Bank of Canada Cuts Rates as Canadian Dollar Tumbles

Even though the Canadian dollar has been in freefall this month, the Bank of Canada decided to cut rates by a quarter of a point on Tuesday, October 21st, 2008. Since many had speculated that rates would have been cut by fifty basis points, the Bank of Canada is now able to claim to be more hawkish on inflationary pressures by only cutting 0.25%. The justification many have given is that it gives them more room to make further cuts in the future. But with the Canadian dollar in free fall, is it responsible to be setting rates at 2.25%?

Canada has one of the lowest interest rates in the world.

One American dollar currently buys $1.25 Canadian dollars. And one Canadian dollar only buys 80 American cents. Only a few months ago, the currencies were hovering around par. A graph of the Canadian dollar versus the US dollar over the last year illustrates the steep decline.

Canadian Dollar vs. US Dollar

To be fair, the US dollar has been strong against most currencies as of late, but the Canadian dollar has been very weak against many other currencies as well this past year.

Canadian Dollar vs. Euro

Canadian Dollar vs. Japanese Yen

Canadian Dollar vs. Swiss Franc

Canadian Dollar vs. Singapore Dollar

Canadian Dollar vs. Chinese Yuan

Even with the price of gold falling below $750 US, gold remains above $900 Canadian.

To find the price of gold in Canadian dollars:

Click Here for the American Dollar spot price of gold.

Click Here for the currency converter.

How much more can the Canadian dollar fall against other major currencies? Unfortunately, the Canadian dollar can fall a lot more. Canada is a commodity rich country, meaning that our dollar tends to trade in line with commodity prices. With lower commodity prices, especially with oil trading below $70 a barrel, the fundamentals of the Canadian dollar are very weak at the moment. From a macro perspective, the country is entering a recession and our housing bubble is in the early stages of deflating. Enormous unfunded liabilities, mostly retirement payments and medical care costs for retiring baby boomers, are coming due over the next two decades. Artificially low interest rates have expanded the supply of money and credit, which dilutes the value of the currency.

To see where the Canadian dollar might be headed, we can look at how the currencies of similar countries are performing. Most people would consider Australia to be the country most like Canada. Our two countries and economies are similar in many respects. The Australian dollar was nearly at par with the American dollar this past July, but has since fallen even more than the Canadian dollar to under 70 American cents.

Australian Dollar vs. US Dollar

If the Canadian government and Bank of Canada want to stop the steep decline in our dollar, monetary policy will have to be tightened by dramatically raising interest rates. This will have the effect of curtailing reckless borrowing and spending and encourage Canadians to replenish their savings. This course of action will bring about a much needed recession that will purge the imbalances in our economy that have been built into the system over the last decade. When Central Banks, like the Bank of Canada, set interest rates at an artificially low level, capital is inefficiently allocated and malinvestments are made. The misallocation of capital is not the fault of the free market or entrepreneurs; it is caused by the Central Bank artificially setting interest rates below the free market level. As the Canadian economy continues to deteriorate, the free market will most likely take the blame for the crisis and the government will interfere even more in the economy to try to fix the problem that they themselves created.

Money is the most important aspect of any economy and therefore when central economic planners at the central bank tinker with the system by fixing the rate of interest, the free market is not able to function properly. This is not because of an inherent flaw in the free market system, rather it is government interference in the market that screws everything up and creates the booms and busts. Once a boom has been created, a bust is inevitable. Attempting to keep the economy in the boom phase is impossible after it begins to turn to a bust. Attempts to keep the boom going are futile and come at the expense of currency devaluation like we are experiencing now. Capitalism cannot be blamed for current and future economic problems because true free market capitalism cannot exist when interest rates are arbitrarily set by central economic planners meddling in the economy. If we do not change course, imbalances will continue to grow within the economy and the recession will ultimately turn into an inflationary depression. If fiscal and monetary policy remain unchanged after entering an inflationary depression, a hyperinflationary blow out and complete economic collapse will follow.

There are big problems in Canada. These problems were created by government and central banks and the solutions they provide to the problems they created will make everything a lot worse. Government can only make the situation better by doing less, not more. They can help the economy by eliminating previous legislation and regulations rather than creating new ones.

There is a housing bubble in Canada that has recently started to deflate. The excess of credit that was pumped into the system while savings were falling. fueled a speculative housing bubble and allowed debt to expand to unserviceable levels. Even though I do not think the problems we face in Canada are as severe as in the United States, we none the less face many of the same issues. Canadians who believe that housing prices cannot fall dramatically can simply look to our neighbours to the south where prices in many areas have totally collapsed. The recent fall in the value of the Canadian dollar caused an equal fall in the value of Canadian houses. The fact that our currency got devalued, made all assets priced our currency less valuable. When a house, bank account, or income is priced in a foreign currency, a substantial amount of wealth is actually realized to have been destroyed. And if the Canadian dollar stays this lower or heads lower, the present value of future earnings just got hammered.

Canadians are not able to afford these expensive house prices since on average we do not have enough savings or high enough incomes to justify these outrageous prices. This temporary increase in the value of houses allowed the government to charge higher property taxes and received more though sales taxes from the excess spending generated from the increased debt that went along with the illusion of wealth. The increase in government revenue was not saved for the future, rather it was spent on current government expenditure. Even though the government took in huge taxes from baby boomers over the boom years, the government still spent more than it taxed and has accumulated massive unfunded liabilities that will be impossible for this younger generation to pay. The government should have been saving some of the tax money that they collected from the baby boomers in order to fund the retirement that they promised they would provide. Instead of this, the government did not save anything, and actually spent more than they took in and promised more than they could deliver.

How did Canadians get into this mess? Canadians trusted that their government would take care of them and they believed the promises made by politicians that they could improve the general quality of life without requiring hard work and sacrifice. The politicians who got elected were the politicians who promised the most benefits to special interest groups. Parents will vote for a candidate who promises to fund public schools while lowering taxes on middle income families. Elderly and retired people will vote for a candidate who promises better health care and retirement benefits while increasing taxes on the working class. Poor people will vote for the candidate who promises the biggest welfare checks and social safety nets while taxing everyone who produces the wealth they are stealing. With candidates trying to please all the special interest groups, they end up promising everyone that they will be able to make their lives better without making anyone else worse off. The more money that government spends is more money that they waste and Canadians would be a lot better off without this massive government trying to run the economy and take care of everyone.

We live in a globalized world, and the value of the currency of a country is vitally important to the health of the economy and the prosperity of the people. Constant currency devaluation will always lead to higher domestic prices in the future. Those who claim that a weaker currency will not cause domestic prices to rise are dead wrong. Canadians import most of their consumer products from abroad, so most of those prices will certainly go up. Domestically produced products will not rise as dramatically because the labour costs to produce those products fell in tandem with the currency. Producing cheaper goods by devaluing the salaries of the workers is not an ideal way to build a prosperous economy. It was Henry Ford, who once owned a great car company, who realized that by paying his workers a high enough salary, they could afford to buy the products that they themselves produced. But even though labour costs have fallen due to the depreciated currency, the capital costs have remained the same. In a global market, it makes no difference what the nominal price of a barrel of oil costs in any one domestic currency, because the price is determined at a global level. Even though oil fell below $70 US per barrel, the price of oil in Canadian dollars is still above $80. Therefore, if a Canadian farmer is competing with an American farmer, the currency devaluation has certain effects. The currency devaluation does not affect the price of the final product produced. If both farmers grow wheat, the price of wheat is determined at a global level and both farmers will get an equal amount of money for their product. So currency devaluation will not affect the real revue received by the farmers. The Canadian farmer will receive increased nominal revenue, but no increase in real revenue. The Canadian farmer will have no change in nominal labour costs, but will have lower real labour costs. And the Canadian farmer will have increased nominal capital costs, but no real increase in capital costs. Therefore, the profits for the farmer come only at the expense of cheaper labourers , since the increased nominal revenue is somewhat offset by the increased nominal capital costs. So even though the Canadian farmer receives more Canadian dollars for his harvest while leaving his nominal labour costs unchanged, the farmer is forced to pay higher capital costs (such as oil). Canadian consumers are stuck paying higher prices for domestically produced products without seeing an increase in their wages.

However, if a company uses skilled labour, these businesses will have to increase labour costs at close to the same rate as the currency devaluation. If the wages of a skilled labourer decrease because of currency devaluation, they are free to obtain a similar job in a foreign country that is able to pay a higher wage. The price of skilled labour can be looked at as a global good with a set world price for skills that are in demand. Therefore, businesses will have to pay a higher nominal price for skilled labourers which reduces the increased in profits. Given this fact, it is the poor unskilled workers who suffer the most from inflation, since their wages do not need to be increased, meanwhile, prices for necessary global goods are increasing.

Businesses that derive their revenue stream from within Canada (typically service industries) are at a particular disadvantage. Even though these businesses receive the same lower real cost of labour, they also receive lower real revenue streams. Their nominal revenues and labour should remain the same. If anything, their domestic revenue streams are actually likely to decrease in nominal terms also as people are forced to spend more money on necessary global goods that have all risen in price, leaving less money to spend on discretionary products and services. Increases in capital costs affect these businesses in the same way as the exporters, yet they do not receive the same increase in nominal revenue to offset the increase in capital costs. Therefore profits for domestic service industries, which compete for capital goods on the global market, will face increased costs and decreased profit margins, at a time when the domestic demand is falling. Service sector industries are then faced the situation of wanting to lower prices to attract more demand and wanting to raise prices to offset the increase in capital costs.

A devalued currency increases exports, which benefits those who export domestic products. The majority of the population in the country does not benefit from a devalued currency. Exports are increased for two main reasons. The first reason is that the labour costs went down which increases their competitiveness though lower costs. And secondly, Canadians are now a lot poorer and are therefore unable to afford to consume as many domestically produced goods, requiring them to be exported. So is increasing exports really all that good for society if it comes at the costs of lowering wages resulting in everyone being too poor to buy the goods that they produced?

China has a lot of exports because they devalued their currency, and their economy is growing rapidly. But since the currency is intentionally devalued by their communist government, the Chinese people do not get to enjoy consuming the goods they produce. As a result, a lot of the population in China has to work very hard producing many products, but they tragically put them all on ships and send them around the world to countries that have stronger currencies. A devalued currency results in a nation of slaves who produce goods that they cannot afford to consume. The notion that a devalued currency is somehow a good thing is preposterous. It benefits a few people at the expense of many. It steals wealth from those who have saved and gives to those who have borrowed. If a Canadian saved dollars in a bank account, from the perspective of everyone else in the world, that person just got about 10% - 20% poorer over the last year. However, if a Canadian had debt in Canadian dollars, from the perspective of the rest of the world, the debt burden just got reduced. And since the federal government is in the most debt out of anyone, they are able to create money and credit out of thin air, which devalues the currency, and allows them to repay their debt in depreciated currency that they counterfeited. When Canadians receive these debt payments in the form of government pensions, the retired population will be outraged that the checks they receive do not buy anything. Even those that are “inflation adjusted” will not keep up with prices since government numbers understate real world inflation.

The Canadian government needs to stop the madness that they created. Houses, condominiums and apartments are still being constructed because banks are still loaning out money to fund these construction projects. And since the banks are giving out credit that they got from the counterfeited money they received from the Central Bank, rather than true savings, that money will inevitably be malinvested. Credit can only be created though real savings. Savings can only be created by under consumption, where people spend less money than they make. Trying to create credit without savings will only lead to inflation and greater imbalances in the economy. This course of action makes things better in the short run, but ultimately makes things much worse in the long run. Lowering interest rates to prevent a recession will only postpone the underlying problems and does nothing to solve them.

The Bank of Canada (unlike the Federal Reserve) still publishes the M3 money supply which is the broadest measure of the amount of Canadian dollars in existence. In August 2007, the M3 money supply was approximately $1,142,475,000,000 or about $1.14 trillion. In August 2008, the M3 money supply was approximately $1,277,530,000,000 or $1.28 trillion. The money supply increased by over 11% in one year, meaning that there are 11% more Canadian dollars than there were last year. Is it any surprise that the value of our money is going down and prices are going up when money is being created at this pace?