Bank of Canada is to blame for excessive consumer debt

Statistics Canada has released data that economists and policy makers are rightly concerned about. Debt-to-disposable income ratio is as high as 148%. This represents a startling lack of responsibility on the part of those consumers who are accumulating this debt. It is almost like they think they won’t have to pay it back.

There are some ideas of how to deal with this growing problem. Many have suggested new regulations that will limit both borrowers and lenders. This interference in an individual’s economic freedom will at best mask the underlining problem. We should focus on the disease and not the symptoms.

The disease is the central bank, the Bank of Canada.

It is evident that the Bank of Canada is the fundamental problem by the words of the Bank of Canada’s own governor, Mark Carney:

“Cheap money is not a long-term growth strategy,” Mr. Carney said in an address to a Toronto luncheon. “Low rates today do not necessarily mean low rates tomorrow. Risk reversals when they happen can be fierce: the greater the complacency, the more brutal the reckoning.”

I couldn’t agree with this statement more, and to be fair to Mr. Carney he has been very consistent on this point. He also knows that it is his own policies that are creating the problem:

“The influence of sustained low interest rates in major advanced economies on risk-taking behaviour is a powerful dynamic that bears watching,” the central bank said last week. “A long period of very low interest rates may be associated with excessive credit creation and undue risk taking.”

Having correctly identified that low interest rates are problematic, Mr. Carney is laying the political groundwork to raise interest rates. Still it will take time for the Bank of Canada to go through its review process, and it is impossible to say if the adjustments will be too little or too much. The economic problem at the end of the day is a knowledge problem.

In his much celebrated essay, “The Use of Knowledge in Society,” F.A. Hayek outlines the basic difficulty everyone faces (both individuals and governments) in making economic plans. People don’t know and can’t possibly know everything that is happening in an economy. How could even a perfect genius be sure they are making the right decision when all the facts are not knowable?

Hayek’s solution was simple, beautiful, and best of all it was already widely practiced. The solution to lack of knowledge is price signals. If peanut butter suddenly becomes scarce the price will rise. People will then consume less peanut butter thus ensuring that an increasingly scarce resource is preserved. There is no need for consumers to know why the peanut butter is scarcer or even to know that the peanut butter is indeed scarcer. All they need to know is that the price is higher and they will take the appropriate action.

In the credit market the price signals that we rely on to make our decisions are lying to us. The cheep credit is telling us that we are in boom time and that there is plenty of unused capital just waiting to be borrowed. Considering that most of us are having trouble making ends meet it is perfectly rational to try and use that unutilized capital (even though that capital does not in fact exist).

Think about it. You reading this post are more likely than most to be familiar with what is going on in the economy, but most people are not like you.

Pretend for a moment that you are someone else. Say that your hours have been cut in half at the Dofasco plant and you are worried that you won’t be able to afford the same standard of living as before. You review your options and one of the things you consider is taking out a second mortgage. Upon investigating this option you find that the price of a loan is absurdly low. You don’t read the Financial Post so you haven’t heard Mr. Carney’s warnings. All you see is that the price is low.

How is it not then rational to take out a loan?

By manipulating interest rates the Bank of Canada is disrupting price signals. Individuals in the market place are being fooled into thinking there is an abundance of spare capital. Even if the Bank of Canada does decide to raise interest rates it will just be another disruption in price signals. It is impossible for a central agency to simply estimate the true cost of lending.

If Canada’s economy goes back into recession because of too much consumer debt, then it will be the fault of the Bank of Canada.