The Budget and the Bank

Over the years, federal budget legislation has acquired the feel of U.S. omnibus bills (the Farm Bill is probably the quintessential example). To some extent, this is to be expected. Ever since the “disastrous” Trudeau era, the imperial Department of Finance has not-so-quietly re-asserted its domain over the federal bureaucracy.

One manifestation of Finance’s power has been the increasing tendency to use the tax system to deliver social and industrial policy — a quick glance at the Department of Finance’s annual, ever-expanding Tax Expenditures report (first introduced under the short-lived Joe Clark government) tells the tale. The Budget Implementation Act (Bill C-50) provides more evidence of Finance’s pre-eminence and the way budget legislation is being used to move forward many unrelated agendas. Consider:

• Exhibit 1, Employment Insurance: Rumour has it that Finance fought long and hard to ensure that revenue flowing into the new Canada Employment Insurance Financing Board would be counted, as it is now, in the consolidated revenue fund (CRF) thus, effectively, changing nothing.
• Exhibit 2, Immigration: Then there’s the whole immigration business, a clear tactical move on the part of the Conservative government.

What has been less discussed, however, are the proposed changes to the Bank of Canada Act that would ostensibly make it easier for the Bank to deal with liquidity crises. Specifically, the proposed wording gives the Bank the power to purchase any securities or “other instrument“ it likes “for the purposes of conducting monetary policy or promoting the stability of the Canadian financial system.”

The Globe and Mail seized on this “other instrument” wording, suggesting that it gives the Bank the power to “accept riskier securities as collateral” and fretting about the potential exposure to the Bank. I actually think something else is going on here — rather than talking about regulating the financial sector, the government and the Bank are signaling that they are willing to provide lender-of-last-resort assurances to those who sell or engage in derivative financial products, of which the asset-back mortgage and commercial debt are but two examples.

To see why, we need to understand what the Bank can and cannot currently do. Currently, the Bank is arguably constrained in what it can purchase. In normal times, Section 18 of the Act says the Bank can only buy (or sell) certain types of assets — coins, foreign currencies, federal and provincial/territorial debt, debt issued by the U.S., Japan or the European Union, International Monetary Fund (IMF) special drawing rights, and bills of exchange or promissory notes issued by a bank or authorized foreign bank provided they have a maturity of no more than 180 days.

HOWEVER, in the event of “severe and unusual stress” on the financial system, Section 18 (g.1) seems to provide cart-blanche power to the Bank to purchase whatever it likes. Specifically, it says the Bank can “buy and sell any other securities, treasury bills, obligations, bills of exchange or promissory notes, to the extent determined necessary by the Governor for the purpose of promoting the stability of the Canadian financial system.”

So if 18(g.1) already provides broad power to the Bank, this begs the question: what is Bill C-50 try to do? First, as the Globe piece suggests, it gives the Bank the power to purchase ill-defined “other instruments.” The definition of the term “securities” in 18(g.1) must not, in other words, encompass these “other instruments” otherwise there’d be no need to change the legislation. Unfortunately, we can only say this by means of logical deduction — the Act does not define “securities” and the proposed changes in C-50 don’t venture to define “other instruments.” Wikipedia however offers this: “A security is a fungible, negotiable instrument representing financial value.” That seems pretty broad. Even uses the word “instrument.” The only plausible interpretation of adding the words “other instruments” then would seem to be that the Bank wants to be able to purchase more esoteric derivatives — financial instruments whose value is distantly related to some underlying, more “real” financial entity.

The second interesting thing that the legislation does is that it explicitly gives the Bank the power to engage in the buying of securities and other instruments “for the purposes of conducting monetary policy” rather than just “promoting the stability of the Canadian financial system.” Now what could this possibly mean?

Surely monetary policy and “promoting stability” are one in the same or close to it, no? After all, the Bank’s emphasis on the importance of communications in monetary policy depends on — and arguably helps shape — “stability” in the market. From this vantage point, stability is really just a way of describing or qualifying “expectations,” which are a formal part of the way the Bank thinks about monetary policy and the transmission mechanism (i.e., how a change in the target for the overnight rate has an effect on the real economy). When expectations are “stable” — when the financial system is “stable” — the monetary transmission mechanism works relatively smoothly. The overnight rate is almost identical to the Bank’s target and the spectrum of rates does roughly what the Bank wants it to do.

When expectations are “unstable” — when the financial system is “unstable” in other words — then the mechanism goes off the rails. The overnight rate veers wildly from its target, as it did last summer when the crisis in the U.S. asset-backed securities market spread to Canada. In early August, the overnight rate shot above the Bank’s target by a fairly wide margin; the Bank stepped in almost immediately — in the name of monetary policy and financial market stability — and expanded the list of eligible collateral for its SPRA — special purchase and resale agreements.

So what gives? Again, I think the Bank and the government are trying to signal to financial markets that “we’re there for you.” In other words, the legislation itself is part of the conduct of monetary policy and assuring stability in the financial system. By sending these signals, the Bank is telling the financial system to “get unstuck” and start the credit ball rolling again. The Bank will be there for you. It says so deep in the bowels of the omnibus bill, err, budget bill.