Can we trust our government with loans from the Bank of Canada?

Since we are talking about banking, it is not irrelevant to draw attention to an el�ementary banking principle: banks do not increase their lines of credit to reward clients for having had to be bailed out from previ�ous insolvency. This established rules of banking have been stood on their head in the dealings of the Bank of Canada. Indeed, it contradicts the explicit provisions in the Bank of Canada Act itself.2

The entry of banks into stock market ac�tivities, both as principals and in financing their clients' involvement, increased their vul�nerability to interest rates beyond what it had been as simple lenders. But there was a fur�ther factor that the Bank for International Settlements had overlooked in declaring the debt of OECD governments "risk-free." In a period of rising interest rates, that is anything but the case. During the two years after the BIS Guidelines had been formulated the av�erage interest rates rose from 9.7% (1988) to 11.6% (1990). This meant that the banks' bond inventories would be shedding value. It would seem that in the urgency of the bank bailout the assembled central bank officials at BIS had overlooked this effect. Undoubt�edly, once they awoke to it, it reinforced the shift in the attitude of banks and central banks on how high interest rates could be pushed. In effect the dominant revenue in the economy had shifted from interest rates to speculative profits.

How the Derivative Gambles Corrupted Governments and our Statistics

On page 12 in this issue, we review an essay of Brigitte Granville in the role of derivatives in amplifying the effects of the Russian default of 1998 throughout much of the world. The Wall Street journal (6/11, �Behind Shrinking Deficits: Derivatives?�) reports on the distortion of official EU budgets by the same phenomenon:

�London�a report that suggested the Italian government had used swaps contracts to hide the extent of its budget deficit has sparked controversy amid fresh doubts over the reliability of such figures.

The report, by Gustavo Pega, of the University of Macerata doesn't explicitly name Italy. But individuals familiar with the matter say the unusual swaps contract described in the report involves that country, which succeeded in slashing its deficit to 2.7% of its GDP, below the 3% ceiling allowed to qualify for European monetary union, from 6.7% in 1996.

Foreign-exchange traders cited the report and questions it raised on the reliability of deficit figures, as one reason behind the euro's slide to as low as 89.45 yesterday. The report explains how one European country used a swaps contract to lock in paper gains on a foreign-currency bond issue�but used a combination of exchange rates and interest rates that effectively mean it received more cash than it otherwise would have during the lifetime of the contract. It paid back the excess amount when the swap contract matured in 1998, after countries had been selected for the first wave of monetary union.�

The international financial system based on deregulation and globalization has brought us a bumper harvest of insolvency and corruption. Governments cannot deal with the deepening economic crisis by running just a "small deficit." The entire malodorous mess at the root must be brought to light. That will call for the largest available power shovel rather than a dainty teaspoon. We must go back to the early postwar years and retrace the suborning of economic analysis that has led us to this disaster.

William Krehm

1. See "Fashioning the God of Clay" in Krehm, William (ed.) (1999). Meltdown, Money. Debt and the Wealth of Nations. Toronto: COMER Publications, p. 226.

2. See the lead article, �Correspondence with BC's Finance Minister�, Economic Reform, 1012001.

--from Economic Reform, December 2001