8   A Statistic that has Grown Like Topsy


I am introducing you to a Canadian statistic that has grown like Topsy, but whose treatment by our central bank can only be described as topsy-turvy. When it started modestly on its career, it was accorded much attention. Books were devoted to its workings.

For example, in 1945 the Canadian Bankers’ Association published A Background of Banking Theory by W.T.G. Hacket, economist of the Bank of Montreal that stated: "When the government borrows by selling the securities to the central bank there is made possible an expansion of chartered bank deposits equivalent to about a tenfold addition to the money supply" (p. 54). That ratio was known in economic literature as ‘the multiplier.’"

The statutory reserve that the commercial banks had to put up with the central bank permitted them to create that multiple in new credit lent out at interest. The reserve put up by the banks with the BoC, however, earned them no interest.

Topsy got off to a slow start. For good enough reason. To get the banks out of the mess they had gambled themselves into in the 1920s, President Roosevelt had declared a bank moratorium as soon as he was inaugurated in 1933. 38% of the banks in the US had already gone belly-up. Severe restrictions were put on what banks could do with other people’s money, or with the credit they themselves created. Ceilings were slapped on the interest rates they could pay or charge their customers. In these respects Canada and many other Western countries followed the American lead.

The Allied part of the Second World War was financed at about 2.5% interest, and as the conflict approached its conclusion the rate was actually lowered. And that is why our statistic got off to so slow a start. Even by 1971 it had not risen above 16.2. But beginning with the 1951 Fed-Treasury Accord of 1951 under President Truman the ceilings on interest rates were weakened, and the banks started a campaign to get back to the high jinks of the 1920s. In this the central banks proved their firm allies. The strategy towards this goal was largely directed from the Bank for International Settlements, a purely technical body, originally set up to handle the transfer problems connected with the World War I reparations from Germany. No member of a government was allowed to attend its sessions. That commended it as the semi-underground bunker from which to direct the banks’ comeback drive.

The Birth of the Traders in Red Suspenders

You certainly have heard of the lads in red suspenders who throughout the world trade in government debt 24 hours a day. For several years the Bank of Canada laboured to bring a short-term government debt market into existence. It wasn’t easy. At no small expense to the taxpayer, the Finance Ministry and the Bank of Canada brought bond traders into existence as master to dictate its pleasure to them.1

In 1967 for the first time Canadian banks were allowed to invest in government-guaranteed mortgages. In the same year the central bank was prevented from varying the amount of the reserves left with the central bank to control inflation. Accordingly, interest rates that had previously been frozen became "the one blunt tool to fight inflation." Today the only ceiling on interest rates is under the criminal code – 60% per annum. In 1980 secondary reserves, made up of interest-bearing reserves, that at the central bank’s discretion had supplemented the primary reserves, were done away with.

If you plot the further deregulation of banking and interest rates against the difficulties that previous deregulation had got the banks into, you will find a perfect correlation. Invariably the banks were allowed to dictate the form of their bailout, and with few exceptions it took the form of the hair of the dog that bit them. And that guaranteed that they would be back with their begging bowls sooner rather than later. To fill those bowls social programs have been slashed.

To grasp the sociology of the process, we must reach for an invaluable tool developed by the late French economist François Perroux – the "dominant revenue." By its absolute volume and rate, the income of a particular group is seen as the index of well-being of society as a whole. In a particular historic perspective this may appear the case; with other social arrangements, however, another economic group might qualify for this uniquely privileged role. Under feudalism, it was the landowners. In Britain after the Napoleonic wars and the abolition of the Corn Laws, the dominant revenue passed from the landowners to the industrial bourgeoisie. By the 1920s, the financial sector had taken over. When they overplayed their hand and helped bring on the Depression of the 1930s, manufacturers, with trade unions as junior partners, salvaged the situation. They came to determine the volume of investment and economic activity. The rentiers and the financial sector were relegated to the doghouse.

But beginning with the 1950s. Interest rates were gradually elevated to the one blunt tool for the enforcement of the free market. Few asked why a free market required for its enforcement the elimination of all rival tools, including those that had worked in the past.

By its very nature, the role of dominant revenue is a power position rather than an intellectual exercise. When challenged, it is defended by all means fair or foul, merely than just surrendered because of its catastrophic results. That is why there is so perfect a correlation between the failures of monetarism and the stepped-up dosages of it to which the world has been subjected.

A Critical Statistic — The Net Operating Income

The insolvency of monetarist policy can be measured by the levels to which real interest rates are driven. When these exceed the Net Operating Income of the economy, that is a declaration of failure, since it rules out a functioning economy; the Net Operating Income is what remains after operating expenses have been covered. From that residue, financing costs must be paid and a profit for the entrepreneur left. Importantly, that residue serves as a cushion of comfort for creditors as well. In its absence, interest rates will go up and the operation will become still more unsustainable.

Twice within a single decade this utter failure of the monetarist model was the occasion for it being driven to even more fanatical extremes.

The first of these was in 1980-81 – shortly after both the Federal Reserve in the US and the Bank of Canada announced their formal adoption of monetarism – the dogma that the price level can be controlled by restricting the money supply while supposedly allowing the interest-rate chips to fall where they may. But at the same time deregulation had introduced chequing interest-bearing accounts where previously cheques could be drawn only on non-interest-bearing accounts. It thus became impossible to say what the money supply – supposed to determine the price level that explained everything – might be. In the ensuing confusion bank rates were driven to just under 20% while prime rates charged the banks; customers nudged the mid-twenties.

Such rates led to Mexico’s debt default and undermined the world financial system. They left their mark on government debt throughout the world. They brought on the savings and loan disaster in the US. Yet that disaster is still hailed as a triumph of Paul Volcker in breaking the back of inflation.


1. The story is told by George S. Watts, the first archivist of the Bank of Canada, in The Bank of Canada – Origins and Early History, edited by Thomas R. Rymes, Carleton University Press, Ottawa, 1983: "By the end of the 1940s it had become apparent that with the return to peacetime conditions, that the postwar expansion was creating an environment in which efforts to foster a money market had prospects for genuine success, For several years, the Bank, in trading treasury bills had progressively widened the spread between its buying and selling levels to create an incentive for the chartered banks to look elsewhere for buyers.

"These efforts had met with little success and in the early 1953 a number of new steps ere taken. The principal objective was to broaden the market for treasury bills and other short-term paper by encouraging some of the larger investment houses to act as jobbers, that is to hold an inventory of short-term securities, ready to buy or sell. With this end in view, the regular auction of treasury bills was changed from a fortnightly to a weekly basis, a nine-month issue was offered in addition to the three-month issue and the amount outstanding was gradually increased over the next few months from $450 million to $650 million.

"Concurrently, the Bank of Canada undertook to provide investment dealers...with an alternative means of financing inventories of short-term Government securities through the institution of Purchase and Resale Agreements (PRA). Under these arrangements, the Bank would, if required, provide participating dealers with short-term accommodation by purchasing treasury bills and/or short-term Government bonds under an agreement to resell the securities at a pre-determined cost to the dealer."

In short, the Bank of Canada was competing with the private banks to fashion the clay god – the money market – before which it bows in reverence today.

– from Economic Reform, April 2007