Loubier.

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[Translation]

Mr. Yvan Loubier (Saint-Hyacinthe—Bagot, BQ): Good morning, Mr. Thiessen.

Last summer in a speech you gave to business people in Toronto, if I recall correctly, you said that inflation was the only concern of the Bank of Canada. Last fall, you changed your mind, and said that the Bank was concerned about both inflation and fluctuations in the Canadian dollar. You also said at that time that you would intervene with force if the Canadian dollar were to drop. The fact is, since the beginning of the year, the Canadian dollar has reached a record low three times, and your interventions have not been very forceful. Sometimes it is difficult to follow you on monetary policy, and sometimes it is difficult to understand your contradictory statements.

Could you please clarify what the objective or objectives of the Bank of Canada are? How do you explain the contradictions in your statements, which sometimes have an impact on the money markets and on the behaviour of speculators?

Mr. Gordon Thiessen: We have only one objective: to control inflation. That is because a very low inflation rate encourages better economic performance. However, the exchange rate does have a very significant impact on the economy. We must look very closely at the exchange rate and its effects on the economy. We have no target for the exchange rate, but when the exchange rate has an impact on the economy, for example when it affects the inflation rate or economic growth, this impact must be taken into account. But that is all. The exchange rate has a significant impact, but our only targets are the inflation rate and the behaviour of the economy.

Mr. Yvan Loubier: Speaking of targets, Mr. Thiessen, at least once this year, the inflation rate, as calculated according to your various indices, was less than 1%. At the moment, the figure you give is 1.2%, if I remember correctly. However, estimates must be taken with a grain of salt, in that they always contain variations that could mean that the inflation rate is actually less than 1% at the moment.

I asked you this question last year, and I'm going to repeat it this year, because there may be a little more basis for my fears this year. Are you not a little worried about the possibility of deflation? Every time we are at the lower end of the range—between 1 and 3%—there is a very serious danger of deflation, perhaps more serious than the danger of an inflation rate of 4 or 5%. Are you not concerned about the fact that the inflation rate has been 1% for a year now?

Mr. Gordon Thiessen: The drop in the inflation rate below 1% was accounted for by some factors that had a temporary impact on the inflation rate. I forget what they were, but our forecast for inflation is that the rate will remain within our target range. We do not see an inflation rate below 1%. However, we must always be vigilant. When the inflation rate is too high, we must react, just as we must react when the inflation rate is too low. For the time being, we do not think there is any great risk of deflation, particularly given that our major partner, the United States, is facing very strong overall demands on its economy. In that case, there is a danger of increased inflation, rather than deflation. If the American inflation rate increases, there will be an impact felt in Canada. I don't think there is any great danger of deflation in Canada.

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Mr. Yvan Loubier: I know that you are an extremely cautious person. Would caution not demand that the inflation rate be a little higher within the range, in order to avoid a very serious deflation problem? Given the trends in the Consumer Price Index, if investors face a possible negative growth in prices, they will stop investing and the jobs that should be created will not be created. We have never seen a deflationary spiral. Personally, I don't think there has ever been a serious deflation in history, anywhere in the world, but I am greatly concerned about this possibility. I have been asking this question for a year, and you say that you are cautious and that you check price trends periodically. However, wisdom and caution would probably dictate a higher inflation rate than we have at the moment, even given the situation in the US The situation in Canada is quite unique, real interest rates are lower than those in the United States. In any case, I find this worrisome.

Why could Canada not follow the American example, and have a monetary policy that takes into account not only inflation control but also employment? There is no doubt that inflation is higher in the United States than in Canada, but the US has price stability, without an inflation control target as such, and the unemployment rate is much lower than here. Why is the Bank of Canada not interested in an approach of this type?

Mr. Gordon Thiessen: In response to your first question, we expect that the Canadian economy will approach full capacity next year, as I said earlier. In that case, the inflation rate is likely to increase, rather than decrease. The recent drop in our exchange rate will also have an impact on prices in Canada. For these two reasons, I don't think there is any great danger that the inflation rate will fall below the lower figure of our target range.

As regards your second question, we see that the United States is experiencing both a drop in inflation and a drop in unemployment. The unemployment rate is the lowest since the 1960s. During the 60s, inflation was very low in the United States. The two go together. There is not really a trade-off between unemployment and inflation.

I think that Canada could now achieve a much lower unemployment rate than it has at the moment, precisely because our inflation rate is so low. We had a very low unemployment rate in Canada during the 60s, but we also had a very low inflation rate. I think the two go together.

[English]

The Chairman: Thank you, Mr. Loubier.

Mr. Harris.

Mr. Dick Harris (Prince George—Bulkley Valley, Ref.): Thank you, Mr. Chairman.

Welcome, Mr. Thiessen and your officials. I'm really happy to be here, because I have a couple of questions that I've wanted to ask for quite some time now.

The first one would be this. On many occasions we've had to prop up our dollar to keep it from sliding. What in your opinion would be the settling level of an unassisted dollar at this time? In other words, if we did not assist our dollar, what do you think we could expect the true settling value to be currently?

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Mr. Gordon Thiessen: Well, there is no such thing as an unassisted dollar, or an assisted dollar. The thing is, there's always a monetary policy in place, and in Canada that monetary policy has to take account of the impact of the exchange rate on the economy.

The exchange rate is always going to reflect that. So you really cannot think—it's just not an experiment you can imagine—what if there was somehow no monetary policy; what would the exchange rate be? I just don't think it is a very helpful way of looking at things.

On the notion that we prop up the dollar, we don't have a target for the dollar. We have a floating exchange rate system, but as I was explaining, the focus of monetary policies in Canada is to keep inflation low and within a certain range.

We think that over time this provides the best long-term support there is for an exchange rate. It doesn't require specific propping up or not, it just is. You follow a good long-term, low-inflation policy, and over time that will be good for your currency.

Mr. Dick Harris: Thank you.

I want to deal with the issue of inflation for a moment. In the past, some people have argued that cutting taxes during a period of robust economic growth was somewhat ill-advised, since the central bank would probably be forced to raise interest rates to stifle inflationary pressures, and as a result of the increased consumer spending.

However, we've noticed that substantial tax reductions have taken place in Ontario, for example, without a corresponding increase in interest rates, and without sparking inflation. Considering that this province has about half of our population, can you comment on why, in your view, the tax cuts in Ontario have sparked neither large interest rate hikes nor inflation?

Mr. Gordon Thiessen: But what monetary policy has to take into account is everything that's going on in the economy. No specific things. You have to look at what the total level of demand in the economy is likely to be as we move forward.

So you have to look at what's happening in the private sector, what's happening in the public sector, and what's happening abroad. You put all that together, and if you're in the central bank, you ask yourself the question: Does all of that demand likely mean that the Canadian economy is going to operate at full capacity, less than full capacity, or will pressure be put on inflation?

That's what the central bank reacts to. It doesn't react to anything else individually. You can have a situation, for example, where there is a huge investment boom in the private sector. It is so huge that the Canadian economy is not capable of dealing with all that demand at one time. In those circumstances, monetary policy is going to tighten to just smooth that out so that you don't end up having an inflationary bubble.

Similarly, if you have a rapid expansion on the fiscal side for one reason or another, and that is on top of a private sector that is already strong, then the combined effect of the two is what the central bank has to take into account.

So you can't just say, if we do that, you'll do that. You have to look at the whole economy.

Mr. Dick Harris: Thank you.

I'm wondering if you could comment on what you feel could be making the difference in the economic climate comparisons between Ontario and British Columbia. Ontario's economy grew by about 5.2% in 1997, and is expected to continue growing, while there are now actually fears of an outright recession in British Columbia.

In your opinion, are there factors other than the Asian currency financial crisis that could explain the difference?

Second, if federal policy is responsible in the main part for Ontario's robust growth, could it also be responsible for the weakness in the B.C. economy?

Mr. Gordon Thiessen: Well, I guess I would suggest to you that certainly right now what's happened to primary product prices is very important in B.C. That economy still has a major part of its activity related to primary product prices, and most certainly that is important.

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I must say, I have difficulty commenting on all the other things. They are difficult to make judgments about. Most issues with respect to taxation, the size of government expenditures, and so on, tend to have their effects over very long periods of time as opposed to short periods of time. So I find it difficult to comment on that.

It's also true, one needs to remember, that the B.C. economy has really had quite a strong run, whereas the Ontario economy went through a rather difficult period in the early 1990s, and is coming back out of that rather nicely.

But for the moment, I would suggest to you that the big difference really is Asia and primary commodity prices.

The Chairman: Any further questions, Mr. Harris?

Mr. Dick Harris: Thank you, no.

The Chairman: We'll go to Mr. Nystrom.

Mr. Lorne Nystrom (Qu'Appelle, NDP): Thank you very much.

I want to welcome my fellow Saskatchewanite, Mr. Thiessen, here this morning, and his colleagues.

I want to ask you questions basically on the unemployment side. The unemployment rate in this country is still hanging stubbornly at a very high level compared with the United States and some other jurisdictions.

I want to ask you what factor this is in terms of your monetary policy decisions and so on. I specifically want to ask you about what is called a “non-accelerating inflationary rate of unemployment,” the NIRU, and what impact and influence that has. Could you explain that to the committee, and tell us what the target NIRU rate would be?

In addition to this, I also want to say that recently there was a Nesbitt Burns report that estimated that the natural rate of unemployment in this country was 7.5%, from a low of 5.5% in Ontario to a high of 16.5% in Newfoundland.

I guess you'd say then that under those conditions, we'd have full employment in Saskatchewan, Alberta and Manitoba.

What is the natural rate of unemployment? Do you work with those kinds of models in terms of the Bank of Canada's decision-making process? Can you tell us what they are? Can you tell us a bit more about the NIRU, and how these models fit into what you do in terms of policy that affects each and every Canadian?

Mr. Gordon Thiessen: Well, as I was just explaining, the way we look at the economy is that you have to look at everything in the economy. What we do is try to make an estimate of what full-capacity utilization is in the economy.

That has to do with every single contributor to the economy, not just the labour force, but also capital, entrepreneurship—the whole works. We think that is the only sensible way to go about this.

With respect to the non-accelerating inflation rate of unemployment, trying to estimate that is so difficult. It has such a wide range of error around it. We just don't use it as an input to policy. We do not have a target for it.

In fact, I think it would be incredibly bad policy to have a target for it, because if you make a mistake, you can get yourself into either a serious inflation or a serious recession. Given the difficulty of estimating it, why would you ever run policy that way? We don't, and we haven't.

And I would suggest that if you see any estimates of those kind of calculations, put a really wide band of uncertainty around them.

Mr. Lorne Nystrom: Yes. I just wanted to see whether or not you use the models and the estimates.

Could you tell us, first, what full employment would be? Do you do those kinds of estimates at the bank? What is full employment, and why is there the big difference between our country and the United States? If unemployment here were to drop by three or four points in the next year or so, is that inflationary?

Can you enlighten us a bit in terms of the thinking in your institution about that important area? It is still a very big issue in this country for a lot of Canadians—

Mr. Gordon Thiessen: Sure.

Mr. Lorne Nystrom: —outside of some areas where things are going well.

Mr. Gordon Thiessen: I'm afraid we're going to have to be very agnostic about what kind of unemployment rate we're going to get down to. There have been so many changes in this economy over the course of the last number of years.

There has been a degree of restructuring in the Canadian economy that is enormous. There has been an introduction of technology in this economy that has been enormous. There has been a change in the orientation of Canadian businesses to be more open and oriented to international trade.

These are huge differences, huge changes in our economy. In those circumstances, I think it is just incredibly difficult to know what kind of an unemployment rate we're going to get down to this time.

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Now, the thing that is rather attractive about the policy we follow of keeping the inflation rate low is that it allows you to feel your way, just as the Americans have over the course of the last few years.

When the Americans started on this expansion in their economy, most people thought that the best unemployment rate they were likely to achieve was 6%. But they just kept their eye on the inflation rate, and as long as the inflation rate was drifting down, it was possible to allow ongoing expansions of demand in that economy, and the unemployment rate now has drifted down to 4.3%.

We don't know if they're going to be able to maintain that over a long period, but I suggest to you that by keeping their eye on the inflation rate, they achieved the best unemployment rate they've had in 25 years.

I'd like to think that this is what what we can do, too. What rate we're going to get down to, I don't know. If you'd have asked anybody in the United States three years ago, “Are we likely to get down to 4%?”, they would have said, “Not a chance”.

Mr. Lorne Nystrom: You mentioned earlier that in the 1960s we had a very low inflation rate and a low unemployment rate.

Mr. Gordon Thiessen: Right.

Mr. Lorne Nystrom: Correct me if I'm wrong, but it seems to me that the objective of the bank then was to have low unemployment and low inflation.

Today the difference is that you're looking at inflation as the really important, primary objective. You even said that again this morning, that we need a low inflation rate, and you seemed to be forgetting about the employment side.

Isn't that a shift in terms of the central bank in this country over the last 30 years? Might that not have been the reason that the unemployment rate was lower in the 1960s along with the inflation rate, while today we have the opposite—lower inflation but still very high unemployment?

Mr. Gordon Thiessen: No, I would suggest to you that it's quite the reverse.

The mistake we made in the late 1960s, and into the early 1970s, was that we took our eye off the inflation rate. At one point we thought there might be a trade-off there. In doing so we made a grave mistake, and we ended up with an inflation rate that was substantially higher, and an unemployment rate that wasn't lower. In fact what we had from the 1970s through to the beginning of the 1990s is both higher inflation and higher unemployment, both of them sort of gradually drifting up to the early 1980s.

So I think when we look back at the 1960s and we say, “Now, what's the lesson we learned from that?”, the lesson we learned is that by keeping your eye on the inflation rate, you are likely to have the economic expansion last longer. Therefore, there's more chance that the unemployment rate is going to come down.

It's very interesting how, as that U.S. expansion has continued, they keep getting gains in the unemployment rate. The longer you can get that expansion to last, the better off you are.

Mr. Lorne Nystrom: I guess my last question would be on how you set the inflation targets. I mean, do you go back? Back in February 1991 you had a target set in the midpoint of 1% to 3%. In December 1993 it was extended until 1998, and in February of this year it was extended once again to the end of 2001. How is that done, and why was that particular rate set?

Then the other question would be, who sets the rate? Is it you as the Governor of the Bank along with your advisory colleagues, is it the Minister of Finance, or do you do it together?

Mr. Gordon Thiessen: We do it together. It's a joint agreement. It was a joint agreement in 1991, it was a joint agreement in December 1993, and it was a joint agreement in February 1998.

We go back, do the work, and ask ourselves: Is there some measurement error in the inflation rate we need to take account of, are there some rigidities?

What we've said here is that we need to live with low inflation for a period of time, and let's just see how successful we are. On the basis of that, let's then decide what some long-term objectives should be.

And that's what we've decided, that we should—

Mr. Lorne Nystrom: How do you pick the number? Why is it between 1% and 3% instead of between 0.5% and 2.5%, or 4% and 6%?

Mr. Gordon Thiessen: That is essentially because when we look at the measurement errors, it looks to us to be of the order of 0.5 to 0.7. Then you say, well, it's a long time since we've been at very low inflation rates, and we're not sure just how the economy is going to proceed.

You put a band around that. Once you get up over 3%, then if you take the compound interest effect of a compounding effect of ongoing inflation rates, you can undermine the effects of fixed income very rapidly.

So it's a kind of compromise one sets, but right now it's relatively arbitrary.

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Mr. Lorne Nystrom: Do you take in the regional variations in the country? If you look down the road, if Ontario keeps on going as it has been, the unemployment rate will keep on falling in, say, a couple of years. The economy there will be looking to run like that in the United States in terms of the unemployment inflation rate. Then you have the Atlantic, including Newfoundland, that needs a lot of stimulus and a lot of help.

How important are these regional variations? I mean, Ontario is so large. It's 38% of the population of the country and almost half the economy of the country. For Newfoundlanders, those regional variations are exceedingly important, but Newfoundland's a very small part of the country. It's not just Newfoundland; there are other parts of the country where the unemployment rate is very high.

How important are those regional factors? You don't see the world—please assure me—from the prisms on top of the Bank of Canada, from what you can see from there, right down to Toronto, or from the top of the CN Tower. The world is more than that. You know that, from a small town in Saskatchewan.

Mr. Gordon Thiessen: Well, there can only be one monetary policy in Canada.

Mr. Lorne Nystrom: I know that, but how important are those factors in determining that policy?

Mr. Gordon Thiessen: You have to run it on the national average. It's the only way to do it. There's no other way. But you know, it's really interesting; if you remember, when it looked like so much of the pressure on inflation was coming out of southern Ontario in the late 1980s, and it didn't look like we had as much pressure elsewhere, there was remarkably little difference in the inflation rates across the country—remarkably little difference. The difference between the Atlantic Canada inflation rate and the Ontario inflation rate was so minute it was very difficult to see. In fact, about the only differences you could ever see was if the provincial governments raised or lowered their sales taxes.

Mr. Lorne Nystrom: I want to ask about your board of of directors. Can you tell us how reflective that board is of the country, not just geographically but also in terms of what walks of life or endeavours they come from in terms of reflecting the demographics of the country to a certain extent—some of the trade union movement or the farm movement as well as business and small business and so on?

A board of any corporation or company or entity is extremely important in terms of the direction it goes. As someone coming from a small province in the west, I have had questions about this over the years.

Mr. Gordon Thiessen: Of course, it is the government of the day that appoints the board. Individual members are appointed for three-year terms, so we at the Bank of Canada obviously don't appoint the people who oversee our operations.

Mr. Lorne Nystrom: I'm aware of that.

Mr. Gordon Thiessen: We do have directors from every province—two from Ontario, two from Quebec. I'll have to refresh my mind about what they all do.

From B.C., our director is in the forest products industry; from Alberta, the director is in a law firm but he is highly involved with the local telecommunications business. We don't have a director from Saskatchewan right now, because he's in the business of deciding about the future structure of the Canadian financial system.

Mr. Lorne Nystrom: Harold MacKay.

Mr. Gordon Thiessen: Yes. From Manitoba, our director is a retired chartered accountant who's had an incredibly wide range of business activities in Manitoba.

In Ontario we have a director from Sudbury who is a lawyer, but he was involved for many years in Ontario Hydro. Our other director from Ontario is Judith Maxwell, whom I think you all know.

From Quebec, we have Raymond Garneau, who's in the insurance business; we have Paul Massicotte in the development industry.

In New Brunswick we have Aldéa Landry, who is a lawyer. She is involved in a lot of social issues in New Brunswick. In Nova Scotia we have Bernie Boudreau, who's recently been in Parliament. From P.E.I. we have Barbara Stevenson, who is a lawyer. From Newfoundland we have Winston Baker, who was recently in the Newfoundland government.

Mr. Lorne Nystrom: Yes—and the brother of one of our colleagues.

I wonder if you can tell us about the gender balance. Do you think the Minister of Finance has done a good job in terms of reflecting the gender demographic of the country?

Mr. Gordon Thiessen: We probably do better than a lot of them. There are three women out of twelve on our board right now.

Mr. Lorne Nystrom: Okay.

The Chairman: Thank you, Governor.

Mr. Brison.

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Mr. Scott Brison (Kings—Hants, PC): Thank you, Mr. Thiessen. I appreciate your being with us today.

My first question is on the euro and its impact, potentially, on the Canadian dollar. There's been a great effort since the Maastricht Treaty in Europe to bring some semblance of similarity between the fiscal structures of those economies, to bring the fundamentals of those economies together.

We still suffer in Canada, for instance, from a very high debt-to-GDP ratio. I think the Maastricht criteria for debt to GDP was 60%. There are provinces within Canada like Nova Scotia, my home province, that has a 97% debt-GDP ratio, so I think the challenges of running the euro are probably in some ways fewer than the challenges of running a currency that reflects all the regions of Canada. I'd be interested in your feedback on the impact of the euro on the Canadian dollar.

My second question has to do with globalization. The ability for a country to have an impact on its own currency through monetary policy is somewhat compromised, and fiscal policy in many ways is becoming a more powerful lever. We've seen our dollar lose a nickel over the past four years, and notwithstanding the drop in long-term rates, the short-term rates are higher today than they were four years ago.

If in fact a strong dollar is a goal, and if in fact we're not going to try to devalue our way to prosperity, what set of fiscal policies would lead to a stronger dollar? For instance, this past year 20% of our foreign debt matured and that was one of the downward pressures on the dollar. In fact, one of the fiscal policies that would be sound would be to pay down our debt, for instance, if that was the case.

Another question relates to an article in the Globe and Mail on September 2, 1993. Liberal leader Jean Chrétien said that “A Liberal government would tell Bank of Canada Governor John Crow to pay greater attention to job creation and not be fixated on inflation.” When he was asked what he would do if Mr. Crow disagreed, Mr. Chrétien said “I'm telling you that he's an official of the government.”

Mr. Thiessen, has the government in fact followed through on that commitment? I'm not saying I agree or disagree with that type of policy. Has the government in fact applied significant pressure to you to be consistent with the promise made by Mr. Chrétien in 1993?

Lastly, I recognize that traditionally there is a debate between inflation and employment. I recognize also your arguments that the two, low unemployment and low inflation, can coincide. Why have the U.S. and Japan—although Japan has certainly had its difficulties recently—been so successful in bringing down unemployment rates? Even in the U.K., where they have effectively half the unemployment rate we do in Canada without really setting off inflation, what are they doing right that we can do?

I would ask you to try to focus on fiscal policy alternatives that you can see from your perspective, because those fiscal policy alternatives are the policy alternatives that we as parliamentarians are in a position to effect changes in.

Those would be my questions for this round.

Mr. Gordon Thiessen: With respect to the euro on the Canadian dollar, it's not likely to have much effect, certainly not initially. If they're really successful with that project, then eventually one might expect that the euro would become an international currency. If that happened, then we would probably wish to look at our reserves, which are now held mainly in U.S. dollars, and ask ourselves whether we wouldn't want to hold some of this competing international currency, the euro.

You're really not going to do that until the euro really establishes a track record of being a strong, stable currency, and probably even more importantly, that there are really deep and liquid markets in euro-denominated assets.

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One of the great attractions of the U.S. dollar these days is that if you want to hold funds in U.S. dollars, you can buy U.S. treasury bills or U.S. treasury bonds. The market for those in New York is so broad and so deep that you can sell them at a moment's notice with just the tiniest spread that you have to pay. It's very attractive.

Until the euro develops markets of that character it will not be as attractive a currency as the U.S. dollar. I don't think the mere creation of the euro has a huge impact on the Canadian dollar in and of itself.

I gave a speech on globalization yesterday in which I tried to explain that globalization doesn't undermine the capacity to have an independent national monetary policy. It really means you have to take account of the role of the exchange rate. We have essentially had an economy and financial markets that have been open between Canada and the United States for about 50 years.

Mr. Scott Brison: On that point, Mr. Thiessen, my concern is countries that operate a fiscal policy inconsistent with their monetary policy. The stream of globalization I'm talking about includes currency speculators, for instance, who can quite quickly resolve or eliminate any inconsistency, as was done in Asia. That's really what I'm referring to.

In fact, traditionally, countries were able to operate a very independent monetary policy that wasn't necessarily consistent with economic reality, but they got away with it. What I'm talking about is the speculator's ability to effectively right that wrong.

Mr. Gordon Thiessen: You're certainly right that markets regard everybody very carefully. If countries are pursuing policies that don't look to be sustainable, that don't look to provide investors with a kind of protection with respect to the value of their investments they seek, they're going to look elsewhere.

It would be wrong, though, to characterize that as in the past you could do all that stuff, and presently you can't. It is really just a matter of degree. If countries essentially pursue bad fiscal and monetary policies, they're going to run into problems. There is no question about that.

One of the really interesting things is that it's easy to say there are these speculators out there who are ready to hit you at the slightest provocation. In fact, when we look around the world, the first people to run for cover when bad policies are being pursued are local investors. They're the ones who understand the situation the soonest. and they're the ones who frequently withdraw their money sooner rather than later.

In general, my point is that globalization gives you access to markets you wouldn't otherwise have. It allows you to borrow in a way you couldn't otherwise and it allows you to finance big projects in a way you couldn't otherwise. It still allows you to run an independent monetary policy.

I think of the dollar as more in line of the result rather than an objective. If you don't have a fixed exchange rate, the dollar isn't, and shouldn't be, a target, but over long periods of time it's in fact a good indicator.

What you see in an economy like that of the United States now, and Japan in the 1980s, is that a strong economy that produces lots of employment and lots of productivity growth also has a strong currency, providing, as well, it keeps its inflation rate low. All of those things go together—low inflation, strong productivity, declining employment. You will see countries like that doing really well and they will end up with a strong currency.

To carry on in terms of that part of your question, essentially the U.S. now and Japan earlier have really taken advantage of technological changes. They have been very oriented to international markets, and that's where you can really take full advantage of technology and productivity improvements.

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The Americans are doing a splendid job of it right now, and they're doing rather well on unemployment. They started earlier than most of the rest of the world to cope with this current surge of technological change and the sharp change in the fact that more and more countries are open to the rest of the world.

So all those international markets are far more competitive than they were before. The Americans are taking the best advantage of that of anybody, while the rest of us are running behind. We're running about five years behind, the Europeans are running behind us, and I'm not sure about the others. But if we all take advantage of those features, if we all do our best to take full advantage of technology and those new markets that are open to us, then I see no reason why we can't follow what happened in the U.S.

You have to make sure you avoid the mistakes the Japanese made. The Japanese essentially allowed inflationary pressures, especially in asset prices, to get away on them, and they ended up with the famous “Japanese bubble”, from which they are only now recovering. But I think that what they did during the 1980s to take advantage of markets and technology was impressive, and I think that's what we should do as well.

So I don't end up out of all of this being able to give you some nice fiscal policy alternatives, but I think if you look around, you will see that in most cases you had a situation where countries did not allow the accumulation of public sector debt to get out of control, because the moment you do that, you are on one of these unsustainable paths we were talking about. At some point, you're going to find that investors, both local and foreign, are going to get nervous and are going to want out.

Mr. Scott Brison: But in terms of a strong currency, you're saying productivity is obvious. So government policies, be they fiscal or social, that create an environment within which productivity grows or increases, will, in the long-term sense, have a significant impact on the dollar.

Mr. Gordon Thiessen: Absolutely.

Mr. Scott Brison: To what extent has the government's ability to eliminate the deficit been based on structural changes made in the Canadian economy in, say, the late 1980s and early 1990s? I'm speaking about things like free trade, the GST, and the deregulation of financial services in the transportation industry.

Mr. Gordon Thiessen: I think all those things have contributed to productivity. It's incredibly difficult to try to say that you can attribute this improvement to that structural change. You really can't. People try to do it, but it's not worth it.

What you do know is that there have been a number of changes made over the course of the last number of years that should contribute to increased productivity in the future. If that happens, then we will get a strong currency out of it. Not only do you get a strong currency, you get growth in incomes and employment. Productivity is really at the centre of all of this stuff.

The Chairman: Thank you, Mr. Brison. Thank you, Governor.

We'll move to Mr. Valeri now.

Mr. Tony Valeri (Stoney Creek, Lib.): Thank you, Mr. Chairman. I have about three questions. I'll try to be brief, because I know some colleagues have some questions as well.

Essentially, this has been covered off I think in some earlier questions, but I wanted to be a little more specific in seeing whether you'd be able to help the committee understand what, in fact, is the operating principle that guides monetary policy.

At one point, it was understood that the measurement of M1 and M2 was the guiding principle, then we moved to this monetary condition index. I've been reading lately that we've gone to the overnight rate. If in fact it is the overnight rate, what does it mean in terms of the role of the exchange rate as a determinant of monetary policy? That's the first question.

The second question is this. I don't often agree with Mr. Loubier, but he did bring up the point about deflation. With the drop in commodity prices, there seems to be some threat of deflation. I find it somewhat ironic with that threat that there is this continuing discussion going on out there about the need for an increase in interest rates.

I wonder if you can comment on that in relation to the potential for deflation. If in fact we measure inflation correctly, it could be said that inflation is dead. There has not been any inflation, so there's this concern about deflation.

Last, just to pick up on what Mr. Brison was talking about with the issue of productivity, Greenspan in the U.S. has said—I'm paraphrasing—that he felt they've entered a new era in the U.S. and that greater productivity pushing the envelope has not yet triggered inflationary pressures. He attributed this increase in productivity to improvements in technology.

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I wondered if you agreed with that, and if in fact you could comment on how that comment relates to Canada.

Mr. Gordon Thiessen: With respect to operating techniques, you're absolutely right that once upon a time, we did have an operating target for M1. But through the whole piece, the instrument that we use, the thing that we really control on a short-run basis, is the so-called overnight trade. That's the one-day rate.

That's the single instrument the central bank has, and we have always used that. We've used it in different ways, but that has always been the operating instrument. It still is.

During the period when we were using M1, we essentially moved the overnight rate to achieve a growth rate in M1 because that looked to us to be the best way to reduce inflation and get the economy onto a sustainable track. It turned out that there were so many changes going on in the financial system that M1 became unreliable, so we dropped that.

More recently, we have been making use of monetary conditions, such as the combined impact of interest rates and the exchange rate on the economy, but we still use the overnight rate to achieve that.

So if, for example, we think that monetary conditions are too easy such that they're potentially leading to a pace of expansion in the economy that will eventually put too much pressure on capacity, then we will raise the overnight rate and the bank rate—the two go together—and that in turn will encourage other interest rates in the country to go up, and it will encourage the exchange rate to go up. We put those market rates and exchange rates together in monetary conditions, but the role of the overnight rate has not changed through the piece.

I know the article you're referring to; he didn't get it quite right.

I'm sorry, Chuck. Do you want to add something?

Mr. Charles Freedman (Deputy Governor, Bank of Canada): Perhaps I can add that when we had the monetary aggregate it was what we called the intermediate target. Ultimately, as the governor suggested, what we were looking at was inflation, but this was in a sense something we could target on as a means to that end. It wasn't actually the ultimate target at that point.

The difference between that and where we are now is we now have an explicit target for inflation, whereas before, we had an explicit target for monetary aggregates and an implicit target for inflation.

Mr. Gordon Thiessen: Your second question was on the issue of deflation. It is true that commodity prices are weak and have been falling, but you have to ask yourself what the appropriate target of monetary policy is.

Monetary policy seeks to encourage the Canadian economy to produce the best levels of income and employment that are possible over time. After all, it really is for providing benefits to all Canadians. So when we look at the role of inflation, what we're really looking at is which prices matter to Canadians as consumers.

So we look at the consumer price index because we say it's the provision of goods and services to consumers that's the end result of economic activity. That's what you want to focus on. Our target focuses on the consumer price index.

Yes, if there were large movements in commodity prices for a significant period of time, that would eventually feed into the consumer price index. So what you find is that the consumer price index moves in a rather stable fashion, but all kinds of other prices will cycle around, whether they're land prices, commodity prices, or equity prices.

But those are not the focus of policy. The focus of policy is the prices for goods and services that Canadians buy, which is the consumer price index.

We do not think that this looks—as I was saying in response to Mr. Loubier—to us to be in danger of falling into deflation. In fact, with the strength of the American economy next to us and with our economy moving closer to full capacity, we don't see that there should be strong downward pressures of the sort that would lead us to deflation.

Finally, there's productivity. Alan Greenspan's absolutely right—it's again the answer I was giving to Mr. Brison—that technology is very important. Those economies that take good advantage of it can achieve productivity gains that allow the really good performance the Americans have. That's what the Japanese managed through much of the 1980s as well. If we are successful in taking advantage of this technology, embodying it in goods, and selling it domestically and overseas effectively and competitively, we're going to do well.

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Mr. Tony Valeri: Thank you.

The Chairman: Thank you, Governor.

Mr. Szabo, please.

Mr. Paul Szabo (Mississauga South, Lib.): Thank you, Mr. Chairman, and thank you, Governor Thiessen.

I thought your explanation that a low inflationary scenario really provides the optimum environment for healthy economic performance...and yesterday on the news your performance was, I think, very consistent that we don't have an inflationary target per se, but rather we monitor a variety of factors that help us to guide monetary policy.

Back in 1993, when the current government took office, deficits were the order of the day and targets of deficit-to-GDP were targets for government performance. Of course now as we enter into a whole new phase of Canadian economic reality, deficits are no longer the measure, the debt is. You know the Auditor General—I think it was two or maybe even three annual reports ago—introduced into the discussion the idea of a sustainable level of debt. I'm sure this is going to be discussed a lot more as we move forward in assessing our need to intervene in terms of monetary policy.

To get the debt-to-GDP down, economic growth contributes to that goal, as well as absolute debt repayment. I wanted to ask you to comment on the outlook for how we are doing there, knowing that in the private sector, say, the debt-to-equity ratio was a very significant indicator of financial health.

When you consider the differences between the public and private sectors, I think you would also have to take into account other major factors such as the value of the assets of Canada, which are not on some balance sheet. I think the Simon Fraser Institute estimated at one point that excluding land, Canada's value was something like $3 trillion. If you took the $580 billion of national debt, we in fact have a substantial imputed equity within Canada. I think that has to be taken into account by the international financial experts as to the financial health and therefore the strength of our dollar relative to that of our international trading partners and financial partners.

I wanted to ask you to comment on the comparability in terms of the position and strength of the Canadian dollar, taking into account first of all our debt-to-GDP likelihood, how we approach it, and the value of Canada in terms of how we stack up in security for the Canadian dollar.

Mr. Gordon Thiessen: I'm afraid the issue of what level of debt you should aim for is a very difficult one.

Some studies have been done. They're really not all that satisfactory yet, and undoubtedly more work needs to be done.

What we do know is that current levels of debt—and I must say, I always focus on total, not just federal; federal-provincial is edging below 100% of GDP right now—are very high.

That puts you into a fragile situation. If bad new comes along internationally for whatever reasons, then investors, both Canadians and foreigners, are going to look at the debt ratio here and worry about how governments service those debts into the future.

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I must say, I'm a strong advocate of getting that debt-to-GDP ratio down. I think how fast you do it is what you as parliamentarians and a government have to decide. I think those are political decisions.

It does seem to me that right now we are leaving ourselves in a somewhat vulnerable position. How low should you go? It's very difficult to tell.

You're absolutely right that you should look at both sides of a balance sheet. Even that is a very difficult judgment to make, even with a corporation. You look at the debt of a corporation. You look at the assets of a corporation. What really matters if you're an investor, holding the debt of that corporation, is how good those assets are. What kind of revenues are they going to generate for the corporation so the corporation is going to be able to pay you the interest it owes you? You have to look at the nature of those assets.

I think, similarly, if you're going to look at it for a government, you're going to have to ask yourself what kind of assets are out there. Are they going to lead to the generation of revenues for governments in the future and thereby make it easier for governments to make high levels of interest payments on the debt?

I think you want to be rather cautious about all of this.

I certainly accept the view that if debt imposes a burden on subsequent generations, it's very useful to see if the government has also acquired assets that will yield benefits to future generations. I think that is really quite legitimate to look at. It's not an easy calculation to make, I must say.

I think I'm left in the meantime saying the focus should now be on getting that debt-to-GDP ratio down. Once we get it down, maybe it would be good idea to ask what's the best way of deciding exactly what we should target. These other considerations should be taken into account. Right now, I'd sleep better if that debt-to-GDP ratio just kept going down.

The Chairman: Thank you.

Mrs. Redman.

Mrs. Karen Redman (Kitchener Centre, Lib.): Thank you, Mr. Chairman.

I have three questions that deal with inflation, Governor.

Recently it has been suggested in The Economist that western countries really have not achieved the low inflation rates they claim, because they fail to take into account asset prices. When they're taken into account, actually the inflation is much higher.

I was just wondering if you could comment on that and on whether or not taking asset prices into account is a better, more accurate way to deal with inflation.

Mr. Gordon Thiessen: No, I don't think so. As I was saying earlier, the objective of economic activity is to provide people with the goods and services they can consume. This really allows you to have the food, the energy, the transportation, the education, and all those things you need. Consumption of those goods and services is the end of economic activity.

Therefore, I think it is absolutely correct for monetary policy to focus on consumer prices. It doesn't mean those other prices can't have an effect over time, but that's the way you want to look at them. Just as we were talking about commodity prices a moment ago, look at commodity prices to the extent that you think over time they may hit consumer prices. Look at asset prices in the same way.

If you think it is likely that sharp rises in asset prices may one day spill over into inflation and consumer prices for goods and services, by all means take it into account. That's the way you should look at it.

I must say, the notion of putting together a price index, which includes asset prices, I just don't think is right.

Mrs. Karen Redman: Thank you.

My other question again deals with inflation. We're looking at a range between 1% and 3% per annum. Does the midpoint of a current target band mean anything? Is it significant? Is a stable inflation rate of 1% as satisfactory as a stable rate of 3%?

Mr. Gordon Thiessen: The midpoint does mean something. Over long periods of time, it's certainly what we aim at. What we don't try to do over short periods of time is to fine-tune the inflation rate. You really can't do it anyway. You can't fine-tune an economy. You can't fine-tune an inflation rate.

Basically, we aim broadly for the centre and we try to avoid falling through the bottom or going up through the top. It sounds a bit crude, but I think it's the best you can do.

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Right now we have a 1% to 3% target range. You aim for the middle of the range over time. You don't want to be likely to fall through the bottom, you don't want to be likely to go through the top. Each of those are things to be avoided if you can.

You can't avoid them all the time, because as I was saying, in answer I think to Mr. Loubier, you can have these temporary effects that can push you down or push you up. You want to look through those, look at the trend, but don't think you can steer the inflation rate the way you steer a car, because you can't.

Mrs. Karen Redman: There have been a lot of comparisons in both unemployment rates and inflation rates with us and the U.S., and I note they don't have targets. I'm wondering if countries that have targets experience better inflation performance than those that don't have them.

Mr. Gordon Thiessen: What you find is that the countries with targets are countries whose past inflation experience wasn't very good. The countries that don't have targets typically have done reasonably well. Us, the British, the Swedes, the Australians, and the New Zealanders—we tended to have, if you look at the 1970s and 1980s, above-average inflation rates, so the targets were a very good way of establishing our commitment to get inflation low and keep it low.

If you manage to do pretty well through the piece, as did the Germans and to a somewhat lesser extent the Americans, you don't have that problem, so you can do quite well without. I think it's much more a question of your past experience rather than your current one.

Having said that, I still think targets are a good idea. I think a target establishes a kind of commitment for the central bank. If we don't achieve that commitment, I think you as parliamentarians have to ask us some hard questions. Why haven't you? We won't always achieve it, but I hope when we don't achieve it there are very good reasons for not having achieved it, not just because we followed bad policy.

I think it gives a degree of accountability to a central bank, and I think that's good.

Mrs. Karen Redman: Thank you.

The Chairman: Thank you, Mrs. Redman.

Mr. Assad, please.

Mr. Mark Assad (Gatineau, Lib.): Mr. Thiessen, I was reading that the chief economist of the Royal Bank, Mr. McCallum, brought forward that he considered inflation was nearer zero or non-existent and the fact that unemployment unfortunately was still very high, at over 8%. He also stated that the economic health of the consumers was rather fragile, and he was congratulating you on the fact that you resisted the attempt to raise the rate even though the Canadian dollar slipped.

I think congratulations are in order, Mr. Thiessen, because, as you mentioned awhile ago to Mr. Loubier, your sole objective was to control inflation.

I understand that when the Bank of Canada was created, there were four pillars, four considerations. Here we were in the middle of the depression years, and one of the pillars was to mitigate unemployment...and also the general welfare of the economy.

By targeting solely the inflation rate, I find it creates a lot of problems. For the last two decades we have used the interest rate to try to curb inflation. It has led us to recessions, some of them so serious that a lot of people have never recovered from some of the recessions we've had in the last two decades.

Mr. Thiessen, considering the experience of the last two decades and the incredible debt that was accumulated in this country because of the fact the interest rates were significantly higher than those in the United States, could we not reconsider, as did all the other countries in the world with the exception of Great Britain and Switzerland, bringing back secondary reserves? These secondary reserves are going to exert a tremendous amount of restraint on the banks to float more loans.

You mention that when you establish monetary policy, you have to take many things into consideration. You mentioned the monetary conditions, the overnight rate, the M1 and M2, which are no longer reliable, and all the rest of it.

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Considering the fact that the economy has changed considerably, could we not give this idea of secondary reserves another look?

Mr. Gordon Thiessen: I can assure you we've looked into it very carefully over a very long period of time, and when we decided we should drop both secondary and primary reserves, we did a lot of work on it. It just wasn't evident there was any benefit to it. It ended up essentially being a tax on one set of financial institutions at a time when financial activity increasingly was not being channelled just through banks but also through a wide variety of institutions.

The more globalized international financial markets become, the easier it is for Canadians to bypass domestic institutions and use international markets. I think it's like one of those taxes you would never really be able to collect, because everybody would avoid it.

It just isn't a very useful way to operate, quite frankly. In the past when we did use it, it essentially was an on-off switch. So when we did try to slow things down, the tap would be turned off. If we ever raised the secondary reserve requirement, all of a sudden the banks would stop making loans and put all their money into government bonds. It just wasn't a very useful way to operate.

I spent a couple of years working for the Australian central bank. They made a lot of use of this sort of secondary reserve situation, and they had an incredibly complicated system. I must tell you, they've abandoned it completely. They didn't find they could make it work. In today's open markets it just doesn't make any sense any more, I'm afraid.

Mr. Mark Assad: But, Mr. Thiessen, the last two decades have shown us that the increases in the bank rate—and some of them were extremely high—have really crippled the economy. We haven't come to terms with that. We haven't found a suitable solution.

Considering, as Mr. Loubier was mentioning, and I mentioned this to you some months ago, the danger of deflation, which is always present and is very serious also, and the fact that we have practically become champions in the industrialized world, because when there's any slight indication there could be inflation our bank rate has gone up—except lately, and I must congratulate you for that. I'm glad we're staying the course.

The American economy is performing admirably. It's in fact beyond what they expected. Obviously Mr. Greenspan is not worried about the inflation rate, which is closer to 3% than it is to 2%. We're closer to 0% than we are to 1%.

I don't think, Mr. Thiessen, there's any pent-up demand in this country. I dare say there's hardly a sector of the economy where the demand is such that we're in danger of inflation, or correct me, sir.

Mr. Gordon Thiessen: We're not suggesting we are in imminent danger of inflation, but the crucial thing here is to get your economy, as I was saying in my opening statement, on a path that's going to get you to full capacity and do it in a nice, smooth way that isn't going to get you—once you get near full capacity—into an inflationary situation.

You see, that's exactly what the Americans did. The Americans, I remind you, raised their interest rates very substantially through 1994, because they saw their economy getting close to full capacity. They were running at short-term interest rates of 3% and moved them up to 6% to make sure they got their economy on a sustainable path. Then they lowered them a bit again, down to about 5.5%, all so that the economy would be on a sustainable path.

Their inflation rate is around 2%, and with a measurement error of about one percentage point, they've got a very low inflation rate.

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I can also tell you, given that I speak to Alan Greenspan a lot, that he is absolutely concerned about inflation—always has been, always will be—because he believes, as I do, that by keeping that U.S. inflation rate low, he's going to contribute to this really good performance of the U.S. economy.

Mr. Mark Assad: Let us say that, for instance, we were to tolerate a close to 3% inflation rate. I was reading some of the articles from the Canadian Economists Association, and they felt that in the past, the interest rate accumulated unnecessary debt on the government, and that it was responsible for the recessions. They felt that even if we had an inflation rate of 3%, there is no pent-up demand, and there was no danger of any kind of inflation, and this would be beneficial to our economy. It would certainly create more employment, and that is one of the major obstacles.

Mr. Thiessen, listening to the different comments this morning... There was a time when inflation in this country was very high, as in the United States. Unemployment was very high, we were into a recession, and yet our dollar was nearly at 88¢. Since then, we've imposed upon ourselves such restraints. We've brought the deficit under reasonable control and I'm sure our productivity is better, and yet our dollar has collapsed—well, not collapsed, but has gone down significantly.

Who is making the rules? How can this happen when here we were, we restructured our house, and yet we're penalized, in a way, with the dollar sliding...and not that it's that bad, because it helps our exports.

Mr. Gordon Thiessen: With respect to the inflation rate of 3%, implicit in what you're suggesting—well, explicit in what you're suggesting—is that this would allow us to lower the unemployment rate, and I just don't believe that. I just do not think it's true. It implies that somehow or other you're going to fool these people.

The way that idea works is that with inflation at 3%, you gradually undermine the wages of Canadian workers. They don't care about it. They don't notice it. They just accept lower wages. Therefore, employers are willing to hire more workers, and you get the unemployment rate down.

I just don't believe that. I think that's incredibly far-fetched, the notion that people are going to sit by, see their wages cut by inflation rates, ignore it, and thereby we're going to reduce the unemployment rate. I think any policy that is based on fooling Canadian workers is just based on very unsound principles, so I think that's absolutely wrong.

With respect to the dollar, I think it is important to remember all the things that are going on in the world right now—some pretty turbulent times, particularly in Asia. That has had quite an impact on commodity prices, and we remain an important commodity price producer. The Canadian dollar certainly has been affected by that, but I continue to believe that the underlying circumstances we're looking at are very good.

I remind you that we currently have the lowest interest rates we've had since the 1960s. I think it is very evident why that is true; it is because we have a low inflation rate. Those low interest rates are allowing Canadian businesses to invest in new technology, to invest in productive capacity, and it will allow them to compete internationally. I think we're going to see a big pay-off from that.

It's no accident that interest rates were high in the 1970s and 1980s. It was the effect of the inflation rate, not the cause.

Mr. Mark Assad: My last question is a short one, Mr. Chairman.

Mr. Thiessen, in conclusion, I realize that inflation has to be kept under control. In terms of what I said about the 3%, I'm just saying that the signal was out there that the Bank of Canada does not intend to intervene, even if inflation starts to come up above the 1%, and we're not even there, and heading up. I'm just saying that there's no indication that there would be a danger of all of a sudden inflation taking off, for the simple reason that there is no pent-up demand. The consumer index has indicated that it's still weakened or fragile. I'm sure we could have two to three years, according to the Economics Association, of maximum growth without any danger of any kind of inflation.

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Mr. Gordon Thiessen: Well, I must say we see a lot more momentum in the economy than that. We don't see inflation taking off; we just see good performance. When we looked at the momentum in the economy, it looked pretty sound to us, and that's true of consumption. We've seen a big pickup in consumption over the course of the last year. We've seen some really impressive investment numbers. We see basically the domestic side of the Canadian economy really doing rather well.

What we want to do is just keep that on a nice, sustainable track, because if we manage to do that, then I believe we're going to see some of the productivity and employment gains that our American neighbours have been seeing.

The Chairman: Thank you, Mr. Assad.

I have a series of questions related to a topic area that this committee will be looking at in the fall—namely, the issue of the future of the financial services sector in Canada. It's timely, since you have published a report—actually, Mr. Freedman, you're one of the authors—in reference to, The Financial Services Sector: Past Changes and Future Prospects, Bank of Canada technical report number 82, by Mr. Freedman and Clyde Goodlet.

A number of issues were raised in this report that are of particular interest to the committee. One of the most interesting questions posed was, how large does a financial services provider have to be in order to be successful, and how does it determine the range of services and products to provide? You go on in the report to say that economies of scale clearly exist in certain parts of the operation of a financial services provider; however, empirical work thus far has provided no evidence that a bank has to be a mega-institution, rather than just large, to exploit most economies of scale. Of course some economies of scale can be exploited by outsourcing or by purchasing certain types of services from specialist institutions, or as happened in other industries and in the back-room operations of banks.

The authors, I believe, conclude that in the end, however, what counts is profitability, not size. It is far from clear that the global mega-institution would be the best at providing the efficient, innovative, and flexible service environment necessary to maintain high profitability.

While we recognize that the Bank of Canada does not have immediate responsibility for bank regulation, clearly the bank is a key player in the oversight of the financial services sector, and consequently we'd like to ask you a few questions related to this particular issue.

One of them deals with the Financial Institutions Supervisory Committee. We'd like to know how it functions during normal times and when there's a problem in the financial services sector. What is its mandate? Is there a lead agency? Who sets the agenda and to whom is it responsible?

Secondly, is the cost of capital domestically affected by having big banks and a strong second tier of financial services providers? Maybe we'll deal with those first and then we'll get onto other ones.

Mr. Gordon Thiessen: Well, with respect to FISC, it does have a lead agency, and that is the Office of the Superintendent of Financial Institutions. The superintendent is the chairman of that committee and the superintendent's office sets the agenda, although I must say that any of those of us who are members of that committee—the Deputy Minister of Finance, the chairman of CDIC, and me—all have the capacity to put items on the agenda if we so wish. Because it's small, it's a relatively informal committee. And of course it does report to the Minister of Finance.

The Chairman: The other question was in reference to whether the cost of capital domestically is affected by having big banks and a strong second tier of financial services providers.

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Mr. Gordon Thiessen: I don't know that I know the answer to that. That's one of the big questions here: How do you get a really competitive financial sector? Because that's how you get the lowest cost of capital. That's how you get those spreads between borrowers and savers as narrow as possible, so that the borrower gets the lowest rate and the saver gets the highest rate possible.

The real issue in all of this is that we know the best way to get that is to have lots of competition with highly efficient institutions, but how do we ensure that? That is the big question.

To some extent, as an institution, we still have an open mind on that one. We're looking forward to what Harold MacKay and the task force are going to produce, and we're going to have to look at this ourselves.

I am a member of another committee, which is called the senior advisory committee. In that case the agenda is set by the Department of Finance and it's chaired by the Deputy Minister of Finance. That is a committee that looks into financial structure issues and reports to the Minister of Finance. In that committee, I and my colleagues are going to have to contribute to these questions, and we're going to have to do whatever work is required to achieve that.

But I must say, in the meantime, Mr. Chairman, I feel really rather constrained, because if we're going to give advice to the minister, I'm sure the minister won't appreciate it if I talk about it publicly in advance.

The Chairman: Well, we try.

Would you say we have a strong second tier of financial services providers here in Canada, Governor?

Mr. Gordon Thiessen: I'd like to see a stronger one, I must say.

We still have a number of institutions, such as the credit unions, one very large and competitive trust company, and a number of non-bank institutions—companies such as Newcourt, GE Capital, and so on—all of whom contribute as well. And of course you have the insurance industry. When you put all that together, whether that's as competitive a financial sector as you'd like, I don't know.

That's a good question. The issue of second-tier institutions is one we do need to focus on. We need to ask ourselves whether the incentives to encourage those institutions are here or not. Right now I don't have an answer to that one.

The Chairman: Governor, what factors would in fact encourage the development of a second tier?

Mr. Gordon Thiessen: Well, there again, I must say we haven't done enough work, but that's one of the areas where we need to ask ourselves whether or not the entry requirements for smaller institutions are reasonable or too difficult. Similarly, is there anything in the process that discourages these institutions from growing?

Those are the questions we need to ask. Right now, I must say, Mr. Chairman, I don't have an answer to that.

The Chairman: The final set of questions relates to the issue of electronic money and commerce. This is also an issue you dealt with.

You point out in your report that the development of new products and delivery mechanisms also has implications for the public and private laws governing the operations of financial services providers, and that electronic money and electronic commerce are growing rapidly. Can these developments be regulated?

Mr. Charles Freedman: Different countries have approached this somewhat differently. In some cases, and particularly in Europe, what we have seen is a situation in which the approach has been to say that only what we would call deposit-taking financial institutions, what they call regulated credit institutions, are going to be allowed to issue stored-value cards, for example—that form of electronic money.

In other countries, of which the U.S. is the most notable example, the view is that you don't want to jump in too early to regulate these kinds of new services, because then you'll stifle innovation and you won't get the kind of technological change you really would like to see.

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So all the countries I know of are watching very carefully what's happening, caught in this kind of tension between, on the one hand, wanting to ensure that there isn't a premature regulation that would stifle competition, and on the other hand, wanting to make sure things don't go wrong.

In our own case, there are committees in Ottawa that keep a very close eye on this, and are thinking about it, but no final decision has been made as yet.

In many cases, of course, these are still in the testing stage. We've had a couple of cases of trying out stored-value cards—there was the Mondex card in Guelph and the Visa card in Kingston—but the national roll-out of the stored-value cards is still just in its initial stages. It's one of those things where the view is, let's watch it very carefully, but let's not jump in to regulate too quickly.

The Chairman: If I can be direct, you are basically saying that if I were to ask you the question, “Should they be regulated?”, your answer would be, “We should wait”.

Mr. Charles Freedman: It depends on what you mean by regulation. In certain circumstances you might want to come in early.

For example, if you were concerned about the nature of the issuers, that these were the kinds of risky instruments that would cause risk to certain banks, you might want to come in earlier.

But in fact the work that's been done so far suggests that the stored-value card basically has quite a lot of safety characteristics in it and it's not going to be easily counterfeited; that's not a problem.

I'd suggest that this is sort of my perception of what's going on, but the interesting thing is that in practice, the difference between where the Americans and the Europeans are on this is perhaps less in practice than it is in principle.

So far, as far as we can make out, the stored-value card, the particular form of electronic money that's further advanced, is likely to be issued only by very large institutions in any case. It is very much of the kind of Visa or Mastercard groupings, or Mondex groups.

In fact, the concern that there might be extra risks in this because you are having fly-by-night issuers is much less of a concern in practice than it might be in principle.

The Chairman: Given the global nature of this apparatus, who's responsible for monitoring them?

Mr. Charles Freedman: It's being monitored internationally in a number of places. The one we're closest to is the Bank for International Settlements, which brings together the G-10 central banks on a very regular basis.

They have published two reports on this issue. One is on the effects of electronic money on central banks, and it looks at a variety of aspects. The other is a very interesting report on the safety of the stored-value card.

In addition, the central banks, along with the finance ministries of the G-10 countries, have also done a report. Some of their concerns have been about things like money laundering, as well as, in some cases, looking at the tax implications.

These things do have an awful lot of implications, and they're being looked at from a lot of different directions. So there is an awful lot of work going on internationally by both central banks and governments working together to ensure that they understand what some of the implications are.

The Chairman: Talking about implications, what are the implications of developments in this area for the effectiveness of monetary policy?

Mr. Charles Freedman: They are very minor. That was one of the issues looked at in the BIS, and there is a report that has three or four pages on that.

There may be some implications for some of the detailed technical aspects of operating monetary policy, but in terms of the sort of concerns you sometimes read about in the more popular press, that the development of electronic money will make monetary policy impossible and so on, I don't believe there's anything to that.

There are some interesting little aspects—perhaps “little” is not the right word. If, for example, you are a country that focuses more on monetary aggregates, then an introduction of electronic money might have some effect on the nature of those monetary aggregates. That is because people will tend to use, say, electronic money more and chequing less, and that may have some effect on the deposit accounts.

But for countries like ours that are focusing on inflation targets directly, there's very little of any significant effect.

The Chairman: Thank you very much, Mr. Freedman, Governor, and Mr. Jenkins.

On behalf of the committee, I certainly would like to thank you very much for helping us consider the Bank of Canada's monetary policy report of May 1998.

As always, it's a pleasure to have you before the committee. You certainly help us in figuring out the various challenges our economy faces. Thank you.

The meeting is adjourned.