Bank of Canada Operations and Policy 9781487578367

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BANK OF CANADA OPERATIONS AND POLICY

BANK OF CANADA OPERATIONS AND POLICY

E. P. Neufeld

UNIVERSITY OF TORONTO PRESS, 1958

Copyright ©, 1958 by University of Toronto Press Printed in the Netherlands Reprinted in 2018 ISBN 978-1-4875-7908-1 (paper)

TO MY MOTHER AND FATHER

PREFACE IN THE PREFACE to an earlier version of this book I noted that there had been a curious lack of interest in Canadian central banking and monetary policy. This is now much less true and it rightly indicates the importance of recent developments. The period of monetary restraint which began in 1955, and in which interest rates rose to levels higher than any since the years before the economic depression of the 1930's, was largely responsible for the renewed interest; but the newly formed short-term money market was also in part responsible for the change, because it brought the capital market into day-to-day contact with cash management of the central bank. Besides this the Bank of Canada introduced a number of changes and suggested others which periodically initiated public discussion of the central bank's operations and policy. This book incorporates these developments while leaving the outline and much of the material of the earlier version relatively unchanged. Discussion of policy has been brought up to date, changes in the short-term money market and in the central bank's techniques have been noted and discussed, and some parts of the chapter on objectives have been clarified. The evidence of the Bank's second Governor on the subject of the constitutional position of the Bank before the House of Commons Banking and Commerce Committee is noted in the first chapter. Certain limitations and difficulties of monetary policy were clearly revealed in the period of monetary restraint which ended in late 1957 and these, together with some indication of the direction toward further improvement, are outlined briefly in the final chapter. My interest in money and banking began as an undergraduate at the University of Saskatchewan where I was guided and encouraged by Professor Mabel F. Timlin. At the London School of Economics and Political Science, Professor R. S. Sayers assisted me more than he knows by his sustained interest in my post-graduate work, much of which is embodied in this book. The Bank of Canada has always dealt kindly with my requests for information, while Professor V. W. Bladen and the Editors of the University of Toronto Press have helped me generously with problems of publication. My wife, by surviving the ordeal of many drafts of typescript and of charts, made it possible for this study to be completed. E. P. N .

CONTENTS Preface I The Bank of Canada and the Government II Bank of Canada Objectives

vii 3 21

III Bank of Canada Control Techniques

47

IV The Bank's Pre-War Operations

81

V The Bank and the War

112

VI The Bank in the Post-War Period VII Prospects and Problems

212

Appendixes A Assets and Liabilities of the Bank of Canada

221

B Government of Canada Deposits at the Chartered Banks and at the Bank of Canada

233

C Chartered Bank Cash, Security Holdings, and Loans; Deposits at the Chartered Banks; Chartered Bank Month-End and Daily Average Ratio of Cash to Deposits D Certain Seasonal Indexes Index

241 249 251

BANK OF CANADA OPERATIONS AND POLICY

CHAPTER ONE

The Bank of Canada and the Government THE ASSUMPTION by contemporary governments of a greater and more direct responsibility for the economic welfare of their subjects and the vastly expanded importance, both financially and economically, of public debt management and fiscal policy, have demanded a close and continuous relationship between governments and their central banks. This has gone much beyond mere ownership of central banks by governments. The multiplication of public debt and expenditure has magnified the central bank's role as government banker and adviser and many government controls, funds, and agencies are now often administered by central banks. Today's hyper-sensitive public attitude toward unemployment has made governments acutely conscious of the necessity of using both monetary and fiscal tools in achieving their own objective of full employment at almost any price. On the other hand, the very tools which central banks use, as we shall see later, are often available only through direct co-operation with the government, while the policies which they pursue can in many instances be successful only if they are harmonized with those of other official authorities. More so than in previous years, especially those preceding the depression of the 1930's, it has become imprudent for governments to be uninterested in central bank policy and impossible for central bankers to dismiss the many-sided impact of government. Inevitably these two institutions have drawn much closer together. In these circumstances the whole question of the constitutional position of the central bank has become considerably more vital. It is the purpose of this chapter to investigate this question as it applies to Canada, by tracing and discussing the relationship between the Bank of Canada and the government of Canada. We shall find that the constitutional position of the Bank is now clear, but not without potential danger, and that development between Bank and government should proceed along certain definite lines.

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4

THE

CONSTITUTIONAL POSITION OF THE BANK OF CANADA

The constitutional adjustments experienced by the Bank of Canada were not as great as those of some older central banks. 1 First of all, it began operations only in 1935 when the economic role of governments was already in the upswing. Nor did it ever enjoy that independence of action only possible under gold standard rules of thumb. And it was originally sponsored by government and very soon became a fully nationalized institution. However, the dilemma between the desirability of a central bank relatively free from partypolitical interference and the necessity of its ultimate responsibility to a party-political government, together with the problem of possible interference from other sectional interests, still remained, and could be resolved only through time. Indeed, the concept of an ideal position has changed remarkably from the time that the project for a central bank was first seriously considered. The Bank was originally thought of as being subject only to the ultimate supremacy of parliament, but the idea developed, in fairly distinct stages, that the Bank not only should be subject to the government of the day but should be, in fact, the instrument for implementing the policy of that government.

First Period-Attempt at Independence The first period can be considered to extend from the middle of 1933 to late 1935, and was one which witnessed two events particularly relevant for this discussion. 2 The first was the completion of a Report by the Royal Commission on Banking and Currency in Canada on September 27, 1933. This Commission was appointed to consider, among other things, the advisability of establishing a central bank in Canada.3 Not only did it recommend that a central bank be established forthwith but it also offered numerous opinions on central banking in general and suggestions concerning the form which the Canadian central bank might take. The Commission's ideas concerning the constitutional position of 1 By constitutional adjustments we mean all changes altering the influence and authority of governments over central banks. They are not confined to statutory changes. 2 These periods are, of course, in some respects quite arbitrary, but they aid exposition. They were deduced mainly by tracing the opinions of the political party which was able, by its majority in parliament, to legislate its conception of central banking. 3 Order in Council P.C. 1562, July 31, 1933.

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5

a central bank are important because of their influence on the later Bank of Canada Act. The Report reads: ... The functions discharged by a central bank being of such vital importance to the economic and financial life of a country, it is perhaps natural to ask whether they could not be adequately performed by some direct organ of government. It has in practice been found that a central bank can give most effective service to the community if it is free from the fear of interference for political ends in operating the delicate mechanism of the national monetary and financial machine ... it has been found that there are pre-eminent advantages to the state in entrusting the special and highly technical functions of a central bank to a body not subject to the vicissitudes of political life. (par. 219)

This is not to suggest that the Commission ignored the obvious ultimate sovereignty of the state, for it pointed out that a central bank "is at the same time an instrument and a force. As an instrument it is the means by which the state-which must necessarily retain ultimate sovereignty in matters affecting the currency-can give effect to the national policy" (par. 207). It is clear that the Commission feared political interference primarily and that, while it recognized the ultimate sovereignty of the state, it did not recognize the right of the government of the day to interfere in the policy and operations of the central bank. The Commission's ideas on the relationship between the central bank and the government become even clearer when its specific suggestions are examined. 1 It suggested that the capital should be offered for public subscription to all British subjects resident in Canada, with limitations on the size of individual holdings. This, of course, precluded government ownership; it also indicated that the Commission was not worried about other sectional interference, since the provision would allow even bankers to hold the stock. The only formal relationship between the central bank and the government, after the government had appointed the first governors and directors, was that the Governor-General in Council would approve all future appointments of Governor and Deputy Governor. All subsequent directors were to be elected by the shareholders even though the Commission recognized in the main body of its Report that in some countries certain directors were appointed by the government. Dividends of the bank were to be limited so that there would be no incentive to make large profits. Also this would make the bank's stock gilt-edged and so would avoid undue speculation. Excess profits were to go to the government. 1

See Report, appendix.

6

BANK OF CANADA OPERATIONS AND POLICY

These suggestions reflected the Commission's belief that the central bank should play a national role. 1 It was imperative that the bank be protected from that most important of all dangers-political interference. Therefore, a government could only approve or disapprove of the two top executive appointments; even the directors were out of its reach. Formation of monetary policy, it appeared, was no role for a government. Presumably the central bankers in this private corporation would be able to choose and implement the policy best suited for the nation and acceptable to it-the national policy. It would not need, indeed it should not need to fear, the guidance of the government of the day. Central bank policy was in fact to be central bank policy, and not party-political policy. The difficulties of maintaining such a loose and distant connection with the elected representatives of the people in the Canadian environment will become evident later. 2 The next important step in this first period was the introduction by a Conservative government and approval by parliament of a bill incorporating the Bank of Canada. 3 It is from the debates on this bill and from the final form which the bill took that the government's conception of the proper relationship between the Bank and the government emerges. When the debates began it soon became evident that the members of the House of Commons feared private interference much more than had the Commission and that safeguards against such a danger would have to be introduced. 4 Hon. E. N. Rhodes, Minister of Finance, outlined the government's views relating to the proposed central bank: . . . Broadly stated, the problem ... is that of creating an institution which shall be devoted to the public interest but which shall not be subject to the exigencies of politics in the narrower sense of the word. The services of the bank should obviously be at the disposal of the government, particularly in times of severe crisis and emergency. Clearly, however, the bank should not be subject Ibid., para. 219. The opinions of the Commission are more understandable when it is remembered that two of the five Commissioners, the Chairman Lord MacMillan and Sir Charles Addis, were from the City of London and apparently recommended their interpretation of the Bank of England constitution for Canada. Differences in tradition and environment were not sufficiently appreciated. See A. F. W. Plumptre, Central Banking in the British Dominions (Toronto, 1947) 187-91, 200-1, for a discussion of this influence from England. 3 The Bank of Canada Act, Statutes of Canada, 1934, c. 43, subsequently amended by S. ofC., 1936, c. 22; 1938, c. 42; 1949 (1st Session), c. 6; and 1954, c. 33. 4 The fact that all Canadian members of the Commission had been against private ownership was a forecast of this development. 1

2

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to dictation by the government, for at times the exigencies of public finance might not be wholly in harmony with banking policies that might be considered wise and essential in the general public interest. Clearly, also, the bank should be protected from pressure by particular private interests. 1

The government's conception was sharply outlined in this question and answer: Mr. Irvine: ... Supposing the central bank was endeavouring to regulate the control of credit in Canada, and supposing the policy it adopted in order to do so was contradictory to the policy of the government of the day, and they clashed, which authority would make the decision? Mr. Rhodes: Unquestionably the authority of the governor and the board of directors of the bank would prevail.

When a member inquired about the position of responsible government in such a situation, the Minister of Finance answered that parliament is always supreme, even when it delegates some of its authority. 2 The first Bank of Canada Act emphasized again the government's ideas on central banking. Private interference was considered to be forestalled by limiting the size of individual holdings of stock (s. 17); by prohibiting anyone directly connected with the chartered banks from holding Bank of Canada stock (s. 18); by prohibiting directors, officers and employees of banks and other financial institutions from being Governor, Deputy Governor or Assistant Deputy Governor of the Bank of Canada (s. 6); and, possibly, by limiting dividends to 41/z per cent (s. 31). Direct relationship with the government was to be much along the lines suggested by the Commission, with two additions. First, the Deputy Minister of Finance was to be a member of the Bank's Board of Directors and of the Executive Committee (but without a vote), so that the government would be aware of the Board's deliberations (s. 5). It was important that he be on the Executive Committee because that Committee would probably be the most effective directing body, it would meet much more frequently, it would be smaller (composed of the Governor, Deputy Governor, one director, and the Deputy Minister of Finance), and it would be in constant touch with the operations of the Bank. The second addition was that the Governor received wide powers, for all actions and decisions of the Board of Directors or Executive Committee had to have his concurrance to be effective (s. 14). Since the Governor was 1 2

Canada, House of Commons, Official Report of Debates, 1934 Sessi, on, 1827-8. Ibid., 840-1.

8

BANK OF CANADA OPERATIONS AND POLICY

initially appointed by the government and subsequent appointments required its approval, it was argued that the government had effective control. 1 The constitutional position of the Bank of Canada as envisaged by the Conservative government was thus not materially different from that outlined by the Commission. The government gave greater importance to the dangers of private interference; and it already revealed traces of the later trend to much greater formal government control. But central bank policy was still to be something other than party-political policy. 2 It was to be national policy in the sense that it was not dictated by the government of the day or by financial interests, but rather was formed by directors from various other occupations and concurred in by the government-approved Governor. Ultimate supremacy, a watchful eye (through the Deputy Minister of Finance) without formal power to enforce its will quickly, and considerable faith in central bankers was thought to be the proper role and attitude of parliament in central banking. Second Period-Effective Government Control

The period from the federal election oflate 1935 to the amendment of the Bank of Canada Act on June 23, 1936, saw a major step in the constitutional position of the Bank, for the Bank was virtually nationalized. It began operations on March 11, 1935, as a privately owned institution. However, during the federal election campaign in the autumn of that year, the Liberal party promptly made greater governmental control of the Bank of Canada an election promise. It won the election and changed the status of the Bank. That the Liberals differed materially from the Conservatives in this question of government control had already become quite evident when the Bank of Canada Act was being debated in 1934, and it is in that discussion that the newer concept first appears. The then leader of the opposition, Rt. Hon. W. L. Mackenzie King, expressed his party's opinion thus: " ... In no sense should the bank be, or be permitted to become, a banker's bank. It is and ought to be a government bank the government being representative of the interests of the country as a whole ... We believe the provisions of the House of Commons, Debates, 1934 Session, 4188. The Conservative Prime Minister, Mr. Bennett, did in one instance seem to move closer to the position that the central bank was the tool of the government of the day (ibid., 4223) but since this is not consistent with other pronouncements and especially not with the legislation in its final form it can reasonably be discounted. 1

2

THE BANK OF CANADA AND THE GOVERNMENT

9

present bill ... do not go far enough to secure these ends . . . " 1 Mr. King made it clear that he desired greater government control and not greater parliamentary control when he questioned : " .. . is there not a possibility that at a time of crisis a situation might arise in which the power of this bank will be greater than that of the government itself? . . . I use the word 'government' rather than the word 'parliament' because I know the Prime Minister will say that parliament can always alter any law that has been made." Mr. King reasoned that when a political party had placed its policy before the people and had gained the confidence of the people through an election, there should be no institution which could possibly frustrate the government in its attempt to implement that policy. He said the remedy lay "in the matter of control" and added : "The question of ownership is, I think debatable." It seems clear that what worried Mr. King and what he wished to avoid was the danger of conflicts in policy, especially during periods of crises.2 When the Liberals won the 1935 election and introduced new Bank of Canada legislation Mr. Dunning, the Minister of Finance, outlined further his party's conception of the more direct place of government in central banking. His words were: " .. . The Bank may and should resist temporary gusts of public fancy, but in the long run it must show responsiveness to public opinion. In the long run the bank in the performance of a vital sovereign function must be responsible to the sovereign will expressed through government." And once again Mr. Dunning elaborated: "The amendment .. . will not mean that the government will be concerned with the daily routine management of the bank, but rather that the government will be assured that the direction of the bank is in the hands of men in whose judgment it has confidence. Since the appointments of directors are for limited terms only a long continuance of a policy that might conflict with the government view becomes impossible. " 3 It is to be noted that now the Bank should resist only temporary political interference and that by a change of directors the Bank's policy could be changed to be harmonious with government views. Three major changes in the Bank of Canada Act were intended to give effect to this concept of central bank control. 4 The Bank's capital was increased by $ 5, I 00,000, all of which was subscribed by the Minister of Finance for the state (s. I 0); with it the state received a majority of the total stock. Besides this, the Board of the Bank was 1 4

Ibid., II, 1285. 2 Ibid. , IV, 4192, 4195, 4196. 3 Ibid., 1936 Session, IV, 3262-4. Bank of Canada Amendment Act, S. of C., 1936, c. 22.

IO

BANK OF CANADA OPERATIONS AND POLICY

enlarged with government-appointed directors, each of whom had two votes (s. 6); these directors were therefore doubly assured of a majority vote on the board. Finally, the Governor of the Bank could veto any action or decision of the Board of Directors or of the Executive Committee, but this veto had to be referred within seven days to the Minister of Finance who was then to inform the Governor-General in Council. The Governor-General in Council would either confirm or disallow the veto (s. 9). Formerly there existed no such limitation on the Governor's veto. It seems, then, that the policies which the Bank decided to follow should in the long run be in harmony with the views of the government of the day. If differences of opinion arose, the government's view had to prevail and this would be accomplished eventually by replacing the directors when their terms expired. There might be a short-run difference, but the power to replace the directors (together with final authority over the Governor's veto) gave the government much greater direct control than it had under the former concept of the Bank's responsibility only to parliament. The government tended to discount the dangers of political interference in monetary policy, while fears of other influences were effectively allayed by the increased government control. But even so Bank policy was not spoken of as being government policy at all times. The Bank was to have a free hand in internal management and in implementing policy, subject presumably only to parliamentary sovereignty. Although the above includes the fundamentals of the concept as it is accepted today, certain awkward questions still remained. What, for instance, was the position of the Governor after his veto had been overruled? Could the Bank disclaim responsibility for policy after such an overruling took place? Was it possible to maintain constitutionally the Bank's slight independence in policy formation which still existed? Would the government continue to tolerate the theoretically possible time-lag in the implementation of its own views, and could it disclaim responsibility for Bank policy during those periods? These questions were finally answered in the third period of constitutional development. Third Period-Clarification of the Concept It was from the first amendment of the Bank of Canada Act in June 1936 to a statement in the House by the Minister of Finance

THE BANK OF CANADA AND THE GOVERNMENT

II

in June 1941 that the current concept of the constitutional position of the Bank was established. It was increasingly emphasized that there had to be perfect harmony between Bank of Canada policy and government policy. Not only was it a question of avoiding possible long-run conflicts in policy; it became steadily clearer that Bank policy had to be government policy at all times. The Governor of the Bank stated the principle that central banks' monetary policy "must conform to the policy of their respective governments. No other conception of the situation is possible in this day and age, nor would any other state of affairs be desirable in view of the vital effects which monetary policy can have on the affairs of a country. " 1 Similar opinions were expressed by private members of parliament. 2 And complete nationalization of the Bank of Canada by the Bank of Canada Amendment Act of 1938 was in conformity with this trend; private shareholders were required to sell their holding and the Bank's capital was reorganized so that it totalled $ 5 million, all of which was held by the government. However, even as late as June 1941, the concept was not clearly established as indicated by a most incredible answer given by the Minister of Finance to another member of parliament who inquired about the relationship between the Bank and the Government. Mr. Blackmore asked: "Do I understand the minister to say that the Bank of Canada ... is independent of the finance department, and therefore independent of this House?" Mr. Ilsley answered: "Correct ... Once the directors are appointed, I have no right, nor has the government any right, to dictate to the Bank of Canada as to what its policies shall be. " 3 This hasty answer prompted the Minister to admit several days later that he might have gone farther than he should have done. He then went on to clarify the question, in a statement of such importance that it must be quoted at length: ... the Bank of Canada was created by parliament as an autonomous corporation with its stock owned wholly by the government, but with its own management and board of directors appointed by the government. It is an arm of the government, but not a department of the government. The character of the act is such that responsibility for its operations is placed squarely on the shoulders of the governor and the board of directors ... The point which I would like to emphasize is that the responsibility with 1

G. F. Towers, in an address to the Montreal Junior Board of Trade, as reported

in the Gazette, Montreal, March 15, 1938. 2 See House of Commons, Debates, 1939 Session, IV, 4084-5. 3 Ibid., 1941 Session, IV, 3377.

12

BANK OF CANADA OPERATIONS AND POLICY

which the governor and board have been charged by parliament does not in any way relieve the government of the responsibility for the monetary policy being pursued by the bank, nor in any way militate against public control of monetary policy. The monetary policy which the bank carries out from time to time must be the government's monetary policy, but the government must leave the carrying out of that policy, the choice of ways and means of executing it, to the management of the bank in whose judgment it has confidence. If the government is satisfied with the policy which is being pursued, there is obviously no quarrel between it and the bank. Let us suppose, however, that the management of the bank and the government do not see eye to eye in the matter of monetary policy . . . . In such a case there can be no question whatever as to the outcome of the dispute. The government's view will prevail. In view of the statutory responsibility placed on the governor and the board of directors, I do not believe that those of them who disagreed with the government on a fundamental issue could conscientiously carry out the government's policy. It would therefore be necessary for them to resign, and they would be replaced by others who were willing to accept responsibility for the type of policy which the government believed to be appropriate. 1

It is interesting that thirteen years later, the Governor of the Bank of Canada explained the Bank's position in almost identical terms. These quotations from his evidence before the House of Commons Banking and Commerce Committee in 1954 are unequivocal. ... The situation is that parliament has placed squarely on the shoulders of the directors and management of the Bank of Canada the responsibility for monetary policy. It would be ofno use for us to come before a committee of this kind and say in respect of certain actions which were criticized, we did not like that, but the government wanted us to do it ... We must and do take full responsibility for everything which we have done . . . On the other hand, there is no alibi possible for the government, because if government said : well, we disagreed with what the central bank did, but parliament has placed the responsibility on them, so what could we do? the answer obviously is that the administration of the day, supported by a majority in parliament, can always alter the legislation. In fact, I doubt whether a disagreement would ever necessitate such a thing, because there are various ways and means by which directors and management can be got rid of.

The last point was made even clearer when the Governor said : ... if we thought that the type of policy which the government wanted to implement was a very bad one and not in the public interest, then in one form or another I assume there would be a change in management . .. The opinion of the government might be right and that of management might be wrong. But if the government was firm in its opinion, it would get it implemented. 2

Ibid., 3936 (italics added). Canada, House of Commons, Standing Committee on Banking and Commerce, Minutes ofProceedings and Evidence, no. 16, March 18, 1954, 714, March 30, 1954, 883. 1

2

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I3

In May 1956 the House of Commons Banking and Commerce Committee once more discussed the constitutional position of the Bank but again the concept established in 1941 remained unchanged. Those hearings did reveal some confused thinking about the nature of Bank of Canada "independence," but the newly appointed Governor, Mr. Coyne, was agreeing with his predecessor's evidence of I 954 when he pointed out that "if the government of the day were sufficiently displeased with the bank or the management of the bank, they could put in motion steps which would bring about a change in the management. At some stage in that process, if the government were so determined as to make a real issue of it, a public issue presumably, the governor would have to resign." 1 This statement also rightly suggests that the precise stage at which the Governor would be expected to resign is uncertain. It might come after the Governor felt that reconciliation between his view and that of the government was impossible, or after he had been informed that special legislation to remove him would be brought down. According to the prevailing concept, then, the Bank must be assured wide freedom in the formulation of policy, but at the same time the resulting policy can be nothing other than the policy of the government of the day. Conflict between Bank policy and government policy cannot arise for these are the same. The only conflict possible is that the management of the Bank may disagree with basic policy desired by the government. Should this happen the procedure is clearmanagement would at some stage be expected to resign. If the government does not interfere, it is implicitly indicating its approval of the policy pursued by the Bank; while by not resigning, the Bank's management is in effect pronouncing its faith in the policy being implemented. No such limits, however, exist on the Bank's discretion in the actual implementation of government monetary policy. The government of the day has no right to overrule Bank management in the finding of ways and means for effecting the policy it approves, and if such power were desired a change of legislation would be required; any such interference without new legislation would be an unconstitutional act by government. Not that this precludes government co-operation on the operational level-indeed, we shall shortly refer to important instances of such co-operation-but it does minimize the risk of extreme government influence. 1

Ibid., no. 10, March 22, 1956, 373.

14

BANK OF CANADA OPERATIONS AND POLICY

This concept seems now to be generally accepted. 1 It did not evolve as a result of government disappointment with Bank operations, for at that time no such difference of opinion on policy existed, but rather because of conceptual differences between the two political parties and the need to reconcile the Bank's position in a system of responsible government. 2 The success in practice of this concept depends virtually on the prestige and integrity of the Governor of the Bank, and on the restraint and wisdom of the government. If in a dispute a Governor finally finds his convictions outraged by government demands he must not hesitate to relinquish his post in such a manner as to attract the attention of public opinion; should he succumb to government demands the last remaining protection of the currency, and monetary policy in general, from extreme political abuses would disappear, and the arguments for administering the Bank on lines other than that of a mere department of government would be seriously weakened. It is most desirable that any government which is tempted to seek political success by initiating dangerous monetary policy should have to weigh the political gains of such a policy with the political repercussions of a Governor's resignation. THE BANK-GOVERNMENT RELATIONSHIP IN OPERATION

The preceding pages suggest that monetary policy is protected from extreme political interference, and that this is a healthy state of affairs. It would, however, be na"ive to move a step further and conclude that cooperation between Bank and government, even on the policy level, should be severely restricted. In fact the Bank is and must be in constant communication with the government; sensible monetary policy cannot be formed and implemented without a clear understanding of government intentions and activities; and certain political considerations should not be ignored by the Bank 1 One member of parliament, however, was persistent in his criticism that "there is no bridge between parliament and the Bank of Canada." What disturbed him was that the Minister of Finance could not be held responsible for, and so could not be questioned on, the actual operations of the Bank. See House of Commons, Debates, 1943 Session II, 1509; 1944 Session, III, 2761-2; 1940 Session, III, 2553. During the official discussion on the 1954 amendment of the Bank of Canada Act, one leading opposition member advocated strongly some direct control on Bank operations in the form oflimits on thesizeofthenoteanddeposit liabilities of the Bank of Canada. Cf. Standing Committee on Banking and Commerce, Minutes, March 3, 1954, 763-5; March 3, 1954, 864-72. 2 The same difficulty arises with all other government corporations, but is sharpened in the Bank's case because of the national importance of its operations.

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when it is deciding on the course of new policy. These aspects of Bank operations must be considered further. The Bank of Canada is expected to fulfil three main functions, each of which makes its relationship with the government both real and continuous. As the instrument by which government monetary policy finds expression, it must of course keep the government well informed. Besides this, the Bank has been the government's fiscal agent ever since it began operations. The Bank is also public debt manager; since April I, 1938, it has been required to "act as agent for the Government of Canada in the payment of interest and principal and generally in respect of the management of the public debt of Canada. " 1 The very nature of the last two functions, with their problems of loan flotations, redemptions, change of debt structure, rates on new issues, financing of short-term requirements and a host of others, demands consultation between the two institutions on a more than casual basis. Nor must it be forgotten in this context that the Bank is the agent for administering the government's Exchange Fund Account and Securities Investment Account. The former is an important day-to-day factor in the foreign exchange market while the latter has at times been a decisive factor in the bond market; in administering both, the Bank must communicate frequently with the government and questions of monetary policy cannot help but form a significant part of discussion. The institutional framework and complex at Ottawa ensures that official financial authorities do in fact co-operate very closely. There is no danger that the authorities which act as fiscal agent, debt manager, and monetary manager will quarrel amongst themselves over the division of responsibility, as is possible in the United States, for the Bank is all three. A further, and not insignificant point is that the informal and unrestrained communication between Bank executives and higher civil servants in the government departments makes it possible for their relationship to be of an almost personal nature. Consultation is easy, and decisions mutually arrived at can be put into effect quickly.2 It may well be that this connection be' This was the date when section 23 (2) of the Bank of Canada Act was required by the Minister of Finance to become effective. See the Act and also Bank of Canada, Annual Report to the Minister of Finance and Statement of Accounts, Feb. 6, 1939, 9. 2 This is in marked contrast to the United States where the attempted division of responsibilities between the Treasury and the Federal Reserve System some times causes friction between them and often causes delay in decision making. See for instance, United States Congress, Report of the Subcommittee on Monetary, Credit, and Fiscal Policies of the Joint Committee on the Economic Report, Senate Document no. 129 (Washington, 1950), esp. 17-32.

I6

BANK OF CANADA OPERA TIO NS AND POLICY

tween the government and the Bank is of more practical importance than the legal ties which bind them; certainly the nationalization of the Bank was not followed by any obvious change either in its operations or in the policy which it pursued. While this functional and operational cohesion between Bank and government might well encourage undesirable developments, as we shall see presently, it does have several important advantages. It can strengthen and even supplement the Bank of Canada's orthodox monetary control techniques. This will be discussed in detail later, but as an example, the government can help to bring desired changes in chartered bank reserves by varying the division of its deposits between the banks and the Bank of Canada. Also, the manner in which the government disposes of any cash surplus might well aid the central bank, as can its instructions concerning the use of the Exchange Fund Account. Another advantage is that it helps to ensure the emergence of a harmonious over-all economic policy. It is now generally recognized that there must be unity of purpose in the three fields of monetary policy, fiscal policy, and debt management for an effective economic policy to emerge. This is true regardless of the objective of economic policy at any given point in time. The arrangement whereby the Bank of Canada is fiscal agent, public debt manager and monetary manager, whereby the government is the direct source of fiscal policy and ultimate source of monetary policy, and whereby close consultation between Bank and government is a fact, is one which is highly conducive to a harmonious economic policy. To what extent it leads to a balanced economic policy is an entirely different question. To find a conclusive answer, one would have to know the weight given to various conflicting factors before final policy is decided, and this usually remains the secret of the conference table. But we can recognize the more important forces present and clarify the problem partially by a priori means. Broadly speaking, it seems permissible to say that there are two decisive forces in the formation of policy-economic and political. The danger of conflicts between various economic objectives, arising out of the institutional framework at Ottawa, is a real one because of the different functions which the Bank must perform. As the instrument of monetary policy it must consider proposed policy in the light of the various objectives outlined in the preamble of the Bank of Canada Act: help stabilize production, prices, trade and employment; control credit and currency; help protect the dollar in the foreign exchanges,

THE BANK OF CANADA AND THE GOVERNMENT

I7

and so on. As debt manager it cannot fail to consider the effects of proposed policy on any immediate government financing operation. Both the cost of new financing and the ease with which it can be executed may be affected by new monetary policy. As fiscal agent it must concern itself with the problems of financing the government's huge budget, sometimes directly, as when it makes advances to the government or buys extraordinary issues from the government. Conflicts between the specific objectives of these various functions are inevitable. For instance, a rise in interest rates may be required for controlling inflation; but this might create uncertainty in the securities market thus making the role of the debt manager more difficult; and it would lead to increased appropriations for interest payments on new issues. It may well be that the Bank over-emphasized its aims as debt manager to the detriment of a more effective anti-inflationary policy in the early post-war period. This functional cohesion, as well as other things, may have encouraged too much "Treasury thinking" and not enough "central bank thinking," as we shall see again. But it must be mentioned immediately that the alternative of segregating the Bank's functions by designating them to separate institutions provides no happy solution. Indeed, it would probably be an inferior arrangement, for although the central bankers' thinking might not then be as easily distorted by the ominous problems of debt management and fiscal policy, it would be possible to have conflicting financial operations. The solution lies in the direction of the Bank giving appropriate emphasis to its various functions. 1 If the Bank wishes to be able to present a "working" policy, it cannot contain itself in an economic vacuum; it must also consider certain political factors. Political considerations may be roughly of two types ; whether a given policy will be generally repugnant to the nation as a whole, and whether a policy which would be accepted, perhaps reluctantly, by the people would run the risk of having unpleasant consequences, or no direct advantages for the fortunes of the political party forming the government. Ideally the Bank should have to concern itself only with the first. This political consideration is by no means unimportant, for a generally repugnant policy will in the long run be no more effective than a law which has lost the force of public opinion. 1 The Bank must of course consider a myriad of specific economic factors when forming policy, but the emphasis here is on the effects of the institutional arrangement on policy formation.

18

BANK OF CANADA OPERATIONS AND POLICY

Whether the second type of political consideration has any influence at all will depend to a large extent on the government itself. The threat of a Governor's resignation, as we have seen, is a positive check to extreme interference, but the government can always remain just within the bounds of toleration, and still have a certain subtle influence. On the other hand, the government may refrain earnestly from using undesirable political pressure of any kind. No incident in the Bank's history suggests that the Bank has been forced to accept government-prescribed policy, even though after the June 1957 election the new government appeared more than uneasy over central bank policy. It is true that often there is no single obvious policy to pursue, but rather various policies or varying degrees of one policy, each of which can be justified economically depending on the emphasis given to the different variables involved. In such a case a policy decision may be made by government and Bank with at least a glance at the possible effects on the party's good fortunes. In part of the post-war period, the Bank justified its bond price policy on economic grounds, and at the same time few could argue that it was not a politically astute policy. Institutional changes do not provide a remedy for these weaknesses, but the system may be improved and fortified. The office of Governor should be protected from any influence (salary cuts, circumscription of authority, decreased active responsibility) which would lessen its prestige and respect; with its acceptance should go a clearly recognized duty of loyalty to the economic welfare of the nation as a whole and not to the government of the day. A tradition of non-interference for political reasons by party governments should be strengthened and guarded. Further, the Bank should be kept as much as possible out of the often biased, exaggerated and unrestrained debates of party politics. For this reason the hope that the Bank might become banker and possibly fiscal agent to the provincial governments may be misplaced. 1 Differences of opinion between the Bank and any province might arise because of the Bank's conception of its duty toward the monetary policy of the nation as a whole. It is difficult to see how the Bank could escape bitter political attacks in such circumstances, especially in the complex provincial political environment.2 1 See Bank of Canada Act, S. of C., 1934, s. 23, and Bank of Canada, Report of Proceedings of the Second Annual General Meeting of Shareholders, Feb. 23, 1937, 13. 2 This is not to deny the undoubted advantages of greater coordination of provincial economic policies with federal policy, but only to question the central bank's place in

THE BANK OF CANADA AND THE GOVERNMENT

I9

It is desirable, too, that the Bank use its powers of moral suasion with great delicacy and discretion. For when such persuasion seems to rely mainly on the powerful backing of government to be effective it will soon be viewed as an arbitrary exercise of authority, instead of an exercise in co-operation. 1 The prestige of the Bank might be further enhanced if the public had a greater understanding of its policies. There are obvious limits to this because of the very nature of central banking, but a fuller interpretation of the excellent but bare statistics which are currently being compiled and published might conceivably do much more good than harm. The Bank might well take an even more active interest than it has so far in providing the material necessary for an intelligent public opinion on monetary matters. The Governor's appearances before parliamentary committees have almost certainly raised the Bank's prestige. But unfortunately, public understanding of the vital role which monetary policy plays in a basically free enterprise economy is not yet what it might be. A rather more knowledgeable interest in the Bank's operations by the press would also encourage wider discussion and understanding of Bank functions and policy. Finally, as a broad generalization, the objectives outlined in the preamble of the Bank of Canada Act should take precedence over the exigencies of debt management. When the Bank was established and during the first few years of its existence, political interference was feared because it was thought that the government might indulge in reckless inflationary financing. This fear has so far proved groundless, but the danger now is that the central bank as well as the government might, because of the huge debt and large budget, overemphasize the specific aims of debt management. The trend should be for debt management, as well as fiscal policy, to aid in the achievement of monetary management objectives. Monetary management should very seldom (but certainly sometimes) be the tool of the debt manager. It seems possible that Canadian monetary policy might at times it. No Canadian province has shown any inclination to associate itself more closely with the Bank of Canada. When the Governor apparently made some reference to the desirability of the Government of Canada tax proposals to the provinces a newspaper headed an article, "Mr. Graham Towers Speaks out of Turn" (see Halifax Chronicle, Feb. 13, 1946). 1 On the use of moral suasion see below chapter III and also E. P. Neufeld, "The Bank of Canada's Approach to Central Banking," Canadian Journal of Economics and Political Science, XXIV (Aug. 1958).

20

BANK OF CANADA OPERATIONS AND POLICY

be distorted because of the multiple functions of the Bank and because party-political factors may have a certain subtle influence. But the benefits of a harmonious over-all policy gained through the centralization of financial operations and policy seem much greater than the dangers inherent in such an arrangement. 1 The arrangement is not perfect and a purist would be frustrated. Improvement, however, lies not in institutional rearrangements, it lies in making conditions such that the Bank's prestige does not suffer and in recognizing the primary importance of the ultimate objectives of monetary management in spite of the real problems arising from large budgets and a large public debt. 1 This is true in Canada because people accept executive responsibility in government. In the United States separation of powers is considered necessary and this thinking prevails even in monetary management, debt management and fiscal policy. Therefore, the Canadian institutional framework in governmental monetary matters would not be acceptable to the Americans. They emphasize co-ordination between independent institutions rather than fusion of responsibilities in any one institution. (See United States Congress, Report of the Subcommittee on General Credit Control and Debt Management of the Joint Committee on the Economic Report, Senate Document no. 163 (Washington, 1952), esp. 49-63.)

CHAPTER II

Bank of Canada Objectives BEFORE DISCUSSING the Bank of Canada's control techniques or its operations, it is essential that we gain a clear impression of what exactly the Bank should attempt to do. The objectives described in this chapter are perhaps not in every case beyond dispute, especially since it has been necessary to make certain assumptions regarding the extent of the Bank's responsibility for debt management and government finance; but much of the discussion should be noncontroversial, for appraisals of whether or not the Bank of Canada has fulfilled these objectives are left to later chapters. Similarly it seems best to leave most discussion of control techniques to the next chapter. The emphasis is entirely on Bank objectives, although some description of the economic phenomena which make certain objectives necessary must occasionally be given. It has already been indicated in chapter I that the Bank is the instrument for implementing government policy, and therefore it might be said that the ultimate objective of the Bank's operations is the fulfilment of this policy. While this is undoubtedly correct, indeed a truism, it tells us nothing of the nature of the Bank's specific objectives and so gives no indication of the general guides for actual operations. The attainment of a high and stable level of employment income and economic growth can be considered to be the Bank's ultimate objective, and that is the expressed aim of the government also. 1 The Bank can attempt to achieve this aim by both direct and indirect means. Directly, it can try to bring a positive influence to bear on national income itself; that is, it can encourage a change in real and money national income. More indirectly, it can accommodate a change in national income which is already taking place and it can in certain ways protect the economy from influences which would disrupt economic growth and price stability; we will find 1 The government formally recognized its increased responsibility for maintaining a "high and stable level of income" in its White Paper, Employment and Income with Special Reference to the Initial Period of Reconstruction (Ottawa, 1945), I.

22

BANK OF CANADA OPERATIO NS AND POLICY

that these activities mainly entail offsetting changes in the demand for bank cash, and exerting a stabilizing influence on the securities and foreign exchange markets. Lastly, since governments will not be without funds, the Bank may have to aid government finance. Each of these objectives must be examined separately even though some of them do in fact overlap. DIRECT INFLUENCE ON NATIONAL INCOME

The Bank of Canada was to some extent born of depressed economic conditions, being established in the middle 1930's, and so it is not surprising that the preamble of the Bank of Canada Act speaks of the desirability for the Bank to use its influence to mitigate fluctuations "in the general level of production, trade, prices and employment." If relative full employment exists and national income is increasing not only because of increased production but also because of price inflation, the Bank must aim at greater price stability (that is, it must influence the trend in money national income). On the other hand, if unemployment begins to appear, appropriate policy would be to lay the foundation for an increase in the demand for men and material (an increase in real national income), perhaps even to the point where prices begin to rise, and so in that sense initiate a change in national income. If, however, relative full employment exists without upward price trends the Bank would not be required to exercise its initiative in pressing for a change in the demand for production factors; increases in national income would have to result from a net growth and more efficient utilization of resources and, as we shall see, the Bank's operations should then be of an accommodating nature. Although it is impossible precisely to isolate accommodating action from initiating action, it is essential for analysis of Bank operations that such a distinction be made. The Bank is of course limited in its ability to change national income, for it cannot go far beyond orthodox monetary methods. These have however in recent years gained renewed respectability in Canada, as in most Western countries; and although it would be rash to claim high employment and stable prices as the reward for their use, none the less a stage has been reached where few would argue that it is not worthwhile to use them to an extent limited only by the bounds of public acceptance (for example, within "reasonable" interest rate variations). Controversy over the efficacy of monetary techniques in fact centres on this central bank objective

BANK OF CANADA OBJECTIVES

23

of changing national income, as distinct from that of merely accommodating a change; it is here, also, that the finest discretion and the surest judgment of the central banker is imperative. Changing the cash base which underlies chartered bank deposits is the Bank's principal method for achieving changes in the national income. While the techniques available for effecting cash changes form the subject-matter of the next chapter, it is convenient to trace now, in a brief and general manner, the effects of such changes. Following a change in cash, the banking system as a whole will be encouraged, or even forced, to alter its assets in order to maintain its customary relative stability of the ratio of cash to deposits. The availability of credit will be affected: a change in loans will affect it directly, and such a change is more likely to occur now than in recent years, for the decreasing proportion of government securities in bank portfolios makes substituting loans for securities less easy; 1 a change in security holdings will alter the liquidity of other members of the market, and thus influence at least marginally their ability and propensity to spent or save, as the case may be. Although the banks are interested primarily in short-term loans they do finance housing under the National Housing Act, and so a change in bank cash may influence even this long-term investment activity. Other types of long-term investment activity will also be affected by cash changes because even ordinary bank loans finance some capital expenditure. The cost of certain types of credit will be affected, for as the banks alter their day-to-day loans outstanding and their holdings of securities in order to adjust their cash ratios, day-to-day loan rates and bond prices will soon change; other market interest rates, and eventually even institutional interest rates such as bank loan rates, will also change. Investment in general will to some extent be affected by those changes. Before the Bank abandoned the use of Bank Rate as a positive control technique, that is, before it adopted a "floating" Bank Rate, it could underline the intended direction of its operations by changing that Rate. Whether or not the new Bank Rate is an improvement will be discussed again, but if the Bank now wishes to emphasize its policy it can do so through speeches or special press releases. Selective agreements with the banks may at times be effective supplements to quantitative techniques in influencing the direction of real and money national income. The exact repercussions of Bank action 1 See E. P. Neufeld, "Changes in Canadian Banking," Banker, London, Sept. 1954, 163-5, and "Curbing Canada's Boom," ibid, July 1957, 433.

24

BANK OF CANADA OPERATIONS AND POLICY

in any specific instance would be rather more complex than the above suggests-a study in itself-but the general effects would not differ. And we shall see in the next chapter that the Bank is fully equipped to set the necessary machinery in motion. The extent of the Bank's operations aimed at correcting the disequilibria under discussion will depend mainly on three things. First, it will depend on the Bank's conception of the scope of monetary management, for the preamble of the Bank of Canada Act does not expect the Bank to go beyond monetary action. It can vary bank cash within tolerable limits and it can talk to bankers and bond dealers about desired policy, but does it, for instance, consider consultation with institutions, other than those with which it is directly associated, beyond the scope of its persuasive influence? We shall see later that perhaps it does not; but if it does, its power to influence national income might be less than if the opposite were the case. Second, it will depend on the Bank's interpretation of the causes of the economic disequilibrium which it would be desirable to correct; if it sees these as mainly external, or otherwise beyond its control, it may well take no positive action at all. And third, it will depend on the Bank's opinions regarding the nearness of conflicts with its other objectives and the importance it attaches to the possible results of those conflicts. Where, for example, does it draw the line between the desirability of encouraging domestic economic activity through monetary expansion and ensuring a healthy balance-of-payments position? Or what are its opinions regarding the stabilization of government bond prices? Later chapters will indicate how these factors have influenced Bank operations aimed at changing national income directly. OFFSET TO CERTAIN FLUCTUATIONS IN CASH AND CASH REQUIREMENTS

There are a number of factors in Canada which cause fortuitous and unwanted changes in the demand for and the supply of bank cash.' When such a change takes place it is often the duty of the Bank of Canada to adjust its assets so that the banking system (and ultimately the whole economy) is not unnecessarily disrupted or does not receive fortuitous supplies of cash reserves. The aim of 1 Mr. W. Manning Dacey helpfully distinguishes between reserve variation for changing national income and for offsetting temporary changes in bank cash; see his The British Banking Mechanism, R. F. Harrod, ed. (London, 1951), 31-2.

25

BANK OF CANADA OBJECTIVES

the Bank here is not to change national income but to protect national income from disruptive forces or to accommodate changes in the national income which are in fact taking place. Numerous factors can cause these changes in cash requirements but the changes themselves are of three types: temporary recurring, temporary nonrecurring, and permanent. Temporary Recurring Changes in Bank Cash

Temporary changes in cash and cash requirements which occur periodically, and so can be approximately predicted, are almost invariably associated with seasonal factors. Figure I gives some

105

100

95

95

Jan.

Mar.

Jltly

Sept..

Nov.

Jan.

F10. 1. Seasonal index of bank cash. (For actual index numbers, method of computation, source of original data, and other comments see Appendix D.)

indication of the importance of reserve fluctuations directly attributable to seasonal factors, for it is a seasonal index of such changes. 1 The amount by which the index for any month is above or below 100 is the approximate percentage increase or decrease in bank cash arising out of seasonal factors. It is clear that there is a definite seasonal increase in reserves in the autumn and also in the spring or early summer. The general pattern remains the same in the postwar as in the pre-war period, although in the post-war period there is a smaller percentage change in the autumn. The autumn increase from September to January, because of seasonal influences, in the 1

See Appendix D.

26

BANK OF CANADA OPERATIONS AND POLICY

post-war period amounted to 5.7 per cent. Absolute changes are, of course, much larger after the war than before. These net seasonal changes in reserves are the Bank's response to two different seasonal demands for cash: seasonal increase in economic and financial activity and seasonal changes in the liquidity position desired by the commercial bankers. The effect of increased business activity on reserve requirements is clearly reflected in the seasonal changes in bank loans. Figure 2 indicates approximately the nature of these seasonal loans, for it

,,

,.

115

War! ·,

\

I

llO

,.~

\

i

\ I

105

,,

\ Pre-war,'

I

I

100

I

-, ____ ,._ \

\,

.... -

., ·

-

,_

;- -'

\

i I

.\ ''

105

I

-- -

\

95

Jan.

110

I \

·,

Mar.

May

July

95

'

' Sept.

Nov.

Jan.

FIG. 2. Seasonal index of chartered bank current public loans. (For actual index numbers, method of computation, source of original data, and other comments see Appendix D.)

depicts the seasonal index ofloans for the pre-war, war, and post-war periods. It is evident that under the more settled conditions of the pre-war and post-war periods there is a quite definite and remarkably unchanged seasonal pattern in bank loans to the public. Seasonal factors raised current public loans by about 6.6 per cent in the autumn of the post-war years, while during the period from 1935 to 1941 they did so by about 7 per cent. The war period was most unsettled, entirely because of the large expansion of loans associated with buying victory bonds during the twice-yearly war loan drives. Only recently have chartered bank loans been classified in a

BANK OF CANADA OBJECTIVES

27

manner even partially suitable for ascertaining the nature of the seasonal increase. It is now clear, however, that loans to farmers and to grain dealers and exporters constitute a large part of the seasonal hump in current public loans. The remaining seasonal increase, in the post-war period, is almost entirely explained by loans for buying Canada savings bonds, which have regularly been offered during the autumn months of the post-war years. 1 Indeed it is these loans which have shifted the autumn peak of current public loans from October, where it was before the war, to November. Table 1 shows changes from June to September and September to December for the years 1948 to 1956 in the various loans referred to above; those months roughly cover the seasonal increase in loans. Loans to farmers increase persistently from June to September (in fact they begin their increase in spring) and then decrease in the last quarter of the year. The seasonal variation in these loans is relatively stable; for the figures shown require little correction for trend influences. Loans to grain dealers and exporters increase in even greater amounts than loans to farmers, although the exact time of appearance of these loans is not as definite. The large increase can come in either the third or fourth quarter of the year, or can be spread over both, depending on the progress of harvesting, delivery, and sale of grain. Table 1 also shows that personal loans tend to increase markedly from September to December; the increase in this category arises, almost entirely, from the autumn purchases of Canada savings bonds.2 It must be recognized, however, that this is a seasonal variation quite different from the two outlined above because it is dependent on administrative decisions regarding the timing of new issues, and not the result of the seasonal nature of economic activity. Should this timing be changed, then the seasonal pattern resulting from it would ipso facto be changed also. Call loans sometimes appear to vary seasonally. These are loans on 30-day call or less to investment dealers and brokers (not the day-to-day loans to the money market), and in fact they are seldom called quickly. To do so would cause considerable disruption because no immediate alternative accommodation is available. When there is a tendency for stock market activity to increase in autumn, or See Bank of Canada, Statistical Summary, for graphs of classified chartered bank loans. Thus from Sept. 30 to Dec. 3 I, I 952 to 1956 (information for former years not available), loans to finance the purchase of savings bonds at time of issue increased by $ 128, $ 145, $ 125, $ 142 and $ 148 million respectively, which equals approximately the total increase in personal loans. Bank of Canada, Statistical Summary, Financial Supplement, 1955, 30, 31; 1956, 28, 29. 1

2

28

BANK OF CANADA OPERATIONS AND POLICY

TABLE 1 CERTAIN SEASONAL CHANGES IN CHARTERED BANK LOANS a

(Millions of Dollars) Changes at end of month

1948

1949

1950

1951

June to Sept.

Sept. to Dec.

June to Sept.

Sept. to Dec.

June to Sept.

Sept. to Dec.

June to Sept.

Sept. to Dec.

+ 15.1

- 9.1

+25.2

- 9.3

+52.9

-12.4

+ 49.5

-21.0

+ 70.7

+75.4

+93.1

- 20.1

+ 9.3

+ 66.4

- 8.4

+ 78.7

- 16.5

+ 80.3

-12.4

+92.9

Loans to farmers Loans to grain dealers and exporters Personal loans

- I 1.6 + 134.9

-51.1 +100.8

Changes 1952 at end Sept. of month J~ie to Sept. Dec.

June to Sept.

Sept. to Dec.

June to Sept.

Sept. to Dec.

June to Sept.

Sept. to Dec.

June to Sept.

Sept. to Dec.

Loans to farmers

1953

1954

1955

195€

+50.5

-26.1

+35.6

-20.5

+25.1

- 20.5

+ 36.8

+0.2

+ 29.6

- 10.9

Loans to grain dealers -15.9 and exporters

+ 70.9

+ 81.6

+ 80.5

- 2.7

+ 24.9

+ 34.7

+ 1.0

+ 1.6

+ 31.6

Personal loans

-8.7 +143.6

- 16.4 + 144.2

-35.2 + 123.3

+30.9 + 178.8

-55.9 + 108.3

a Original data from Bank of Canada, Statistical Summary, Oct. 1951 , 163, 164; Oct. 1952, 163, 164; April 1953, 60 ; and ibid. Financial Supplement 1956, 28, 29.

especially when bond dealers increase their inventories at the time of a new issue, call loans tend to increase also, 1 and may reinforce the seasonal trend in current public loans shown by Figure 2. An autumn increase in loans is not always alone in requiring a seasonal increase in bank cash, for the banks have at times built up 1

See Bank of Canada, Statistical Summary, for monthly statistics of these loans.

29

BANK OF CANADA OBJECTIVES TABLE 2 RATIO OF CASH IN CANADA TO CANADIAN DEPOSITS a

1935 to 1953 1940 to 1945 1956 to 1957 1935 to 1939 1946 to 1953 Daily Month Daily Month Daily Month Daily Month Daily Month average end average end average end average end average end Jan.

10.7

10.6

10.9

10.4

11.0

10.5

10.9

10.5

8.3

7.8

Feb.

10.6

10.4

10.6

10.2

10.6

10.2

10.6

10.3

8.2

7.2

Mar.

10.2

10.0

10.7

10.2

10.5

10.3

10.5

10.2

8.2

6.9

Apr.

10.0

9.9

10.7

10.5

10.6

10.6

10.5

10.3

8.2

7.7

May

10.0

9.8

10.8

10.4

10.6

IO.I

10.5

IO. I

8.2

7.3

June

10.0

9.7

10.9

10.2

10.4

10.0

10.4

10.0

8.2

7.3

July

IO.I

9.8

II.I

10.7

10.4

10.3

10.5

10.3

8.2

7.5

Aug.

10.2

10.2

11.0

10.7

10.6

10.3

10.6

10.4

8.4

7.6

Sept.

10.3

IO.I

II.I

10.8

10.5

10.2

10.6

10.4

8.3

7.3

Oct.

10.5

10.5

I 1.2

11.2

10.5

10.7

10.7

10.8

8.3

8.1

Nov.

10.9

10.7

I 1.3

10.9

10.5

10.3

10.8

10.6

8.2

7.5

Dec.

10.5

10.2

I 1.2

I 1.0

10.5

10.6

10.7

10.6

8.2

7.7

a Figures for I 935 to 1953 were computed from monthly figures based on daily averages and from month-end figures of the chartered banks' cash and Canadian deposit liabilities shown in Appendix B. The average figures for 1956 were computed in accordance with the legal cash requirements introduced in 1954 and outlined below. The years 1954 and 1955 were excluded because of the transition in those years to a lower cash ratio following the change in the Bank Act of 1954.

their cash ratios during the last quarter of the year. This is suggested by the daily average and month-end statistics of cash ratios given in Table 2 above. That Table shows that the practice of persistently window dressing month-end cash ratios has been entirely abandoned, for month-end ratios are usually lower than daily average ratios for the same month; such practice was common among the banks before the formation of the Bank of Canada. 1 The exception to this is 1 For a discussion of both month-end and year-end window dressing in Canada up to about 1939 see A. F. W. Plumptre, Central Banking in the British Dominions, (Toronto, 1947), 238-40.

30

BANK OF CANADA OPERATIONS AND POLICY

October, for Table 2 shows that the banks built up their cash at the end of this month in all the periods examined, that is 1935-9, 1940-5, 1946-53, and 1956-7. There is sometimes a similar tendency at the end of November. A number of the chartered banks' annual reports are published at the end of October (with the remainder coming in November) and the high month-end ratio for October as compared with the month-end ratios for the other months of the year reflects a desire on the part of at least some of the banks to window dress their annual statements. In the pre-war period the banks built up their autumn cash ratios for a rather prolonged period, as shown by the significant rise in the daily average ratios (as distinct from merely month-end ratios), a practice which, however, disappeared entirely in the post-war period. It may well be that this was partly because the relatively larger seasonal swing in note circulation during pre-war years (see Figure 3 below), as compared with post-war years, required the banks to hold a relatively larger supply of notes; and as long as the banks held these Bank of Canada notes they were considered cash for purposes of computing reserve ratios. 1 After the war the seasonal swing in circulation decreased, and in fact so did the tendency to build up daily holdings of cash in autumn. Another reason may be that facilities for effecting large cash changes were not as highly developed before the war as they were after it so that the banks had in the former period to build up cash over a much longer period in order to show a high ratio on their annual statements. The January daily average cash ratio is high in all periods, because the chartered banks in that month take in large numbers of notes from the public. Since the Bank of Canada usually mops up this seasonal cash in due course, it would be imprudent for the banks to use it to expand deposits, hence the temporary rise in cash ratios. With the day-to-day loan market, variations of this type may in time disappear, for it will be possible for the banks to adjust their cash more quickly than was hitherto possible. The seasonal change in note circulation is the last important seasonal influence on bank cash. Since 1950, all bank notes have been the liability of the Bank of Canada, and before that practically all of them were. This, together with the fact that Bank of Canada notes held by the chartered banks and chartered bank deposits at the Bank of Canada constitute total bank cash, means that when 1 Since statistics of the daily average number of notes held by the chartered banks are not available it is impossible to state categorically that this has been the case.

BANK OF CANADA OBJECTIVES

31

circulation increases bank cash decreases unless it is offset by central bank action. Figure 3 indicates the importance of seasonal variation in note circulation for, like the preceding charts, it is a seasonal index of such variations. It is seen that note circulation increases gradually, because of seasonal factors, for most of the year, with a definite increase in the early part of the year and a much greater increase from August to December in the post-war years and August to October in the other two periods. However, the important change from pre-war years is that the whole index has flattened out. In the pre-war period the total seasonal swing from the low of January to high of October amounted to about 13.2 per cent, while in the postwar period the swing from the low of February to the high of December amounted to only about 4.7 per cent. To what extent should the Bank accommodate these various seasonal demands for cash? Clearly, it must allow an increase in reserves to accommodate farmers, grain dealers, and grain exporters, for such loans are necessary for the actual harvesting and marketing of the crop. Not to do so would either disrupt that essential activity or would cause annual disorder in the securities market through attempts of the banks to reduce deposits by selling securities. Nor need the Bank look with disfavour on the use of cash to expand autumn loans associated with stock market activity (although it must ensure that these loans do not become excessive). 1 The Bank of Canada must estimate to what extent any change in loans is owing to seasonal influences; for it is the trend of non-seasonal loans which is most relevant to a policy of price stabilization. 2 The Bank's reasons for aiding "seasonal" financing of Canada savings bonds are somewhat different although just as valid. The total operation is aimed at providing a suitable investment for small investors, influencing national income by encouraging saving, and aiding government finance by helping to place the savings issue. But the loans are not directly inflationary, and the inflationary 1 It is not assumed that if the Bank wished to check this type of loans, or any other specific type of loans, it would do it by open market operations. Indeed, it will be noted later that the Bank would probably succeed in checking dangerous trends in the stock market by suggestions to the chartered banks and the stock exchanges regarding margin requirements, and even just by making its opinion clear. If it were successful, the demand for additional reserves would decline and desired effects would be achieved without a general contraction of reserves through open market operations. 2 A definite tendency in the post-war period for a permanent expansion of bank loans to occur in the autumn (see Figure 6) illustrates forcibly the need to make this distinction.

32

BANK OF CANADA OPERATIONS AND POLICY

tendency of the government spending the proceeds is offset by the repayment of the loans by the subscribers of the bonds. It is equally true that the Bank must offset the variation in note circulation for it is the sole issuer of notes. If the customers of the banks for any reason want to hold more notes, then those notes must be supplied in order to prevent disruption to business or possibly even ,-,

'

,/ _,/Pre-war·, -- · - ·,

10~ I

I

100 /

... -

----- ·-

! ., , .,. ., ,

_ War ,,,.... ',

__ ... \\

Post-"'·Ar

95

95

Jan.

105

Mar

May

July

Sept.

Nov.

Jan.

FIG. 3. Seasonal index of active note circulation. (For actual index numbers, method of computation, source of original data, and other comments see Appendix D.)

panic. 1 This makes any statutory limitation on the Bank's note issue largely meaningless, and there is no reason why the present suspension of the 25 per cent gold reserve against notes and deposits of the Bank of Canada should not be continued. The limitation may have served a purpose during the first few years of the Bank's existence by convincing the business world that the Bank was sound (since there was a general misconception of the nature of a central bank), but that is no longer necessary. 2 That it enables the politician to protect the public 1 This need for a central bank to offset seasonal disturbances was by no means always recognized. Thus when speaking of pre-1914 Bank of England operations an author could say that "the failure to adopt some system of positive action to insulate the English banking system from all consequences of this seasonal drain must be accounted as a serious blot on its record." R. S. Sayers, Bank of England Operations 1890-1914 (London, 1936), 135. 2 The Bank of Canada Act, S. of C., 1934, c. 43, s. 26, prescribed a 25 per cent gold reserve against bank notes and deposits. The Exchange Fund Order, P. C. 1734, April 30, 1940, s. 5, passed under The War Measures Act, Revised Statutes of Canada, 1927, c. 206, suspended the reserve requirements, since all gold was sold to the Foreign Exchange Control Board. This suspension was continued by the Foreign Exchange Control Act, S. of C., 1946, c. 53, s. 70, assented to Aug. 31, 1946, and by The Currency, Mint and Exchange Fund Act, S. of C., 1952, c. 40, s. 25, assented to July 5, 1952. The Governor-General in Council may invoke the reserve requirement at any time.

33 from the possible monetary abuses of the central banker was probably never a veryconvincingargumentinits favour, and was made irrelevant when central bank policy became government policy at all times. There is no great harm in the Bank's tolerating year-end window dressing, or even in assisting the banks with it, for the Bank knows their true position and the banks' legally required cash ratio is computed in a manner which largely precludes window dressing. Nor does such a temporary change in the ratio weaken control by the central bank. 1 Certainly there is no urgency for the Bank to supply the cash required for this practice, but it is not sufficiently important to justify determined counter-measures. Indeed a former Governor of the Bank has even given it his qualified approval: "I do not suggest that it is a wrong thing to do. As a matter of fact, if it is recognized as a testing of a liquid position, if it is fully recognized and explained to be that, then it is a perfectly satisfactory thing. If it is a suggestion that that year-end cash represents the average for the year, then it would be a wrong thing". 2 And the Governor continued that it was by allowing Treasury bills to run off and by selling them that the chartered banks accomplished their window dressing. Since the Bank accommodated this annual desire for increased liquidity it must have been satisfied that the banks were doing it for the reason quoted above. But that reason was valid only in the somewhat superficial sense that the banks determined whether the Bank of Canada was continuing to provide an elastic demand for Treasury bills, for as will be noted again the Treasury bill market was, until mid 1954, the Bank of Canada. It was a very different situation from that existing in a well-developed short-term money market. So it may perhaps not be unfair to suggest that reasons other than a testing of their liquidity position prompted the banks to window dress their cash position. The recently developed money market has made window dressing even easier. For example, at the end of October and November 1954, the banks ceased extending day-to-day loans to dealers and the latter had to seek central bank funds at Bank Rate; after the monthend, funds flowed into the market once more.3 The Bank of Canada of course facilitates window dressing under those conditions just BANK OF CANADA OBJECTIVES

1 See, however, Plumptre, Central Banking in the British Dominions, 258. Before the 1954 Bank Act, the Bank of Canada received daily figures of the chartered banks' cash and of their Canadian deposit liabilities; now it receives weekly figures. 2 Canada, House of Commons, Standing Committee on Banking and Commerce, Minutes of Proceedings and Evidence Respecting the Bank of Canada, no. 12, May 5, 1939, 629. 3 See the Financial Post, Nov. 6, and Dec. 4, 1954.

34

BANK OF CANADA OPERATIONS AND POLICY

as surely as under the previous arrangement whereby the chartered banks sold Treasury bills directly to it. The extra cash, however, is not a prelude to a change in bank lending policies and so does not weaken central bank control over the money supply; and in view of the readily available monthly statistics of the chartered banks' individual positions, it would be difficult to accuse them of seriously deceiving anyone but for this same reason it is difficult for the non-banker to understand what the joys of window dressing really are, particularly since a loss of interest income is involved. Temporary Non-Recurring Changes in Bank Cash

Occasionally there are quite sudden and sometimes unexpected temporary changes in the demand for and supply of bank cash. Just as in the case of most of the more predictable seasonal influences on cash, the Bank must meet each with appropriate operations. The difference is that the Bank is not always able to anticipate them and must therefore act with much less preparedness. It is probably true that the art of central banking finds greater expression in situations such as these than it does in offsetting more or less expected developments. Sudden and resolute action is required. The most important offsetting action of this type occurred when the exchange control authority had to deal with a sudden inflow of foreign exchange. Under conditions of officially fixed exchange rates (such as existed from September 16, 1939, to October 1, 1950) an excess supply of or demand for foreign exchange is reflected in the size of the official reserves of gold and foreign exchange. Any net inflow of foreign exchange must be financed by the government. Since October 1, 1950, the rate on the Canadian dollar has been determined by market forces, and foreign exchange need be officially financed only when the Exchange Fund Account (the exchange stabilization fund) increases its holdings of foreign exchange. Financing under conditions of officially fixed rates would be potentially much larger, other things being equal, than under a fluctuating rate, for in the latter case equilibrium is attained by the rate itself and not by the official provision of a perfectly elastic demand for and supply of foreign exchange at the fixed rate. However, even the use of the stabilization fund in a free market might conceivably require considerable financing at times, especially when there is a sudden movement to a higher exchange rate and the authorities feel that the upward trend must be smoothed out and lengthened.

35 Whether or not such financing must be offset by the Bank of Canada will depend on the way in which the inflow is financed . If the Exchange Fund Account has sufficient Canadian assets (which are in the form of relatively small deposits with the Bank of Canada, and prior to 1950 also in Treasury bills) 1 then it can use these. This would increase chartered bank cash and for complete insulation the Bank of Canada would have to sell an equivalent amount of its assets. Normally the account's Canadian dollar requirements are reflected in its advances from the Minister of Finance. If the government had to sell securities to the Bank of Canada to obtain funds for making these advances, or if the Bank of Canada accumulated some of the inflow of foreign exchange on its own account, bank cash would again be increased and complete insulation would again require the Bank to sell some assets. Should the government decide to obtain funds through the sale of short-term securities to the chartered banks, then the Bank of Canada's action must be quite different. In order to prevent a disruptive or deflationary contraction of loans or sale of securities by the chartered banks it might have to expand bank cash to enable a net increase in chartered bank assets and liabilities (government securities and, initially, government deposits). This would tend to be inflationary but not as inflationary as financing entirely through a net expansion of Bank of Canada assets. If the net increase in official reserves of gold and foreign exchange is financed out of a government cash surplus then no change in bank cash results and no offsetting action is required. The Exchange Fund Account officials may of course decide, in a free market, that the increasing demand for Canadian dollars will be resolved entirely by an increase in the rate on dollars, in which case there will be no need for official financing and so no need for offsetting operations by the Bank. The same general argument holds when other sudden expenditures require the government to be financed by the banking system. Whenever, for instance, the government has no cash surplus (even though it may have a budgetary surplus) and chooses to borrow from the banking system, the Bank of Canada might have to accommodate such an operation. When the government wishes to redeem securities held by the Bank, an offset must be provided or else bank cash might be seriously reduced. Offsetting action would BANK OF CANADA OBJECTIVES

1 See Canada, Foreign Exchange Control Board, Annual Report to the Minister of Finance for the years 1946-51 . The annual statement of the Exchange Fund Account is tabled in the House of Commons.

36

BANK OF CANADA OPERATIONS AND POLICY

also be required if there was a sudden increase in the demand for notes to hold following any decline in confidence in the banking system. It might also be pointed out that sometimes the Bank can offset the expansionary effects of certain bond stabilization activities. This is the case when the Bank wishes to alter the pattern of rates and does it by switching one security for another. The sale of the one issue not only influences the pattern of rates but also offsets the effect on bank cash of the purchase. Finally, the Bank of Canada must be prepared to offset the temporary cash dislocations which periodically occur in the market, and which might otherwise inflict unnecessary damage on one or several institutions. That is, the Bank must act as lender of last resort for both money market dealers and the banks. Permanent Changes in Bank Cash

When unemployment exists or when inflation is active the object of more or less permanent changes in bank cash would be to influence national income, as discussed above. However, at times the Bank must vary cash on a more or less permanent basis when the objective is not to influence national income directly. Such action is mainly in response to an expansion of gross national product as a result of increased population and productivity and perhaps as a result of higher prices. Cyclical and secular trends are important here. A real increase in per capita gross national product usually means that the dollar value of business operations in general is also growing. This will in turn entail an increased demand for bank credit, and other credit as well. 1 For a time the banks may be able to accommodate the demand for bank loans by selling securities; and the demand for other credit may be met by an increase in the velocity of circulation of money. But a limit to such an increase in bank loans will be set by the liquidity requirements of bank portfolios, or perhaps under certain conditions by the undesirable effect on the bond market of bank sales of bonds; and a limit on other credit expansion will eventually be set by the inability of money velocity to maintain a sufficiently rapid rate of increase at levels of interest rates thought to be appropriate. It would then be appropriate for the Bank of Canada 1 The discussion assumes (realistically, this writer believes) that increased productivity is reflected in increased real and money income, and not in decreased prices and increased real but stable money income. However, to the extent that an element of both is present the argument would be modified but not changed.

37 to allow an increase in chartered bank cash on a basis more permanent than the seasonal increase, for not to do so might discourage an increase in real production. The same holds for an increase in gross national product arising from population growth even though there may not have been an increase in per capita production. The two, as well as certain price increases discussed below, are of course not clearly distinguishable in their individual finaleffects. However, that is not to deny the existence of these separate and different influences. What is the proper course of action for the Bank when more bank cash is demanded because of a tendency for money gross national product but not real gross national product to increase, that is because of a tendency for prices to rise? If a price rise threatens because of a tendency for demand to become excessive, then an increase in bank cash and the money supply to encourage that demand would not of course be warranted. But if the price rise is clearly cost inspired through either the pressure of wage increases or higher prices of imported raw materials, semi-finished goods and capital goods, the problem is rather complex. It may then be that to deny an expansion of bank cash would be to attempt to regain price stability by affecting the cost side of production; which in turn might entail a movement in the exchange rate and, given wage rigidity, an increase in unemployment. If society, including the central bank, is not prepared to accept the transitional social and economic costs involved in such a movement to equilibrium then the Bank of Canada will inexorably be moved to increase bank cash, particularly if the banks have no more securities to sell and money velocity is at a maximum level. More generally, if market rigidities cannot or will not be removed then the best practical policy may not be the ideal policy. Whether or not the Bank will in any situation have to permanently accommodate a movement toward inflation of the kind discussed above, will depend mainly on the size of the cost increases involved, on the liquidity position of the banks and the state of the bond market, on the leeway remaining in money velocity, and on the degree to which society is prepared to accept the transitional costs of exchange rate movements and temporary unemployment. BANK OF CANADA OBJECTIVES

BALANCE OF PAYMENTS AND EXCHANGE RATE OBJECTIVES

The only reference to balance of payments or exchange rates in the Bank of Canada Act was in the preamble, which expected the

38

BANK OF CANADA OPERATIONS AND POLICY

Bank to "control and protect the external value of the national monetary unit ... so far as may be possible within the scope of monetary action." To make this possible it was given fairly wide powers for dealing in gold, foreign exchange, and foreign securities. 1 It did not, however, have the resources of an exchange stabilization fund. The Exchange Fund Account,2 established from gold revaluation profits, was set up for exchange stabilization purposes in 1935 but was not proclaimed in force till September 16, 1939. 3 At that time the Foreign Exchange Control Board was established 4 and was appointed agent of the Minister of Finance for the operation of the Exchange Fund Account. The Minister was and is directly responsible for the operation of that account. This arrangement was continued under the Foreign Exchange Control Act of 1946. 5 When the latter Act was repealed and thus the Foreign Exchange Control Board abolished in 1952, 6 the Bank of Canada became agent of the Minister for the operation of the Exchange Fund Account. The Bank of Canada's influence in official exchange operations was greater than the foregoing would suggest. From 1935 to 1939 it was the only official authority in the exchange market. From September 16, 1939, to October 15, 1953, it was technical adviser to the Foreign Exchange Control Board, and was agent or banker of the Board. Technical operations were carried out by the Bank for the Board. But most important of all, the Governor of the Bank of Canada was always Chairman of the Board. Insofar as the Bank uses its own resources in the foreign exchange market, its day-to-day operations are independent of the government of the day. But when it acts as agent for the Minister of Finance in managing the much larger foreign exchange resources of the Exchange Fund Account, then it is directly responsible to the Minister. It is safe to conclude, however, that the Bank of Canada has been directly and vitally concerned with the foreign exchange rate and thus the balance of payments, and that when investigating Bank of Canada objectives it is necessary to determine what it attempts to accomplish in this field. Bank of Canada Act, S. of C., 1934, c. 43 ands. 21. The Exchange Fund Act, S. of C., 1935, c. 60. 3 Canada Gazette, Ottawa, Sept. 15, 1939. • Foreign Exchange Control Order, P.C. 2716, Sept. 16, 1939, passed under the War Measures Act, R.S. of C., 1927, c. 206. 5 The Foreign Exchange Control Act, S. of C., 1946, c. 53. 6 The Currency, Mint and Exchange Fund Act, S. ofC., 1952, c. 40, s. 22 ands. 30. It was proclaimed in force on Oct. 15, 1952, as announced in the Canada Gazette, Oct. 18, 1952. 1

2

39 The two most important objectives of Bank influence in the foreign exchange market are the maintenance of a day-to-day orderly market, and the achievement of a smooth transition from one level of exchange rate to another when market forces tend to demand such a change. Violent day-to-day fluctuations are disruptive to business; such an imperfect market also encourages disequilibrating speculation by making it possible for important members of the market to influence the exchange rate for their own benefit. This is precluded by the Bank's maintaining a day-to-day, even hour-tohour watch on the market and frequently buying and selling exchange either for its own account or for the large Exchange Fund Account. On the average this day-to-day type of fluctuation will not require the Bank to be a large net seller or net buyer of exchange. A longer-run type of stabilization is the kind needed when the market justifies a more or less permanent change in the exchange rate. For instance, an upward pressure on the exchange rate might, without official intervention, result in sharp and large fluctuations during the upward trend. Since a gradual change is less disruptive to business than a violent one, officials might wish to smooth out and lengthen out the change. This stabilization can be effected without being discounted in the expectations of the other members of the market, for it can be hidden from them for a short while at least. The Bank, however, would probably need to be a net buyer of exchange. The possibility that the Bank might aim at maintaining a permanently artificial exchange rate in a free market seems remote. If it is really artificial then a higher than normal rate would require the Bank to have an unlimited supply of foreign exchange; if it is lower than normal then it would require the Bank to have an unlimited supply of Canadian dollars. The first is ruled out because it does not exist, and the second is ruled out because it would have catastrophic inflationary consequences, barring the totally unrealistic possibility of a permanent cash surplus in government account or continuous market borrowing by the government for financing an ever increasing supply of foreign exchange. Recent years have illustrated forcibly the importance of capital flows into and out of Canada when the market feels the existing rate is inappropriate. There is no reason to believe that a once-for-all intervention by the Bank would have a permanent effect on the exchange rate. Thus the Bank must attempt to ensure an orderly market on a day-to-day basis and during a transition although as the market BANK OF CANADA OBJECTIVES

40

BANK OF CANADA OPERATIONS AND POLICY

broadens even this type of intervention should diminish. Fundamentally the rate must be determined by market forces and these are reflected in the balance of international payments. However, the Bank can influence the exchange rate more permanently by initiating changes in yields on market securities and by influencing economic activity in general. The spread between yields on United States and Canadian securities has become important in influencing movements of both short-term and long-term capital across the border; while inflation holds serious consequences not just for domestic incomeexpenditure relationships but also for the balance of payments. The latter is extremely important for Canada where exports of goods and services constitute a large portion of gross national product. A balance of payments in fundamental equilibrium is a very necessary aim of Bank of Canada operations. OBJECTIVES IN THE SECURITIES MARKET

Central banks have long been understood to use the securities market for influencing bank credit by changing commercial bank reserves and for influencing savers, borrowers and international capital movements by changing the level of interest rates. And lately it has been argued that the same market can even be used to influence lenders other than the commercial banks. 1 However, these are not the only reasons explaining and justifying central bank operations in the securities markets; central banks are also expected to exert a stabilizing influence on the markets. The nature of the Bank of Canada's responsibility in this respect is best seen by discussing it in relation with the Government of Canada securities market, the provincial, municipal and corporation bond market, and the stock market. To exert a stabilizing influence on the Government of Canada securities market means in fact broadening it, assuming in that market the role of jobber. This role, the former Governor of the Bank has assured us, was assumed by the Bank when it was formed in 1935; and he believed that the Bank would probably always be a substantial participant in the market. 2 Such operations are legally 1 See for instance, Robert V. Rosa, "Interest Rates and the Central Bank," in Money, Trade and Economic Growth, in Honor of John Henry Williams (New York, I951 ), 270-95. 2 Standing Committee on Banking and Commerce, Minutes, no. 16, March 18, 1954, 701. The role of the Bank of Canada in bond stabilization was also mentioned by the newly appointed Governor in ibid., no. 9, May 31, 1956, 349, 359, and in the Bank's Annual Report for the year 1956, 49, 52.

BANK OF CANADA OBJECTIVES

41

possible because the Bank during most of its life has enjoyed wide freedom in choosing the Canadian government securities it wishes to trade, and the 19 54 amendment to the Bank of Canada Act removed the remaining restrictions. 1 The Bank has also ensured a degree of stability in the short-term (mainly Treasury bill) market, both before and after the formation of the call loan market in mid 1954. The advantages of a broad capital market for the efficient mobilization and investment of the nation's savings are obvious and need not be discussed; it is sufficient to say that the Bank should at all times be interested in the smooth functioning of both short- and long-term capital markets in order to achieve maximum efficiency in the distribution of capital. But it is of interest to recognize other reasons making it important for the Bank to ensure such a market in government securities specifically. By its size and liquidity this market is the key bond market. The trend and relative stability of prices in that market will normally influence the whole array of fixed interest market debt. Since 1939 Government of Canada direct and guaranteed debt has increased almost fourfold while provincial, municipal and corporate debt has only about doubled; and the former is larger than the combined total of the last three. These quantitative trends mean further that yearly refunding of federal debt not only is a much larger task than before the war, but also requires attracting a greater proportion of the total funds in the bond market. It is not implied that short-run fluctuations are more likely now than before the war, indeed they may be less; but the consequences of violent fluctuations in the federal government bond market are now rather more serious. To permit large and sharp movements in government bond prices would make refunding operations even more difficult than they have become because of their increased size. Large refunding might have to be carried out at other than normal or average market rates without some stabilization from official sources, for it is unlikely that proper timing alone could always achieve justifiable results. In addition, official intervention may occasionally be desired because the concentration of a large portion of the federal debt in the portfolios of relatively few institutions might make the market something less than perfectly competitive. It is conceivable that one or several large institutions might hope to exert a positive and deliberate influence on the market and thus make profits through operations that are less uncertain than speculation. Such operations are made ' See Bank of Canada Act, S. of C., 1954, s. 18.

42

BANK OF CANADA OPERATIONS AND POLICY

difficult when an official institution is one of the largest holders of federal government securities and when that institution does not hesitate to enter the market at any time and on any side. And lastly, a more stable federal bond market is desirable because it will in fact improve the chances of successful open market operations when these are aimed at varying bank cash. The extent to which the Bank should be responsible for bond price stabilization must be made clear, however, for the foregoing does not suggest that this objective has become so important that other central banking objectives can be sacrificed. The Bank must, by participating in the federal government bond and bill market, prevent violent fluctuations in security prices. Also, if market conditions point to a change in interest rates, it may be necessary for the Bank to change its net holdings for a short while in an effort to lengthen out the change. Often the Bank might have to stabilize certain issues in order to prevent large changes in the pattern of government bond prices, and this it may be able to do by switching operations with no net effect on reserves. The main objective would be to make the bond market more orderly without changing bank cash. This is not too difficult with the day-to-day type offluctuations, for the Bank may often have to sell as much as it buys. Even changes in bank cash for a week or more during a transitional type of stabilization are not serious, for they would probably be reflected in chartered bank cash reserves or day-to-day loans only, and not in bank credit policies or holdings of securities. However, the important limits of Bank operations of this type must come when stabilization goes farther than just reducing very short-run fluctuations . The Bank's responsibilities cannot be rigidly outlined because they vary with economic conditions. But the essential principle which applies to all economic conditions (except war) is that sustained stabilization of federal government bonds, at either higher or lower rates than the market seems to demand, should not be a responsibility of the Bank when it results in variations of bank cash which would not otherwise have been desirable. One would also expect that the extent of short-term stabilization by the central bank would diminish as the market broadens, so that at some future date the central bank should find it sufficient to operate rather infrequently for such purposes. The Bank of Canada is not directly concerned with the provincial, municipal and corporation bond markets. None of these markets is, either in size or in the degree of risk which the bonds carry, a key market, as is the federal bond market, and therefore

BANK OF CANADA OBJECTIVES

43

direct stabilization is not necessary. Moreover the Bank of Canada Act does not permit the Bank to deal in municipal or corporation bonds. Its dealings in provincial bonds have been negligible, 1 and its indirect assistance in the flotation of new provincial issues is largely precluded by its not being debt manager of or fiscal agent to any of the provinces. Its influence on these markets is indirect, by way of the federal bond market. The Bank's objective in the stock market is easily defined: it is to curb excessive speculative operations. What exactly this has meant in the past will be left to later discussion, but it might be noted that this objective recognizes that not only the quantity but also the type of credit is at times important in maintaining a stable economy. It is not practicable nor legally possible for the Bank of Canada to control stock market activity through direct participation, and, as is the case with most qualitative controls on credit, reserve variation cannot be used. As will be seen later, advice to the banks and stock exchanges regarding margin requirements on loans against securities has been and will probably continue to be the most direct way OJ damping excessive and dangerous stock market optimism. ASSISTANCE TO GOVERNMENT FINANCING

The Bank is associated with government finance through being the government's debt manager and banker. Management of the public debt, with its problems of loan flotations, redemptions, refunding, registering of bondholders, paying interest, choosing terms of issue, and deciding on a suitable debt structure, is beyond the scope of this study, except where it impinges on the Bank's central banking operations. With respect to the latter we have already seen that the Bank may exert a stabilizing influence on the market before and during a new issue in order to make its tasks of debt management easier. More important for our interest than the technicalities of debt management is the type of assistance to government finance which requires the Bank to make advances to the government and buy securities from it; or which requires it to buy securities in anticipation of refunding or redemption, or entails accumulating for its own account foreign exchange which would normally be bought for the Exchange Fund Account. Each is a method of extending credit 1 The Bank held not more than$ 4 million provincial securities at the year-end from I 935 to 1946; after that it held none. Bank of Canada, Statistical Summary, Aug. 1954, 139.

44

BANK OF CANADA OPERATIONS AND POLICY

to the government and can normally be justified only if the changes in bank cash resulting from them are in accord with sound monetary management. Such harmony is usually possible if the resulting change in cash is for a short period (say less than a few weeks) or is of a relatively small amount. But occasionally the government requires substantial assistance from the banking system for a longer period. The prime example was the sudden financing of the 1950 capital inflow, but any large unanticipated government expenditure which exhausts government cash on hand may necessitate using this expedient. In such an event the financing should be done by the chartered banks, although the Bank of Canada may have to expand bank cash sufficiently to support the inevitable increase in chartered bank deposits. During the war, and even occasionally after it, this financing has been accomplished by the chartered banks' taking up the government's illiquid and low-interest-bearing deposit certificates and lately by sales of short-term market securities directly and indirectly to the banks and Bank of Canada. It may not be an entirely satisfactory arrangement, but it is undoubtedly better than risking the soundness of the currency by requiring the central bank alone to provide such finance. In the emergencies referred to above, government will in one way or another be financed-this can be taken as given-and it is for the Bank to recommend the type of assistance that is least disruptive to its other central banking objectives and then help to ensure that it is made available. CONFLICTS IN BANK OF CANADA OBJECTIVES

In the fulfilment of certain Bank objectives conflicts with other objectives become inevitable, as has already been seen. This is the case with the desirability of maintaining a balance of payments in equilibrium and the need, under certain conditions, of expanding the monetary base with consequent price increases and an increased demand for imports. 1 It is true that more flexibility for reaching external and internal equilibrium exists when exchange rates are allowed greater variation than under gold standard conditions, but there are limits beyond which depreciation cannot be permitted to 1 Theoretically the problem is complex, because of the different possibilities of external and internal imbalance in a given country and all others with whom it trades ; because of varying marginal propensities to import and elasticities of demand for imports; and because of the different policies which countries other than a given country might adopt. See J. E. Meade, The Theory of International Economic Policy, I The Balance of Payments (London, 1951), chap. x.

BANK OF CANADA OBJECTIVES

45

go. Indeed it might well be that because of the importance of primary products (with low elasticities of demand) in Canadian export trade, depreciation to any appreciable extent may do positive harm. In such a case the conflict in objectives would come even sooner. All this means that monetary expansion for encouraging domestic activity cannot be dissociated from its effects on the balance of payments (which ultimately of course also affects economic activity). The limits for gaining the best of both worlds can best be discussed in connection with actual conditions at specific points in time. However, it is essential to recognize that such a conflict does exist; when Bank policy is analysed, assumptions must be made regarding the nearness of that conflict and the extent to which one objective should be sacrificed for the other in an attempt to attain the ultimate objective of high and stable employment and prices. Another conflict is the one which may arise because the government must be financed at all times. The government might require finance from the banking system at a time when any net expansion in deposits is undesirable for reasons of maintaining price stability. Here again complete discussion of the problem, entailing analysis of the various types of financial assistance under many different circumstances, cannot and need not be given. It need only be recognized that in an emergency the government can not and will not be without money, that the Bank must assist such finance in a manner least disruptive to its other objectives, and that such assistance may at times conflict with a need to combat inflation. The Bank of Canada must always stand ready to lend money to the banks and the money market dealers, as lender of last resort. It is conceivable that in doing so the Bank may find itself running counter to its general cash policy; although since such assistance is clearly understood to be temporary it may not prove unmanageable from the viewpoint of cash control. These three conflicts can arise even within the limits of Bank objectives outlined in the preceding sections. Other conflicts arise if the limits of some of those specific Bank objectives are extended. If the Bank is expected to stabilize bond prices even when stabilization results in variations in bank cash which would not otherwise have been desirable, then such an objective will conflict with the objective of maintaining price stability. Stabilizing bond prices beyond short-run fluctuations or transitions to a different level means that the public and not the Bank controls the quantity of money. Also, if the reserves of the Exchange Fund Account have to be

46

BANK OF CANADA OPERATIONS AND POLICY

increased substantially in order to fulfil an official policy that exceeds mere smoothing out of the market, then bank credit may be increased to an extent that precludes its being offset by Bank operations. Or if central bank credit is used instead of chartered bank credit, multiple expansion of ohartered bank deposits would result and anti-inflationary objectives would again be frustrated. In other words, an attempt to "peg" bond prices or the exchange rate in a free market might conflict with the attempt to protect the domestic value of the currency.

CHAPTER III

Bank of Canada Control Techniques THE METHODS the Bank of Canada has developed to fulfil its objectives are in some respects unique, for they have had to be adapted to the limited facilities of the Canadian financial community. This story of the development and adaptation of control techniques forms an interesting chapter in central banking generally, for it shows how a central bank without tradition and prestige, and operating in a semi-developed financial community, was able to become an indispensable adjunct to an already well-developed banking system. The Bank of Canada attempts to achieve its monetary objectives by varying the reserves of the chartered banks, by influencing the interest rate structure, by operating in the foreign exchange market, and by informal advice to and special arrangements with the financial community. VARIATION OF CHARTERED BANK RESERVES Open Market Operations If open market operations are to be effective commercial banks must maintain stable reserve ratios and the central bank must be able to buy and sell relatively large quantities of securities without causing disruption in the securities market. Stable reserve ratios can only be maintained if the individual banker has access to a highly liquid security, and if the central bank accepts its role of lender of last resort. 1 Clearly, stable reserve ratios are only possible if bankers can change their reserves painlessly most of the time and if extraordinary pressure on their reserves is relieved through central bank action. Thus a bill market with highly liquid assets is desirable for maintaining the stability of reserve ratios as well as for broadening the scope of the central bank's open market operations and distributing short-term capital more efficiently. 1

See R. S. Sayers, ed., Banking in the British Commonwealth (Oxford, 1952), xiii, xiv.

BANK OF CANADA OPERATIONS AND POLICY

In London the discount market and the Bank of England provide the desired liquidity, with the result that the cash reserve ratios of the joint-stock banks can be stable, and open market operations, in conjunction with Bank Rate, can be effective. But while the shortterm money market in Canada only began to function in mid 1954, the chartered banks' cash ratios were surprisingly stable and the central bank's open market techniques functioned successfully long before that time. The nature of the Canadian Treasury bill and bond market and the methods used to provide the government with shortterm cash will explain how this was possible, and will also indicate the current effectiveness of open market operations in the Canadian capital market. The short-term money market. Both proponents of and opponents to central banking in Canada prior to the formation of the Bank of Canada expressed concern over the effectiveness of a central bank where no bill market existed, and some of the former argued (without great conviction) that a future central bank in Canada should develop such a market. Both groups also believed that the foreign exchange market would provide better facilities for varying bank cash than would the short-term securities market. 1 But this belief did not delay the attempt to establish such a market, and indeed when Treasury bills began to be sold by tender on March I, 1934, it was because of the expected needs of a future central bank as well as a desire for cheaper government financing. 2 There were seven issues in 1934, fourteen in 1935, twenty-two in 1936, and from 1937 to January 30, 1953, there were twenty-four issues every year, approximately one every fortnight. 3 From July 2, 1945, until January 30, 1953, there was a constant $ 450 million in Treasury bills outstanding, so that each issue came to be $ 75 million in 91-day bills. After the latter date, weekly instead of fortnightly tenders were called. Further measures for improving and broadening 1 Cf. C. A. Curtis, "Credit Control in Canada," Papers and Proceedings of the Canadian Political Science Association, II (May 1930), 101-22; A. F. W. Plumptre, "Currency Management in Canada," ibid., IV (May 1932), 139-50; J. E. Van Buskirk, "The Proposals for a Canadian Central Bank," ibid., V (May 1933), 216-26; Canada, Royal Commission on Banking and Currency, Final Hearings at Ottawa, Sept. 14, 1933, which states the bankers' case; "Bank of Canada Now Responsible for Credit Policy of Dominion," Monetary Times, March 16, 1935, 5. 2 See Bank of Canada, Report of Proceedings of First Annual General Meeting of Shareholders, Feb. 25, 1936, 17. Also referred to by A. F . W. Plumptre, Central Banking in the British Dominions (Toronto, 1947), 332. 3 The only exception is that several times, when the total amount was increased, more than one issue appeared on each issuing date. But issuing dates were kept constant at 24 per year.

BANK OF CANADA CONTROL TECHNIQUES

49

the short-term money market were introduced not long thereafter, with the result that the demand for bills increased steadily. 1 The government was quite prepared to meet this demand with an increasing supply of bills and by late 1957 there was $ 1,660 million in bills outstanding-a $ 1,210 million increase in less than five years. Bills of over 91 days and not exceeding 273 days were introduced in January 1953, but no more were offered to the market after November 1955. Tenders are sent to the Minister of Finance in care of the Bank of Canada, and are opened every Thursday by officials of the Department of Finance. The whole of each issue is always taken up because the Bank of Canada submits a reserve bid in addition to its regular bid. In that way there is no danger that collusion among tenderers could produce an artificially low price. Allotments to others than the Bank of Canada and the chartered banks were small until perhaps late 1954. 2 Dealers now are substantial tenderers both for their own account and the accounts of clients. Before the 1953-4 changes in the money market, trading took place almost entirely between the chartered banks and the Bank of Canada, and not between one chartered bank and another. There were several reasons for this. First of all, and most important, the Bank of Canada never refused to buy Treasury bills and did not exact a penalty rate, 3 since the Bank was concerned to maintain their liquidity. Second, by selling to the Bank the chartered banks could adjust their reserves more quickly than by selling to other banks or customers of other banks. Third, selling to the Bank concealed the operation from competitors. The Bank of Canada often would not sell bills between issues at all, and seldom immediately after an issue, so as to discourage artificially low tenders. The Bank's need to maintain the liquidity of the bills restricted its freedom of operation in that market. But there was always a demand for bills at the Bank, and in fact only in that limited sense could it be said that a bill market existed in Canada before 1954. See below, p. 54. The Governor stated in 1939 that non-bank holdings varied between $ 8 million and $ 20 million, which then was 5 1/2 per cent to 13 per cent of the total issue. See Canada, House of Commons, Standing Committee on Banking and Commerce, Minutes of Proceedings and Evidence Respecting the Bank of Canada, May 6, 1939. A sharp increase in non-bank holdings began in June I 954. See Bank of Canada, Statistical Summary, Dec. 1954, 255. For a brief description of the Treasury bill tender see also Bank of Canada, Annual Report, 1956, 46-8. 3 See Standing Committee on Banking and Commerce, Minutes, no. 16, March 18, 1954, 700. 1

2

50

BANK OF CANADA OPERATIONS AND POLICY

This artificial bill market was none the less of considerable assistance to the chartered banks and to central banking for it enabled the banks to maintain relatively stable reserve ratios. (It is to be remembered that highly liquid assets are required only for cash adjustments of individual banks which must be made quickly; less liquid securities will serve the purpose if the adjustments need not be made suddenly.) Nor did it provide the cash for substantial unwanted monetary expansion, for the total supply of bills was held constant (except for occasional once-for-all changes)-they were not an instrument for providing temporary government financeand the amount available specifically to the banks was further controlled by the Bank of Canada's participation at the tenders. For the banks to have cashed their limited supply of bills and subsequently expanded their deposits permanently would have left them without adequate second line reserves. The restriction of the supply of bills is clearly illustrated by the low yield of Canadian bills in comparison with those of the United States. From early 1947 until October 1953 the average tender rate on Canadian Treasury bills was well below the tender rate on United States Treasury bills, whereas the opposite was the case with yields on longer-term government securities. The sharp downturn in United States Treasury bill rates in late 1953 resulted in the Canadian rate being higher, and except for the first ten months of 1955 it has usually remained higher than United States rates. However, as we shall see presently, back of this changed pattern was the fact that it had become less important for the Bank to buy all bills offered to it at near market rates. The somewhat higher Treasury bill tender rate in Canada than in the United States until about 1943 is explained by the abnormally low rates in the United States; by the fact that the Canadian bill market was just being developed; and by the increasing liquidity of federal government bonds which obscured the advantages of Treasury bills. The foregoing indicates that until mid 1954 the Bank regulated the supply of bills in the possession of the chartered banks to an amount approximately sufficient for meeting their ordinary liquidity requirements. For the banks to have cashed these bills in order to expand their other assets permanently would have left then in an uncomfortably illiquid position. Under these conditions it was not really dangerous for the Bank of Canada to provide a continuous market for bills, and it enabled the banks to maintain reserve stability. The initiative for permanently changing bank cash still

BANK OF CANADA CONTROL TECHNIQUES

51

remained with the Bank of Canada, but it had to do this by means other than operations in the Treasury bill market. The system, however, had severe limitations: it often entailed some net expansion in total bank cash when individual banks wished to adjust their cash positions ; and more important, it did not encourage (perhaps even discouraged) a more efficient distribution of short-term capital, for it gave the banks little incentive to develop non-bank interest in bills. That the system functioned even in a limited sense was in part because an alternative means for providing temporary finance to the government was found in deposit certificates. These certificates were taken by the chartered banks exclusively and the terms were arrived at by direct negotiation between the government and the bankers. Actually the government informed the President of the Canadian Bankers' Association of the amount and terms which it would like the banks to accept, and the President then notified the banks in order to obtain their opinions. A meeting with the government decided final terms. The certificates were then distributed to the individual banks according to the proportion of each bank's demand deposits to total chartered bank demand deposits. Practically all the certificates matured in six months (although one issue in July 1952 had a term of four months), and their yield was low, arrived at in large part on the basis of the extra cost involved for the chartered banks in servicing the deposits. 1 These certificates appeared first on July 29, 1942, when $ 75 million worth were issued and they reached a peak of $ 1,340 million on October 23, 1945. They were then progressively reduced until there were none outstanding on October 21, 1947. But then appeared the practice of using them for occasional short-run government requirements. There have been four new issues (not counting mere conversion issues) since that date; the last appeared in July 1952 and was redeemed in April 1953. However, when the government required bank finance in July 1954 it arranged a direct sale of $ 200 million 1½ per cent bonds (maturing in approximately 4 months) to the chartered banks and Bank of Canada ; these were marketable bonds and so more acceptable to the banks. The illiquidity of the deposit certificates makes them especially important for present discussion. When the banks took them it was 1 From the first issue on July 29, 1942, to the issue on Nov. 19, 1945, the rate was 3/4 per cent. From March 5, 1946, to Sept. I, 1948, it was 5/8 per cent. From March 4, 1949, to March I, 1950, it again was 3/4 per cent, and after that it increased gradually until it reached l 3/4 per cent.

52

BANK OF CANADA OPERATIONS AND POLICY

more or less with the understanding that they would be held to maturity, 1 and no instance has come to light where a bank cashed many before maturity. 2 The way in which Treasury bills and these illiquid deposit certificates were used made it possible for the Bank to maintain a highly liquid bill market and for the government to receive any required short-term finance at a very low rate, while at the same time the supply of liquid assets in the hands of the chartered banks was controlled. 3 Permanent changes in bank cash were for the most part initiated by the Bank of Canada's operations in the Canadian government bond market. After 1952, the Bank of Canada, the chartered banks and the government co-operated in introducing a series of innovations aimed essentially at transforming the narrow, artificial Treasury bill market into a broader short-term money market. 4 This, it was hoped, would result in a more efficient distribution of short-term capital and would enable the individual chartered banks to adjust their cash positions more often without having to sell Treasury bills to the central bank (that is, without increasing total bank cash). For the government it would mean an increased market for its low yield securities; the Bank of Canada would benefit by its increased control 1 There was some indication that a specific bank"might be able to realize on them if it found itself in short-run difficulties, but if it did 'it was on the understanding that it would repurchase them as soon as its temporary difficulty disappeared. The Bank occasionally held a few, not exceeding $ 8 million, so chartered bank sales were insignificant. 2 That the banks would take them on these terms, especially with their low yield, poses the question of the extent of government pressure involved. The Governor of the Bank of Canada stated categorically that "there was not any element of forced loans" (see Standing Committee on Banking and Commerce, Minutes, May 23, 1944, 165). This was probably true in wartime emergencies, but the Financial Post (Jan. 31, 1953, 3) states that the banks complained in mid 1952 about them becoming a continuing means of financing. This writer certainly gained the impression that at best they were considered to be a necessary evil. 3 It is to be remembered that until 1954 the chartered banks seldom borrowed from the Bank of Canada. The only other short-term federal government security was the sixmonth Treasury note, which had a rate identical to that of deposit certificates. They first appeared on Sept. 1, 1945, but were soon held entirely by the Bank of Canada and their total amount outstanding changed little from May I, 1947 until they were entirely redeemed on May 1, 1956. Some were at one time held by the chartered banks but statistics are not available (see Bank of Canada, "General Public Holdings of Certain Liquid Assets," Research Memorandum, March 1953, 9). In general discussion of Bank of Canada operations, the division between shorts and longs is under and over two years to maturity, as this was the division in its statement. Occasionally more exact data on the type of longs the Bank dealt in come from incidental market and Bank comments. The 1954 amendment to the Bank of Canada Act required the Bank to give greater details of its security holdings, including a separate item for Treasury bills. 4 An excellent outline and discussion of the initial changes is given by R. M. MacIntosh, "Broadening the Money Market, "Canadian Banker, LXI (Autumn 1954), 63-73.

BANK OF CANADA CONTROL TECHNIQUES

53

over bank cash and over short-term money rates; new holders of Treasury bills would gain from the more profitable employment of their funds; and bond dealers would enjoy a greater volume of business. The principal task at hand was to encourage a wider demand for Treasury bills and other short-term securities. This was begun on January 30, 1953, when the fortnightly tenders for Treasury bills were changed to weekly tenders and when 273-day bills (and temporarily some 182-day bills) were offered in addition to 91-day bills. Later on in the same year the Bank of Canada entered into purchase and resale agreements with thirteen securities dealers who acted as jobbers in the short-term government securities market. These agreements assisted individual dealers in financing portfolios of government securities under three years to maturity including Treasury bills; the Bank of Canada agreed to buy limited amounts (set for each dealer) of such securities from the dealers, with an understanding that it would resell them to the dealers at a predetermined price and within a specified period of time. 1 This improved the ability of dealers to satisfy such demands for short-term government securities as might exist. However, neither these agreements nor the introduction of weekly tenders and long-dated bills produced by themselves the desired results; dealers did make limited use of the purchase-resale agreements, but no real non-bank interest in Treasury bills developed: securities held by the Bank of Canada under purchase-resale agreement fluctuated around $ 20 million throughout 1953, while non-bank holdings of Treasury bills at the end of December 1952 and 1953 were $ 29 million and $ 31 million respectively, in spite of a $ 200 million increase in total Treasury bills outstanding during the year and an increase in their yield. 2 It was not until mid 1954, when further innovations were introduced, that the Treasury bill market began to show signs of active development. Earlier in the year, at least one of the chartered banks, the Royal Bank of Canada, supported the idea of an active money market. 3 It proceeded shortly thereafter to take advances from the Bank of Canada, probably in part as an encouragement for other banks to do the same when the need arose; the Bank of Canada favoured such a development, for not only would it tend to bring Bank Rate in closer relation with market rates, but it would also 1 See Banlc of Canada, Annual Report, 1953, 8. The cost to dealers is equal to Bank Rate, which is a penalty rate. 2 See Bank of Canada, Statistical Summary, Nov. 1954, 219, 220. 3 The Royal Bank of Canada, Annual Report, Jan. 14, 1954, 17.

54

BANK OF CANADA OPERATIONS AND POLICY

protect the short-term securities market from shocks arising out of the need for chartered banks to sell large amounts of securities for purposes of cash adjustments; also, of course, it would enable the banks to operate on finer cash margins. For some time past the Bank of Canada had encouraged the chartered banks to seek non-central bank interest in Treasury bills, by widening the spread (near the last average tender rate) at which it would trade them. In June 1954 the Bank of Canada discouraged further direct Treasury bill transactions with the chartered banks by routing payments for the bills it bought through the clearing; whereas formerly the chartered banks received cash immediately from such transactions they now received it two days later. This increased the relative attractiveness of taking advances from the central bank which produces cash immediately and it encouraged the banks to use the new day-to-day loan facilities which provide cash in one day's time. The chartered banks began to extend day-to-day loans to security dealers in June 1954, a decisive step in the formation of the shortterm money market. Since the rate on these loans was below that on Treasury bills it enabled dealers to hold a portfolio of such securities; it also prompted dealers to repurchase all the securities held by the Bank of Canada under purchase-resale agreements. The dealers were further encouraged to deal in short-term securities by a reduction from 1/ 100 per cent to 1/250 per cent of the banks' "over-certification" charge for "daylight over-drafts. " 1 (In 1957 the over-certification charge was entirely abolished on securities movements arising from dealers switching day-to-day loans from one bank to another, and from the Bank of Canada extending lender of last resort facilities to the market. Movements of securities resulting from straight purchases still involve the 1/250 per cent charge, as do those involving loans from outside the banking system.) And finally the more flexible method of computing the chartered banks' legally required reserve ratio, as outlined in the 1954 Bank Act, tended to make chartered bank funds available for lending to security dealers on call; instead of working to a daily average cash ratio each day (legally a 5 per cent cash ratio, but in practice approximately 10 per cent), they now were permitted to work to an 8 per cent cash ratio for the month as a whole and this computed, not with daily 1 A dealer requires finance from the time he buys securities on a certain day until he sells them later on in the day. He receives a certified cheque from his bank to pay for the securities, but does not cover it until he receives payment for the sale of the securities some hours later; the charge for this "daylight over-draft" is the "overcertification" rate.

BANK OF CANADA CONTROL TECHNIQUES

55

average figures, but with Wednesday figures for deposit liabilities and Bank of Canada note holdings, and daily average figures for chartered bank deposits with the Bank of Canada. 1 All these various factors helped to set the machinery of the money market in motion. The chartered banks extend loans to security dealers which the latter use to finance inventories of government securities under three years to maturity; the Bank of Canada acts as lender of last resort to both for it will still enter into purchaseresale agreements with the dealers (at a cost equivalent to Bank Rate and for no minimum period) and it is willing to make advances to the chartered banks at Bank Rate for a minimum of one week. There is, however, a ceiling on the amount which each dealer and each bank may borrow from the Bank of Canada, and in addition to this limitation on borrowing a bank must pay a progressively higher interest rate if it borrows more than a certain amount (individually specified for each bank) or more than once a month including renewals. The Bank of Canada has emphasized that it accommodates the market on a temporary basis only.2 Both banks and dealers have frequently made use of the Bank's lender of last resort facilities, particularly during periods of monetary restraint. For example, the Bank of Canada held some securities under purchase and resale agreements during thirty-one of the fifty-two weeks ending September 30, 1957. This is understandable for when the market is held on a tight cash rein, even a minor dislocation of cash will be sufficient to place the cash-losing banks and dealers in temporary difficulties. Cash dislocations have arisen from a variety of factors which typically involve large cash movements in the market; payment for a new security issue is one of the 1 Formerly the cash ratio for any one day was computed by using the daily average figure for deposit liabilities of the preceding month but one, and the current daily figure for chartered bank deposits with the Bank of Canada and holdings of Bank of Canada notes. Now the average for the month (a daily average not being required) is computed by taking the average figure of deposit liabilities and Bank of Canada note holdings for four consecutive Wednesdays ending with the last Wednesday but one of the preceding month, and the daily average figure for chartered bank deposits with the Bank of Canada for the current month. See Bank of Canada Act, S . of C., c. 43, 1934, s. 27, and The Bank Act, S. of C., 1954, c. 48. This, as R. M. MacIntosh points out ("Broadening the Money Market," 70), increased the chartered banks' investible funds by improving their ability to forecast cash requirements (and so plan their investments accordingly); and the reduction of the working cash ratio from 10 per cent to close to 8 per cent made further funds available. 2 For a full discussion of the mechanics of the market see also J. S. G. Wilson, "The Canadian Money Market Experiment," Banca Nazionale Del Lavoro Quarterly Review, no. 44 (March 1958), 19-55.

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BANK OF CANADA OPERATIONS AND POLICY

more important ones. Some banks still strive to build up their cash ratios for their annual statements at the end of October and of November, and this procedure too has on occasion forced dealers to seek accommodation at the Bank of Canada. Unusually large dealer inventories, built up in anticipation of bond and bill price changes, have also at times resulted in dealers going to the Bank for accommodation. There is no doubt that the machinery of the money market functions reasonable well. The market for Treasury bills has broadened substantially; at the end of 1953, holdings of Treasury bills outside the banking system amounted to only $ 31 million, but by April 1956 they reached a total of $ 578 million; and subsequently even after a prolonged period of monetary restraint those holdings remained for the most part above $ 300 million. 1 The chartered banks now as a matter of course adjust their cash position through the day-to-day loan market; although at times they run down their day-to-day loans so low, or dealers provide such a small demand for loans, that the market temporarily disappears. For example, day-today loans outstanding have gone as low as $ 13 million and have frequently been below the $ 80 million to $ 100 million level which is probably required if the market is to provide reliable services to all its members. In other words, the market is not yet as efficient and fully developed as it might be although undoubted progress has been made since it was formed. An impressive aspect of its development has been the growth of the market for commercial paper of finance companies. The development of the short-term money market has probably made the Bank of Canada's control over the money supply more effective. For one thing the Bank of Canada is no longer committed to take Treasury bills at near tender rates when these are offered to it, and a potential seller usually can find a buyer among the dealers; none the less the Bank is not entirely indifferent to Treasury bill rates and there may be times when it tends to hold the rate at the tender, with some marginal consequences for its cash control. The enlarged bill market and the weekly bill tender also now provide improved facilities for cash management by the central bank. The Bank of Canada explained in its Annual Report for 1956: . . . Apart from the normal practice of subscribing for approximately the same amount as it held of the old issue, the Bank may from time to time decide to bid for a larger amount or for a smaller amount, according to its view of the monetary situation and its desire to either add to the money supply at that 1

Bank of Canada, Statistical Summary.

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time or the reverse. In this way the central bank-as in other countries-has an opportunity at least once a week, quite apart from buying and selllng operations in the open market, to increase or decrease its holdings of Government securities.

The operations of the dealers and the banks are now so closely geared to the short-term money market, through the bill tender, the day-to-day loans, and the frequent use of Bank of Canada temporary accommodation, that they are more aware of central bank operations and policy changes than they used to be. Operations of the central bank now affect them almost on a day-to-day basis. This in itself, however, has made short-run cash management a much more difficult task than it used to be. Minor cash variations if they are not neatly offset by the central bank may cause unnecessary disorder in the market. Criticism of the Bank of Canada by members of the market now frequently takes the form of dissatisfaction with the magnitudes of short-run variations in total cash permitted by the Bank of Canada. The money market has also increased the Bank of Canada's ability to translate changes in the supply of money into changes in market interest rates. Now when the Bank of Canada changes the cash of the chartered banks the change is reflected in a change in day-to-day loan rates in a few days at most, while rates on Treasury bills also move before long. We shall see again that the Bank of Canada may have lost a certain influence over interest rates by adopting the "floating" Bank Rate, but this change was not related to the development of the money market which we have been discussing. The bond market. The initiative of the Bank in open market operations has always had, and still has, greatest sway in the Government of Canada bond market. This is because that market is sufficiently broad to permit central bank operations without serious disruptions in bond prices and also because the powers and resources of the Bank have been such as to enable it to participate actively in the long-term as well as the short-term bond market. Nor does official policy or tradition deter it from entering the long-term market; it has in fact been active in longs on numerous occasions. The variations in the Bank's week-to-week security holdings suggest that the central bank's normal operations are carried on without difficulty and that even extraordinarily large operations have been possible. The federal government bond market was already well developed when the Bank began operations and since that date it has become

BANK OF CANADA OPERATIONS AND POLICY

even more susceptible to central bank control. 1 First, foreign influences have been reduced. These are felt directly on the Canadian bond market through the Canadian optional-payment bonds and the movement of foreign capital into and out of all types of Canadian bonds. Federal and provincial optional-payment bonds outstanding have decreased by about 50 per cent since 1938, and relative to total debt outstanding they have decreased much more than that. This disturbing influence on the Canadian bond market has therefore been much reduced.2 The same is true of the other type of foreign influence, for Table 3 below, outlining the estimated distribution of Government of Canada debt, shows that non-resident holdings of the debt have decreased from 32.5 per cent of total debt to 3.9 per cent between 1938 and 1956. This, however, is not to suggest that non-resident dealings, and especially indirect foreign influences, cannot still have important effects on Canadian bond markets, as we shall see later. The Bank of Canada's controlling power over the Canadian bond market has also increased because of the absolute and relative increase in its holdings of government securities. Thus where it held 4.2 per cent of total federal government debt in 1938, in 1956 it held TABLE 3 ESTIMATED PERCENTAGE DISTRIBUTION OF CANADA DIRECT AND GUARANTEED FUNDED DEBT a December 31

1938

1945

1949

1953

1955

1956

Bank of Canada Chartered banks Govt. accounts Resident corporate Res. non-corporate Non-resident

4.2 17.7 3.7 19.5 22.4 32.5

10.5 19.1 4.7 22.1 36.8 6.8

12.8 19.9 5.0 20.5 33.7 8.1

14.8 18.3 8.4 18.3 34.4 5.8

15.1 19.6 9.3 18.5 33.4 4.1

15.9 16.6 10.0 17.7 35.9 3.9

a Computed from statistics in Bank of Canada, Statistical Summary. 1 It is not possible to outline the Canadian capital market in general here, nor to trace developments in the government bond market before the Bank of Canada was established. (Some excellent discussion on this can be found in Plumptre, Central Banking in the British Dominions, 123-51, 410-13, and also briefly in G. S. Dorrance, "The Bank of Canada," in R. S. Sayers, ed., Banking in the British Commonwealth, 186-30.) This does not appear a serious omission since the Bank operates almost entirely in the Canadian government bond market. 2 For a full discussion of the nature and effects of optional-payment bonds see W. T. G. Hackett, "Canada's Optional Payment Bonds," Canadian Journal of Economics and Political Science, I (May 1935), 161-70; and especially Plumptre, Central Banking in the British Dominions, 134-8, 232. Statistics of such bonds appear in Bank of Canada, Statistical Summary.

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15.9 per cent. 1 Table 3 indicates further that government accounts have also more than proportionately increased their holdings of federal government debt, and at least part of this can occasionally be used for central banking types of operations. Other holders who are most likely to react to marginal price changes (chartered banks and resident-corporate) have maintained approximately the proportion of total debt they held, so that the breadth of the market has probably not suffered on that account. The percentage loss of holdings by non-residents has largely been gained by resident noncorporate holders, that is there has been a switch from a potentially unstable holder (not merely a holder who responds to price changes) to a stable holder. In summary the trends in the distribution of government debt, and the decline of optional-payment bonds outstanding, have tended to improve conditions for effective central bank open market operations, either for reserve variation or interest rate control. That the government securities market is quite adequate for central bank control of cash reserves through open market operations is clearly indicated by this explanation of the Bank of Canada's market technique given by the Governor of the Bank; it also illustrates the breadth of the market: ... The central bank ... does not step out and bid for securities if it thinks an increase in cash reserves is desirable, or step out and offer securities in the market, if it thinks a decrease in cash reserves is desirable .. . For the most part there are transactions going on in the market all the time ... and the central bank is usually in a position to be able to respond to offers to buy from others rather than to take the initiative to make offers itself. 2 1 This had earlier been made legally possible by the relaxation of the restrictions on the Bank's holdings of long-tenn securities. Originally, in orthodox fashion, the Bank could hold federal and provincial securities of over two years to maturity in an amount not exceeding three times the paid-up capital, which at that time would be$ 15 million. The 1936 amendment greatly changed this by limiting holdings of those securities to 50 per cent of the Bank's notes and deposit liabilities, which at that time would allow it to hold $ 180 million worth. But of these securities, those of more than 10 years to maturity were limited to three times the paid-up capital and rest fund, or about $ 30 million then and $ 90 million when the rest fund had reached its maximum amount. The 1938 amendment did not change the limitations for total securities of more than two years to maturity, but it did change the limitations for the portion of which the period to maturity exceeded ten years; the Bank could hold them in an amount equal to five times its paid-up capital and rest fund, which then would allow a holding of $ 35 million and ultimately$ 75 million, actually$ 15 million less than under previous legislation. This was because the capital of the Bank had been reduced from $ JO.I million to $ 5 million. The 1954 amendment removed all remaining restrictions on the type of Government of Canada and provincial securities it could hold. 2 Standing Committee on Banking and Commerce, Minutes, no. 9, May 15, 1956, 349.

60

BANK OF CANADA OPERATIONS AND POLICY

Reserve Variation through Foreign Exchange Operations If the Bank is able to vary its net foreign assets (foreign exchange and foreign securities minus deposits payable in foreign currencies) then it can alter chartered bank reserves by that method. This was possible from the time the Bank opened until September 16, 1939, when the exchange rate was fixed and the Foreign Exchange Control Board was established to buy and sell all foreign exchange. After October 1, 1950, however, the Bank was again free to enter the market when it pleased and it is possible once more for the cash reserves to be consciously varied through foreign exchange transactions. The transactions would of course have to coincide with, or at least not be harmful to, exchange stabilization objectives sought at the same time. Also, the Bank could use the assets of the Exchange Fund Account but legally only through the co-operation of the Minister of Finance since the Bank is agent of the Minister for administering that Account. There is no indication that operations in the foreign exchange market have played anything but a minor role (if that) in managing bank cash. On the other hand there have been instances when such operations have had a disturbing effect on bank cash. Reserve Variation through Operating Government Accounts

The federal government carries deposits with both the chartered banks and the Bank of Canada. This has two important advantages from the point of view of monetary control. First it makes offsetting operations by the central bank unnecessary when the government is either receiving or spending large sums of money. Second, it makes it possible to divide government deposits between them in a manner which will help to control bank cash. Thus a transfer of government funds from the Bank of Canada to the chartered banks would result in an increase of bank cash. These "re-deposits" and their opposite, the "draw-downs," are of some importance to a bank's daily cash position. The co-operation of the Department of Finance is of course required in such manipulations, but this raises no problems in Ottawa. There is a fairly definite indication that this technique is consciously used to influence bank cash. A Deputy Minister of Finance wrote in 1938: ... For actual custody of public funds use is made of the Bank of Canada and all the chartered banks with their many branches throughout the country.

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These banks are designated by the Minister of Finance, and the government funds are allocated as between the various banks on the basis, generally speaking, of the relative amount of work done by each bank for the government although obviously the division of funds between the Bank of Canada on the one hand and the chartered banks on the other hand must take into account general considerations of monetary policy . 1

Indeed, since most government funds are routed through the Bank the division of funds is clearly dependent on official action; and the division has frequently been in accord with desired control of bank cash especially at the time of maturity of a government issue. 2 At no time has the division frustrated or hampered seriously cash management by the central bank. Various federal government funds hold a substantial amount of Government of Canada securities and one of these accounts, the Securities Investment Account, has been used to attain certain objectives of the central bank. The Bank of Canada is the government's agent for operating that account. By buying or selling securities for it, the Bank can change bank cash and influence security prices. 3 The other accounts, the most important of which is the Unemployment Insurance Fund, are not available for central bank manipulation, and indeed large and sudden fluctuations in total government holdings of securities are usually accounted for by variations in the Securities Investment Account. 4 (In the past, however, official purchases in New York of foreign-pay securities held in sinking fund accounts have at times been important, and these are included in the total of government holdings.) Needless to say it is only when there are securities in the Account, or when the government has a cash surplus with which to buy securities, that this technique can be used. Changing Legally Required Reserve Ratio

The 1954 amendment to the Bank of Canada Act (section 18) gave the central bank a further weapon for controlling bank cash: it empowered the Bank to vary the legal minimum cash reserve ratio of the chartered banks between 8 per cent and 12 per cent, 1 W. C. Clark, "Financial Administration of the Canadian Government," Canadian Journal of Economics and Political Science, IV (Aug. 1938), 411. 2 See below, pp. 92, 123-4, 151-2. 3 Assuming, of course, that the resulting changes in government deposits will be appropriately divided between the Bank of Canada and the chartered banks. • See Bank of Canada, Statistical Summary, 1956 Supplement, 34.

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requiring the Bank however to give one month's notice before the month to which the change is to apply and limiting any change to not more than 1 per cent per month. While this new weapon has not yet been tested, it could be a useful addition to the Bank's armoury of control; but only if it is used on rare and exceptional occasions and does not seriously impair the banks' well-established custom of maintaining fairly stable cash ratios. For it is usually a distinct advantage for monetary management to have the chartered banks react sensitively to any absolute change in their cash. The new power could also tempt the Bank to undertake large operations affecting bank cash for purposes other than monetary management, for example government finance and bond stabilization, hoping to offset the effect on bank cash by changing the minimum reserve ratio. This would be unfortunate. It is better to arrange direct sales of securities to the chartered banks if finance is required, even on short notice, and the banks would no doubt prefer this to having their cash policy disturbed by a change in the minimum reserve ratio. Besides, the Canadian bond market has in the past been sufficiently broad for even large offsetting operations by the central bank, and it is usually unnecessary to use other techniques. It is true that the reserve ratios of the chartered banks did vary somewhat in the post-war years but, as we shall see later, the variation was essentially a by-product of ultra-cheap money; to have neutralized excess bank cash at that time by varying minimum required ratios would have conflicted with the official policy of stabilizing bond prices; this policy made it important that the chartered banks should buy, or at least should not sell, government bonds. Even the 1950 case, when large unwanted cash resulted from the Bank of Canada's financing a sudden unanticipated inflow of foreign exchange (the government had insufficient cash), does not prove conclusively the need for variable ratios; the first part of that inflow was financed with chartered bank funds (the government sold them deposit certificates) and it was the decision not to negotiate for further funds which required the central bank to accumulate foreign exchange and thus to expand cash beyond monetary requirements. In general, the power to vary reserve ratios should be held in reserve for that peculiar situation in which large expansion of the cash base is undesirable yet unavoidable and cannot be offset by operations in the market. There is little doubt that the Bank of Canada does indeed regard this control technique as an emergency

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measure. 1 A failure to realize this has on occasion caused some members of the capital market to undertake operations based on the assumption that the minimum ratio would be raised-at a time when no emergency of the kind outlined above existed. In November and December of 1955 the Bank of Canada urged the chartered banks to adopt a uniform practice of maintaining an amount of cash and secondary reserves (Treasury bills, and day-today loans) equal to 15 per cent of their deposit liabilities on a daily average basis, in addition to the legal requirement that the cash part of it could not fall below 8 per cent of deposits. The banks were disturbed over this suggestion, but none the less accepted it and have adhered to it from the agreed date of May 31, 1956. The more important aspects of this controversial measure may here be noted. 2 Its purpose the Bank of Canada outlined as follows in its 1956 Annual Report: ... The function of a minimum liquid asset ratio is to increase the effectiveness of monetary policy in moderating a too rapid expansion of credit, by bringing the influence of monetary restraint to bear on the lending policies of the banks, on interest rates, and on security markets generally, earlier and more gradually and with greater certainty than would otherwise be the case. 3

These results were to follow from the fact that the fixed ratio would prevent the banks from running off some portion of their liquid assets to expand loans; and would require them to sell their less liquid securities, on which the capital loss deterrent to selling would be greater, if they wished to expand loans. Unfortunately such a measure injects an element of rigidity into the capital market. For example, it prevents the banks to some extent from switching into other types of secondary reserves such as United States Treasury bills covered with a forward exchange contract. It creates a forced demand for bills and therefore in effect may involve a sort of subsidy by the banks to the government. The importance of its contribution to monetary control is uncertain for several reasons. It is ineffective to the extent that the banks hold secondary reserves above the minimum requirement, and to the extent that the banks are prepared to accept a capital loss in selling other securities. In fact, the banks 1 Cf. Standing Committee on Banking and Commerce, Minutes, no. 16, March 18, 1954, 727; no. 17, March 23, 1954, 767, 768; no 9, May 15, 1956, 361, where the Governor said of the technique, "I think it gave us an emergency instrument which would not very often be used. I hope the occasion to use it will never arise, but it might." 2 See also E. P. Neufeld, "The Bank of Canada's Approach to Central Banking," Canadian Journal of Economics and Poliitcal Science, XXIV (Aug. 1958). 3 Bank of Canada, Annual Report, 1956, 16.

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have on occasion already gone over the minimum ratio; and they have shown no reluctance to sell longer-term securities, when their holdings of these were above what they considered to be the minimum level, at a time when the demand for loans was strong. (It is to be remembered that switching out of securities into loans is often viewed not merely as switching to a higher yielding asset, but also as attaining a new customer or holding an old one.) The fixed ratio does not solve the root of the problem, which is the excess bank liquidity, necessarily above the 15 per cent requirement, created during periods of easy money; and it is problematical whether the contribution which the ratio makes to rendering that difficulty more manageable for the central bank is worth the economic costs of an additional rigidity in the capital market. The reserves of the chartered banks, then, can be and have been consciously controlled. Most important for this control are open market operations in the bond market, Treasury bill operations, and switching government accounts between the Bank of Canada and the chartered banks, but foreign exchange operations and security transactions of government accounts are also possibilities. The power to vary the cash reserve ratio has not yet been exercised. The possibility of controlling bank cash effectively is no assurance in itself that bank loans can also be closely controlled, for large holdings of government securities would enable the banks to switch government securities for loans (and a judiciously planned portfolio can achieve this without a capital loss, that is, as securities mature). But control over bank cash can effectively regulate the total money supply, thus giving the Bank a strong influence over general public liquidity. Loans themselves can be, and, as will be seen in later chapters, have been to some extent controlled by suggestions to the banks. In any case the chartered banks' holdings of government securities now form a smaller proportion of total assets than they did even several years ago, and this change, together with perhaps marginal assistance from the 15 per cent reserve ratio, has strengthened the central bank's ability to control bank loans by quantitative techniques. BANK RATE AND INTEREST RATE VARIATION

A further traditional control technique of central banking is the variation of Bank Rate, the minimum rate at which a central bank will extend short-term advances to various members of the money

BANK OF CANADA CONTROL TECHNIQUES

market-in Canada the chartered banks and the short-term money market dealers. As a control technique the Canadian Bank Rate was for the most part made ineffective when the Bank of Canada decided that from November 1, 1956, it would be tied to the average Treasury bill rate of the weekly tender, but one-quarter per cent above it, instead of being relatively fixed and changed only at the initiative of the Bank of Canada. Before some of the implications of this innovation are noted, it is useful to review the history of the former concept of Bank Rate in Canada, particularly as a return to a fixed rate is not an impossibility. As an instrument of credit control a relatively fixed Bank Rate can be effective in three different ways. First, it can prompt a change in short-term money market and institutional interest rates (bank advances or overdrafts, call loan rates, Treasury bill rates, time deposit rates, and so on) when a tradition of a relationship with institutional rates has been established and when the banks and security dealers are accustomed to using central bank credit. Second, it can serve to make the central bank's market operations effective by discouraging continuous borrowing from the central bank. And third, it can serve as a signal of the intentions or expectations of the central bank. For a long time only the third effect of Bank Rate carried any real significance in Canada. The first was weakened initially by the nonexistence of the tradition mentioned, and indeed the various rates charged by or allowed by the chartered banks were for many years extremely rigid, reacting only to wide movements of interest rates. 1 This rigidity constituted the most important limitation of orthodox credit control in Canada. It was important, however, only to the extent that such short-term rates affected borrowing, lending and saving. Many writers have minimized this sort of influence because interest charges for carrying inventories form only a small proportion of total costs, because long-term rates are frequently viewed as the more important rates for regulating economic activity (that is, investment), because savings are considered to be more a function 1 No detailed statistics of chartered bank lending rates are available, but the interest rates allowed on personal savings deposits in the past are interesting. For many years prior to May 1933 it was 3 per cent; from May I, 1933, to Nov. I, 1934, it was 2 1/2 per cent; from the latter date to June I, I 936, it was 2 per cent; and then from June I, 1936, until Dec. I, 1953, it was I 1/2 per cent, when it again was raised to 2 per cent (See Standing Committee on Banking and Commerce, Minutes, no 15, March 16, 1954, 677). In August 1956 it was raised to 2 1/4 per cent, in Sept. 1956 to 2 1/2 per cent, and in Feb. 1957 to 2 3/4 per cent.

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of income than of interest rates, and because the availability of credit as distinct from the cost of credit has been emphasized. Thus the absence of a definite relationship between Bank Rate and institutional interest rates in Canada may not have been vitally important, but it still was a defect in the system of monetary controls, particularly as it affected money velocity. Nor was it until the new money market began to function in 1954 that any direct relationship at all existed between Bank Rate and short-term market rates. We have already seen that the custom of individual banks and bond dealers going directly to the Bank of Canada for credit at Bank Rate has only recently been firmly established. 1 This situation, of course, also explains why the second function of Bank Rate (to discourage or encourage borrowing from the central bank) was for many years superfluous in Canada. That Bank Rate would be effective mainly along general psychological lines was recognized even before the Bank began operations,2 and the same general explanation has often been repeated. 3 But the reason for this effect was not always appreciated. The Governor's explanation of the 1944 change in Bank Rate revealed more clearly the function of Bank Rate in Canada at that time: . .. The level of bank rate is not in itself of great importance because the amount of borrowing from the Bank of Canada which takes place is insignificant. In those circumstances, you may ask, "Why bother to change?" We did bother to change as a means of indicating our belief in the maintenance in the future of a low level of interest rates and as an indication of our intentions to pursue a policy which would permit a low level of interest rates in the future; that is, after the war, as well as at the present time.4 ' The chartered banks' balance sheets up to May 1954 show advances from the Bank of Canada only five times : in Oct. 1938 $ 5 million, and in April 1947 $ 4 million, both times by the same bank, and in Jan.($ 10 million), Feb.($ 10 million) and May 1954 ($ 15 million) by another bank. The possibility exists, of course, for the banks to borrow and repay between month-ends. This practice, however, was probably not important either, for from 1935 to 1944 there were only seven small transactions concealed in this way, four coming in May 1935 (when the Bank had just opened), one in July 1935, one in June I 936, and one in May 1943. (See Standing Committee on Banking and Commerce, Report of Proceedings and Evidence, 1944, Exhibit no. 36, 1621.) After mid 1954 both advances to banks and purchase resale agreements between dealers and the Bank of Canada appeared frequently (see Bank of Canada, Statistical Summary). 2 See W. C. Clark, "The Bank of Canada," address before the Dominion Association of Chartered Accountants, Montreal, Sept. 7, 1934, reprinted in the Canadian Chartered Accountant, Toronto, Oct. 1934; also reported in the Monetary Times, Sept. 8, 1934,5. 'Cf. K. R. Wilson, "What Next in Ottawa Fight on Inflation," Financial Post, Oct. 21, 1950, I; "'Cheap Money Here to Stay' Says Bank of Canada," Financial Post, Feb. 12, 1944, 1. • Standing Committee on Banking and Commerce, Minutes, May 23, 1944, 177. The Financial Post's comment (Feb. 12, 1944, 1) and quotation of some official is

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Then when Bank Rate was raised on October 17, 1950, a Press Release gave this explanation: .. . At the time the reduction in Bank Rate took place in 1944, the Bank expressed the view that it did not then see any prospect of an economic situation in the post-war period of a character which would call for a policy of raising interest rates. The change to a 2 per cent Bank Rate is an indication that the earlier view no longer holds good under today's conditions when Canada faces the prospect of substantially increased defence expenditures adding to the pressure on the country's resources at a time of virtually full employment. 1

It is patently clear that, at least up to the time of these changes, the Bank used Bank Rate to indicate what it considered to be appropriate interest rate policy and also to give warning that it would attempt to effect such a policy. There were good reasons why the financial community should interpret a change in Bank Rate seriously, and indeed an almost immediate decline in bond yields followed the lowering of Bank Rate in February 1944, and an even more strikingly sympathetic change in bond yields followed the raising of that rate in late 1950. In both cases the Bank's market operations were such as to encourage the change to take place; in the first instance it expanded bank cash, thus raising bond prices through an increased demand by the chartered banks for securities, and in the second case it restricted bank cash, whereupon the chartered banks sold securities and prices fell . Bank Rate was therefore beginning to be an instrument which mobilized market expectations for purposes of fulfilling official monetary policy; it held indirect significance not just for the shortterm sector of the capital market but for all the sectors since it suggested a complementary trend in the Bank's powerful open market operations. But the official announcement which followed the reduction of Bank Rate from 2 per cent to I½ per cent on February 15, 1955, raised new problems of interpretation. It said: also interesting: " This type of 'advance notice' action is said to be virtually unprecedented in Central Bank practice, and many people here think that in more orthodox circles abroad, it may be regarded as a most deplorable precedent. Officials here, however, take a common-sense attitude in the matter. "'If we haven't got enough nerve to stick our necks out by announcing a cheap money policy,' said one of them, 'how can we expect investors to have enough confidence to create capital? Many of them are worried now. They remember the collapse of bond values after the last war, when interest rates went sky high. They want some assurance that the same thing won't happen after this war.' " 1 Bank of Canada, Press Release, Oct. 16, 1950, reprinted also in Bank of Canada, Annual Report, 1950, 13.

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... In the past, Bank Rate has been changed infrequently in Canada and little use has been made of the Bank's facilities. The growth in the breadth and scale of activity in the short-term money market over the past two years has made it desirable that the Bank Rate be made more flexible and bear a closer (though not fixed) relation to other short-term interest rates. The present adjustment will help to make bank rate a more significant factor in the money market and facilitate its more flexible use in the future as circumstances may require. While the structure of short-term interest rates, including Bank Rate, provides an index of monetary conditions, it does not follow that every change in Bank Rate or in the level of other short rates necessarily indicates a change in general economic conditions.

Was this to be interpreted that Bank Rate should become a narrow, money market phenomenon, one which moves in accordance with the state of short-term funds in the market and not with trends in commodity prices, employment, and the balance of payments? The introduction in 1956 of the "floating" Bank Rate confirmed that this was indeed the case. But only more so, for while the above quotation expressed the Bank's intention of making "bank rate a more significant factor in the money market and facilitate its more flexible use in the future as circumstances may require," the "floating" Rate, by largely removing the central bank's initiative for changing it, made Bank Rate in an important sense much less significant, even meaningless. 1 But it is interesting and paradoxical that the period between the 1950 and 1956 announcements was also the period when Bank Rate seemed to be becoming increasingly more effective. With the development of an active short-term money market, accompanied by active use of Bank of Canada as lender of last resort, Bank Rate became a cost factor and not merely a psychological factor in market reckoning; with it Bank Rate became a potential instrument for bringing about swift changes in certain market interest rates. Also as Bank Rate was changed much more frequently than formerly (there were seven changes between February 1955 and October 1956), it attracted considerable attention. Even more important, those changes began periodically to be followed by changes in institutional interest rates such as the rate on chartered bank savings deposits. Bankers' explanations of changes in their interest rates began to include a reference to Bank Rate. It seemed then that Bank Rate was rapidly evolving into an increasingly more influential technique of control, but it was effectively sterilized before experience could reveal with what finesse it might in future be used. 1

See also E. P. Neufeld," The Bank of Canada's Approach to Central Banking."

BANK OF CANADA CONTROL TECHNIQUES

The principal advantages and disadvantages of this change in the concept of Bank Rate may be noted. The Bank of Canada's reasons for introducing the "floating" rate are indicated by these three separate quotations from its 1956 Annual Report (pp. 45, 46, 48): . . . This procedure gave rise to some misunderstanding ; in some quarters it was apparently thought that the central bank was setting or fixing or controlling interest rates of all kinds by its action in changing and publishing its own minimum lending rate .. . The influence [on interest rates] of the central bank does not arise from changes in the Bank Rate . . . but rather from the operations which the Bank undertakes in order to affect the money supply and from the effect of the resulting change in the money supply . . . . The simplest method of ensuring that the Bank Rate will always be higher than the treasury bill rate is to keep it at some specified and published margin above the treasury bill rate ... . . . unexpected, unpredictable, infrequent and relatively large changes in the Bank's lending rate under the previous system were known to have a disturbing effect on business in general and on all persons who might be contemplating the making of investments or entering into business arrangements involving credit and rates of interest. No difficulties of this sort have been reported since the adoption of the new system.

Now a "floating" Bank Rate is of course not essential for keeping it above the Treasury bill Rate, and it may be wondered whether the "disturbing" effect which an officially inspired change in the Rate had on business was not what was wanted under the economic circumstances which prevailed. And Bank Rate changes, by their effect on expectations alone, can most assuredly influence some interest rates, at least for a time. It would appear that public "misunderstanding," as revealed by public criticism of movements in Bank Rate, was an important reason for discarding the traditional type of Rate. This does seem to be a somewhat unconvincing argument for the change, given that Bank Rate has other positive advantages, for public explanations of the economic issues involved and of the role of monetary controls and policies in those issues would tend to achieve greater understanding as well. It may also be wondered whether criticism initiated by Bank Rate changes was on balance undesirable, since public discussion might well hasten greater understanding of the role of the Bank of Canada and since the monetary policy of that period was not perfect in any case. In all this it must be remembered that the developments which required numerous Bank Rate changes were of an unusual nature, in that they revolved around an incredibly swift economic transition from slack to boom.

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The gain from the new type of Bank Rate is therefore not clear.

It may be that the former type of Rate change, implying as it did

conscious action on the part of the central bank, was a useful weapon.

It seemed to have the potential for influencing businessmen's ex-

pectations in an economically stabilizing manner, and for prompting desirable changes in the relatively rigid institutional interest rates; it could also at times bring swift changes over the short run in some market interest rates, which might under certain emergency conditions be desirable. The beneficial effect on businessmen's expectations and on interest rates of an official reduction in Bank Rate during the initial stages of a downturn in economic activity may be fully as important as its effect during the upswing. Nor did a change in that Rate have to be confined to turning-points in central bank policy, for when it was moved to keep pace with market interest rates it implied a confirmation or intensification of the trend of policy; for this reason it was not as inflexible an instrument as would appear at first sight. By way of retaining perspective, it is desirable to remember that control of bank cash, and not Bank Rate of whatever concept, is unquestionably the most powerful instrument of monetary policy. FOREIGN EXCHANGE OPERATIONS

It has already been indicated that the Bank can use foreign exchange operations to vary chartered bank reserves, while earlier discussion made it clear that the principal objective of exchange operations must be the smoothing out of the foreign exchange market. But little has been said of the institutional framework of the exchange market and its relation to Bank operations. Certain aspects of this are unique and might be discussed with benefit. As long as the exchange rate was fixed (Sept. 16, 1939 to Sept. 30, 1950) the Foreign Exchange Control Board was the entire foreign exchange market, and the various banks including the Bank of Canada were merely its agents. However, when on the latter date (a Saturday) the Minister of Finance announced that rates would in future be determined in the market it was necessary to re-establish such a market by Monday morning. 1 But the foreign exchange 1 See Sidney Turk, "Foreign Exchange without Tears," an address to the Chief Treasury Officers' Association, Ottawa, Nov. 23, 1950, reprinted in the Canadian Chartered Accountant, Jan. 1951, 15-21. Mr. Turk, who was Chief of the Foreign Exchange Department of the Bank of Canada, gives an interesting account of the transition to a free market.

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brokers had long been extinct and a wide local market was essential. 1 The banks therefore decided to appoint their own brokers, one in Toronto and one in Montreal, an arrangement which has been maintained. So the exchange market consists of the nine chartered banks, the Bank of Canada, and the Montreal City and District Savings Bank, with communication between them effected by brokers who are the employees of the banks. They are paid a salary and do not receive commission. This was a distinct change from pre-war days, for at that time the brokers were independent and were more numerous. In 1933, for instance, there were six brokers in Montreal and two in Toronto, and in 1939 there were four in Montreal and three in Toronto. 2 The transitional arrangement probably has persisted because the banks consider it an improvement. They point out that in pre-war days there was often much "haggling," and consequent delay, over brokerage charges. Also, since each transaction required a payment of commission there was a tendency to keep transactions to a minimum. Today the absence of brokerage charges and the presence of only one broker encourages more and quicker inter-bank trading. Nor are the disadvantages of a monopoly situation relevant here, for even before the war the role of the exchange broker was limited entirely to bringing buyer and seller together. 3 It is difficult to estimate how this change has affected the Bank's role in the exchange market. But its task has probably been made slightly easier in that it now needs to operate through only one broker in each of the financial centres, and the more active local participation in the market may have tended to reduce the day-to-day fluctuations from what they would otherwise have been. It has been pointed out that the Bank might have gained positively from the new arrangement had it decided to assume the position of broker itself, for it would then have had more detailed information on the state of the market than it now has.4 Had it been clear that a really independent broker1 This was especially true since foreign exchange controls existed, and the banks were not allowed to deal forward with non-residents. 2 See Report of the Royal Commission on Banking and Currency in Canada (Ottawa, 1933), and Plumptre, Central Banking in the British Dominions, 143. 3 The number of brokers was probably excessive in pre-war days because they consisted mainly of semi-retired businessmen. This also explains the dearth of experienced brokers after the market had been closed for eleven years. The only way in which an independent broker could now become established is for more than one bank to become dissatisfied with the broker which they themselves employ. It is a possibility, but it seems highly improbable. 4 S. A. Shepherd, Foreign Exchange in Canada: An Outline (Toronto, 1953), 22.

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age system would not develop, the Bank might have taken advantage of the situation and assumed the function of broker. This, however, is pure conjecture. The other important change from pre-war days in the foreign exchange market is the presence of the Exchange Fund Account and the size of the official reserves. Although this Fund was established in 1935 for purposes of exchange rate stabilization, it was not proclaimed in force till exchange rates were officially fixed in September 1939. And even if it had been proclaimed it could have been used to operate in one direction only since it consisted entirely of Canadian assets. So during that period the Bank's participation was limited to the use of its own resources. The Bank did have larger foreign exchange resources then than it has at present, since it held the country's supply of gold and foreign exchange (which are now mainly in the Exchange Fund Account), but the supply was small, considering both the size of Canada's foreign trade and the necessity for the Bank at that time to maintain a 25 per cent gold reserve against its note and deposit liabilities. 1 This situation was abruptly changed during the war. The Exchange Fund Act was proclaimed, the Foreign Exchange Control Board was created and became the Agent of the Minister of Finance for administering the Exchange Fund Account, while the Bank of Canada became merely an agent of the Board. 2 The Exchange Fund Account had only its original capital of $ 83.9 million (Canadian) in September 1939. Subsequently the Canadian dollar resources of the Fund were greatly expanded by loans from the government. The first of these loans came on May 1, 1940, when the F.E.C. B. acquired all domestic holdings of gold and foreign exchange 3 (including those of the Bank of Canada), which were then credited to the Exchange Fund Account. 4 Since then the Exchange Fund Account has been the principal holder of Canada's gold and foreign exchange holdings. But as long as the exchange rate was fixed it had no opportunity for playing its originally intended role, that of exchange rate See below, p. 102. The real connection between the F.E.C.B. and the Bank of Canada was of course much closer. See above, pp. 37-8, for details and statutory references. 3 Acquisition under The Foreign Exchange Acquisition Order, 1940, P.C. 1735, April 30, 1940, and paid for by funds secured under The Exchange Fund Order, 1940, P.C. 1734, April 30, 1940. 4 For yearly advances and repayments during the war see Foreign Exchange Control Board, Report to the Minister of Finance, March 1946, 38. For subsequent years see the Exchange Fund Account's statement of assets and liabilities in the yearly reports of the F.E.C.B. 1

2

73 stabilization. Two developments during this period, however, were advantageous to the Account when free exchange rates did return. First, the government's practice of making advances to the Account became firmly established so that there was no danger that the Canadian dollar resources of the fund would be limited in future to its original capital and reserve. Second, the foreign exchange resources of the Account were much larger than when it first acquired the official reserves in 1940, 1 and, what is more important, there developed a firm conviction that the foreign exchange resources of the country (thus largely of the Account) had to be much larger than during pre-war days. Thus when exchange rates were freed, the potential and actual resources of the Exchange Fund Account were significantly larger than when it was first proclaimed, and consequently it was potentially a more important factor in the market than it would otherwise have been. Besides, no gold or foreign exchange was now required for central bank reserves: so that all holdings could be used for exchange rate and balance of payments purposes. Another development which has probably eased the Bank's task in the foreign exchange market (that is, smoothing the market) has been the decline in Canadian optional-payment bonds noted previously. There are only about half as many of these outstanding as there were before the war. Developments have in general been such as to enhance the powers of the Bank of Canada in the foreign exchange market. As agent for the administration of the Exchange Fund Account (since F.E.C.B. was abolished) it manages much larger resources than in pre-war days. Transferring the official reserves from the Bank of Canada to the Exchange Fund Account has been advantageous to the operations of the former for it has separated exchange transactions from bank cash (unless, of course, Bank finance is required) and it has better concealed the resources and operations of the stabilization account from other members of the market. 2 It also relieved the Bank from direct responsibility for exchange rate policy- a not BANK OF CANADA CONTROL TECHNIQUES

1 On Sept. 15, 1939, official holdings of gold and U.S. dollars amounted to$ 393.1 million, while on Dec. 31, 1952, they amounted to $1,860.2 million. (See Bank of Canada, Statistical Summary, 1950 Supplement, 124; Dec. 1952, 217.) This also constitutes an increase relative to national income and to the volume of international trade. 2 The Bank of Canada has to publish weekly statements, while the statement of assets and liabilities of the Exchange Fund Account appears only once a year. It is true that it has become customary to publish the monthly holdings of official reserves, but this is sufficiently infrequent to render it of little value to the market.

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undesirable development in view of the direct political repercussions of any change in that policy. MORAL SUASION OF THE BANK OF CANADA

The fourth and final important control technique of the Bank of Canada is its informal influence on the financial community. Moral suasion is a necessary element in central banking because it strengthens and supplements the mechanistic control techniques; it provides a subtle dexterity to central bank operations, so essential in meeting peculiar or extreme monetary problems. It is also the source from which spring many selective credit controls. This instrument is not easily acquired by a new central bank, and a certain compactness in the financial community, and a more than polite respect for the central bank, seem essential before it can be influential. The Bank of Canada was fortunate in that when it began operations there were only ten chartered banks. This has always facilitated close personal contact with the banks and purely physical obstacles to effective moral suasion have never been important. But the banks had been almost unanimous in their opposition to a new central bank and the consequent suspicions of the banks had first to be overcome. The appointment of a young, and more than ordinarily successful, member of their group as Governor 1 was a first and important step in this direction. 2 Periodic discussion with the bankers and the fact that the Bank took no radical steps, asked no embarrassing favours, and inaugurated no new policies further encouraged this desirable trend in the early years of the Bank's existence. Bankers appraising the undesirable effects of the new central bank's operations could point only to the loss of revenue incidental to the Bank of Canada becoming the government's banker, and at least one prominent banker had to admit in mid 1937 that "the Bank has not attempted in any manner to influence banks to make imprudent loans upon inadequate security, either to corporations or to governments ... " 3 Initial suspicions were definitely 1 Mr. G. F. Towers was only 37 years old when he was appointed first Governor of the Bank and previous to that he had already been an Assistent General Manager of one of the largest banks in Canada. 2 Since the banks had for many years been in contact with the government through the Finance Act the whole problem was probably easier than it would otherwise have been. See G. S. Dorrance, "The Bank of Canada," in R. S. Sayers, ed., Banking in the British Commonwealth, 125-6. 3 J. P. Bell (a manager of The Canadian Bank of Commerce), Address to the Winnipeg Bankers' Lecture Club, reported in the Financial Post, June 26, 1937, 17.

BANK OF CANADA CONTROL TECHNIQUES

75

disappearing; a journalist could report in late 1937 that "a cloud of approbation, no bigger than a man's hand, seems beginning to make itself evident among our chartered bankers who originally so strenuously opposed the setting up of a central bank. 1 This trend continued and it was hastened by the Bank's war operations. In 1944, when the General Manager of the Bank of Montreal was asked his opinion of the Bank of Canada as an institution in relation to the banking system generally, he stated laconically and without qualification: "I think it is a very necessary adjunct. We could not have done without it. " 2 This elimination of initial suspicions was a necessary development for the establishment of intangible central bank influence over the financial community. But it was not sufficient, indeed it was only a beginning. Not only would the bankers have to regard the central bank with benevolence but they would also have to regard it with sufficient respect to follow its suggestions when these were proffered. Conditions in the pre-war period were, however, not propitious for this further development. The Bank of Canada did request periodic meetings with the bankers but these were mainly occasions for fact finding and not for rendering advice. 3 And indeed what important advice could the Bank give? There was unemployment, the Bank was expanding bank cash, and the chartered banks were buying securities. 4 The balance of payments was in a healthy position also. The bankers' case that only the absence of sufficiently risk less loans prevented an increase in bank credit was never seriously discredited among orthodox circles. There was indeed one instance of advice to the financial community, for in 1936 both the stock exchanges and the banks increased their margin requirements for loans intended for speculation. 5 This Rielle Thomson, "The Unknown Bank," Saturday Night, Oct. 9, 1937. Standing Committee on Banking and Commerce, Minutes, July 20, 1944, 1158. Question by Mr. McGeer and answer by Mr. Gardner. 3 The Governor reported: "We maintain periodical contact with the banks. We see all the general managers at least twice a year. We made the suggestion, as a matter of fact, that we should meet twice a year, and that is being done. In the interval it may be that some of them are occasionally in Ottawa or that some of us are occasionally in Montreal and Toronto. We try to keep in touch with what is going on in the banking world in that manner. I am free to admit that the contact has not been a constant one by any means . .. " (Ibid., May II, 1939, 536.) 4 See below, pp. 94-9. 5 It was not officially stated at the time that the Bank gave its advice in this instance, and even in 1939 some doubt still existed (see Plumptre, Central Banking in the British Dominions, 140). But all doubt was removed in 1944 when the Governor said in reference to the 1936 case that "we did speak to the committees of the stock exchanges and also to the banks, and suggested that the percentage of margin requirements should be raised. That was a matter of suggestion and persuasion . .. " Standing Committee on Banking and Commerce, Minutes, June 27, 1944, 684. 1

2

76

BANK OF CANADA OPERATIONS AND POLICY

was not so significant in itself, or even because it was probably something less than a complete success, 1 but rather because of the source from which the advice received support. Two days after the Bank of Canada gave the increased margins its official blessing (in its Annual Report of February 23, 1937), the Minister of Finance stated in his budget speech that the Bank of Canada could not regulate speculative credit specifically, but that if it was to be regulated "there will be needed the effective co-operation of the stock exchanges and the banking institutions . . . " 2 In other words the Bank's action was openly supported by the strong voice of government. This was the first of an important trend. But aside from this one case little opportunity existed for advice being given or taken, and Canadian central bankers were looking to the future for positive developments of this nature. The Governor indicated this in 1939 when he told a House of Commons committee: "I would say that our number of years of operation and the character of the problems which have come up during that time, have not necessitated extremely close contacts with the banking organizations. I think that as time goes on these contacts may become closer. " 3 The Governor also pointed out that the "attitude of public men, of business, of the people generally toward the central bank, will be an important factor in what it is able to do," and he reminded the Committee that the Bank's persuasive influence could not develop overnight. 4 It is clear that up to early 1939 the moral suasion of the Bank had not really been tested, that by itself it probably could not have stood a determined test, and that more time and different economic conditions were required for further development. At the same time the financial community regarded the Bank with much less suspicion than it had when the Bank began operations. Further developments, however, came rather more quickly than might have been expected, for in less than six months war was declared. Almost overnight the Bank had to face problems of foreign exchange control, and soon the problems of debt management and war finance mushroomed out of all previously known proportions. Two factors in connection with this raised the prestige of the Bank immeasurably and suddenly. The first was that, when war came and with it the new venture into exchange control, it became at See below, pp. 106-7. Hon. Chas. A. Dunning, budget speech, Feb. 25, 1937. 3 See Standing Committee on Banking and Commerce, Minutes, May 26, 1939, 791 . • Ibid., May 8, 1939, 451; May 3, 1939, 427.

1

2

BANK OF CANADA CONTROL TECHNIQUES

77

once evident that the Bank had anticipated this, for it had a plan ready made. 1 The second was that interest rates soon settled down at a low level and the authorities were able to keep them there in their effort to ease the problems of war finance. 2 Much closer cooperation and consultation between the Bank and the chartered banks, and especially between the Bank and the government, became an indisputed necessity. Bank policy was war policy, and war policy was government policy, and the constitutional position of the Bank (as outlined in the first chapter) became clearer in practice as well as clear in theory. In the meantime, the assets of the Bank were expanding rapidly, a fact which, as already noted, held important implications for the effectiveness of future bank operations. By the end of the war this increased co-operation together with the acknowledgement that the Bank had done a difficult task rather well, the realization that the Bank had gained tremendously in experience and in material resources, and the growing general awareness that Bank policy was government policy, all contributed to establishing a healthy respect for the Bank in the eyes of the financial community. The post-war period provided the conditions in which the persuasive influence of the Bank might be put to a test. Later chapters will outline in detail the specific use made of that influence and its success, but here it is important to note that the over-all development of that technique confirmed earlier trends. Periodic consultations with the chartered banks continued 3 and these were not merely of a factfinding nature as they had been in the pre-war period. Definite suggestions concerning their lending and investment policies were made to the banks in January 1946, in mid 1947, in February 1948, and in February 1951. These suggestions were intended to play an important part in the contribution of monetary policy to controlling 1 A few months after exchange control was introduced one bank reported: "A noteworthy feature of the banking situation is the increased activities of the Bank of Canada, principally in connection with the formation of the Foreign Exchange Control Board ... it is to the credit of the Bank of Canada that regulations were so promptly defined and put into operation" (Imperial Bank of Canada, Sixty-Fifth Annual Report Presented to Shareholders, Nov. 22, 1939, 29). See also Allan 0. Gibbons, "Foreign Exchange Control in Canada, 1939-51," Canadian Journal of Economics and Political Science, XIX (Feb. 1953), 36. 2 A bank report noted in 1941 that "the experience of the past year lends further emphasis to the efficiency of our financial organization and the ability with which those charged with controlling our financial policy have carried out their duties" (The Royal Bank of Canada, Proceedings at the Seventy-Second Annual Meeting, Montreal, Jan. 9, 1951). 3 See Canada, House of Commons, Special Committee on Prices, Minutes of Proceedings and Evidence, no. 64, May 27, 1948, 3329.

BANK OF CANADA OPERATIONS AND POLICY

inflation because of the concomitant policy of government bond price stabilization; and what is more important, they proved in themselves to be successful experiments. 1 That they were relatively successful was owing to the increased prestige of the Bank, to the growing economic awareness of the commercial bankers,2 and to the fact that the advice of the Bank has had additional force by being associated with government policy.3 By being in a sense a part of government policy it doubtless has been considered rather more sympathetically than would otherwise have been the case. Further suggestions were made to the banks in November 1955 (on term loans, secondary reserve ratios, and credit authorizations in general and authorizations to instalment finance concerns in particular); in November 1956 on credit availments of finance companies (although it has not been officially stated that the initiative here came from the Bank); and in March 1957 on the separation of the chartered banks' savings and commercial banking business, and on the guarantee of minimum participation by chartered banks in financing housing. The use of moral suasion on these occasions could be called a success in the somewhat restricted sense that all but one of the ideas and suggestions were in fact adopted by the banks. It was something less than a success in that some of the measures were adopted in spite of serious disagreement over them between the Bank of Canada and the banks. Abstracting from the merits of the measures, it would seem that when they are adopted without a meeting of minds between the parties involved there is at least the suspicion that not persuasion but something akin to arbitrary power is the decisive force involved. Nor is the issue meaningless merely because legally the central bank's advice could have been ignored; the important point is that, for whatever reason, it was not ignored. This raises the fundamental question as to where the bounds of moral suasion should properly be set. See below, pp. 181 et seq., for a discussion of these suggestions. The Governor of the Bank has stated on several occasions that the banks had already been thinking along the lines suggested by the Bank of Canada when it rendered specific advice. Cf. Special Committee on Prices, Minutes, 3329. This economic awareness is especially evident in the contents of some of the banks, post-war annual reports. 3 It has become customary for the Minister of Finance to include actions of the Bank of Canada when he is reviewing steps which the government has taken to influence price trends. Cf. addresses by Hon. Douglas Abbott, "Prices and Credit," an address at the semi-annual meeting of the Academy of Political Science, New York, April 1, 1948; Address to the Opening Session of the Federal-Provincial Conference, Dec. 4, 1950; Address before the Empire Club of Canada, Toronto, Dec. 14, 1950; Address to Calvin Bullock Forum, New York, April 18, 1951. 1

2

BANK OF CANADA CONTROL TECHNIQUES

79

As might be expected, most of the advice the Bank has given has been directed at the chartered banks. Occasionally (certainly in early 1936, in February 1951 and in mid 1956) it has been extended to the stock exchanges and investment dealers. On one occasion (March 1951) it appears that the Bank's opinion on appropriate lending and investment policy was extended even to the life insurance companies. This was denied to some extent in the press, but it is significant that within a month the life insurance companies announced an investment policy which was very much in accord with contemporary government monetary policy. A few days later the Minister of Finance referred favourably to the move, and the Annual Report of the Bank of Canada also mentioned it. The life companies' endeavour to dispel any impressions of a "forced" investment policy with their own "voluntary" policy is understandable, for it was a new experience for them as well as for the Bank of Canada, admitting of course that some doubt still exists as to the exact position of the Bank in the whole episode. 1 Be this as it may, there is no doubt that official thinking permeated the policies of the companies and it is reasonable to interpret it as an important extension of the Bank's moral influence over the financial community; important because of the significant role oflife companies in the capital market. In 1956 the Bank met with the larger instalment finance companies to discuss the possibilities of limiting the growth of instalment credit through a voluntary agreement. But in the words of the Bank, "It turned out that agreement of all concerned could not be reached. " 2 This attempt at extending the moral influence of the Bank of Canada therefore failed. It would appear from the foregoing that for a period after late 1955 the Bank of Canada intensified its use of informal suggestions and that it encountered increasing difficulty and criticism in doing so. This intensified use of persuasion occurred in a period when swift changes in economic conditions demanded a major change in monetary policy over a short period of time, but there may also have been some change in the central bank's views on economic stabilization and in its attitude toward the price mechanism of the capital market following the change of Governor at the end of 1954. 1 The denial of any "forbidding" type of agreement was reported in the Financial Post, March 24, 1951. Then in April the life companies announced their voluntary investment policy (see Bank of Canada, Annual Report, 1951, 12) and on April 18 the Ministerof Finance pointed out that the companies intended to follow an anti-inflationary policy. (See Abbott, Address to Calvin Bullock Forum, New York, April 18, 1951.) 2 Bank of Canada, Annual Report, 1956, 16.

80

BANK OF CANADA OPERATIONS AND POLICY

Be that as it may the criticism existed and it is essential for a discussion of the limits which should be imposed on moral suasion to understand the basis for the criticism. First it is to be noted that many of the measures which were introduced, or were to be introduced, by moral suasion were innovations of a permanent type and were not temporary expedients intended to meet a special and temporary situation; agreement on such suggestions involved agreeing to permanent changes in the capital market structure and capital allocation. Second, some of the measures were introduced without any public discussion, which seemed to imply either that the public was an uninterested party, or that the changes were so obviously desirable that public acceptance would come as a matter of course; the permanency and complexity of the measures, however, combined to cast doubt on the validity of this assumption. Third, disagreement and criticism seemed in part to be based on conflicts in personalities. This is a danger inherent in the use of moral suasion where cooperation and sympathetic understanding are essential ingredients; it seldom arises as long as impersonal central banking techniques alone are used. Successful use of moral suasion therefore requires a capacity for avoiding such conflicts. It would seem that innovations which are permanent, important, and controversial (either as result of public reaction or reaction of those directly involved) should not be introduced through central bank persuasion.' To do so could constitute an undesirable disregard for the legislative process. Further, to the extent that the innovations permanently change the allocation of capital they entail a value judgment on the part of the central bank regarding the desirability of various kinds of capital formation; and it would seem preferable that if the market mechanism is to be amended or supplanted (as distinct from merely being made economically more efficient) and capital allocation thereby altered, the relevant value judgment should be made by parliament. If parliament intends that the central bank should be able to exercise such powers then an appropriate amendment to the Bank of Canada Act would be desirable. It is of course not possible to say precisely with what moral suasion should or should not be concerned, but as was indicated earlier there are important areas where it can make a useful contribution to central banking. 1 See E. P. Neufeld, "The Bank of Canada's Approach to Central Banking," for a more complete discussion of limits to the central bank's use of moral suasion and participation in capital allocation.

CHAPTER IV

The Bank's Pre-War Operations THE BANK became a going concern on March 11, 1935. Until the outbreak of war in September 1939 economic conditions did not demand consummate brilliance in technique from the Bank, a happy state of affairs for this fledgeling. But by the end of this period the Bank had been confronted, at least in some mild manner, with most of the objectives previously outlined. It is the isolation of these various objectives and the determination of the techniques employed for their attempted fulfilment that form the central purpose of this chapter. But first a brief glance at the initial launching. THE BANK BECOMES A GOING CONCERN The Bank's official certificate to commence operations was dated March 7, 1935, and it authorized commencement in four days. 1 To make this meaningful the Bank needed resources, and these were assured by the Bank of Canada Act. The Bank was to assume the liability for all Dominion notes outstanding in return for which it was to receive all gold and silver held by the Minister of Finance, and the balance in government securities (s. 25 (3)). It had also the resources of its subscribed capital of $ 5 million, and the chartered banks were required to surrender all their gold to the Bank in return for deposits at the Bank of Canada (s. 28 (1)). The Bank needed the gold to fulfil its reserve requirement of 25 per cent gold against its outstanding notes and deposit liabilities, and any amount above that 25 per cent would of course allow some expansion of its assets and liabilities. 1 Legally the steps were as follows. By the Bank of Canada Act, S. of C., 1934, c. 43, s. 3 (2), the Minister had to give notice that the capital stock had been subscribed before the shareholders became a body corporate. This notice was given in the Canada Gazette, Oct. 23, 1934, extra. The Governor in Council could then authorize (under Bank of Canada Act, s. 20 (1)) the Minister of Finance to issue a certificate to the Bank allowing it to commence operations. This authorization was given in Order in Council P.C. 573, March 6, 1935. The certificate authorizing commencement was issued by the Minister of Finance on March 7, 1935, and appeared in the Canada Gazette, March 11, 1935, extra.

82

BANK OF CANADA OPERATIONS AND POLICY

The size and timing of these transfers is best seen with reference to the estimated statement of the Bank's assets and liabilities for the opening and closing hours of March 11, 1935, and for March 13 and 31 of the same year, as outlined in Table 4 below. On the opening day the Bank automatically assumed a liability of $ 185.4 million representing the old Dominion notes outstanding, in return for which it received $ 69.4 million in gold, $ 1 million in silver, and $ 115 million in Dominion of Canada five-year 3 per cent bonds, all from the government of Canada. During the first day, the chartered banks transferred $ 37 .5 million gold and $ 177 .8 million Dominion notes to the Bank 1 in return for which they received TABLE4 PRINCIPAL BANK OF CANADA ASSETS AND LIABILITIES DURING THE FIRST MONTH OF OPERATIONS a

March II, 1935

Liabilities 1. Capital 2. Notes in circulation 3. Deposits (i) Govt. of Canada (ii) Chartered banks Total

Assets 1. Gold coin and bullion 2. Silver bullion 3. Foreign exchange 4. Investments (i) Govt. of Can. shorts (ii) Govt. of Can. longs Total

March 13,

March 31,

Opening

Closing

1935

1935

185.4

96.b

5.0 97.8

5.0 96.3

161.b

4.2 151.9

18.3 149.0

185.4

257.

258.9

268.6

69.4 I .0

106.6 1.0

106.6 1.0 .4

106.6 1.0 7.4

I 15.0

34.9 115.0

34.9 115.0

37.1 115.0

185.4

257.5

257.9

267.1

--

a March I 3 and March 3 I statistics from Bank of Canada, Weekly Statements; March I I closing figures arrived at mostly by working back from year-end statistics in Bank of Canada, Statistical Summary, 1946 Supplement, 4, 5, with statistics of the yearly change in assets and liabilities given in Canada, Parliament, House of Commons, Standing Committee on Banking and Commerce, Minutes of Proceedings and Evidence Respecting the Bank of Canada, 1939, xix, 621. b Estimate. 1 See Canada, House of Commons, Standing Committee on Banking and Commerce, Minutes of Proceeding and Evidence Respecting the Bank of Canada, no. I 9, I 939, 62. The slight discrepancy between the total of gold transferred by the banks and by the

THE BANK'S PRE-WAR OPERATIONS

approximately $ 161 million deposits with and $ 54 million notes of the Bank of Canada. Total bank cash, then, was $ 215.3 million after the transfers, or just the same as before them in spite of the repayment by the chartered banks of all($ 35 million) outstanding Finance Act advances. 1 The latter was offset by the redemption of an equivalent amount of Treasury bills held by the chartered banks from the proceeds of the sale of $ 34.9 million Treasury bills to the Bank of Canada. This roundabout offsetting was probably chosen because the bills held by the chartered banks were evidently already overdue for redemption, and also because it gave the Bank a supply of the regular Treasury bills. 2 By the end of the first day all the important transfers had taken place without any disruption to bank cash. The Bank of Canada had $ 35 million in Treasury bills, which was 48.9 per cent of the total bills outstanding, and $ 115 million in five-year government bonds. It therefore had securities to sell. It also had ample leeway in buying securities, for its gold reserve was about 42 per cent of its note and deposit liabilities, well above the required 25 per cent. It had no foreign exchange and so could not enter the market on the selling side, unless it sold gold. But as Table 4 shows, this was remedied before the month was out. Thus the Bank became a going concern. BANK POLICY AND BANK CASH

The Provision of Seasonal Cash It will be remembered that one of the objectives of central banking in Canada must be the accommodation of seasonal demands for cash. The size of this accommodation, the manner in which it was provided, and the use to which it was put is discussed in this section. It may be useful to mention that when the writer refers to long-term securities he means those of over two years to maturity; and shortgovernment and the total given in the second column of Table 4 (amounting to $ . 3 million) is not readily explainable, but may have been owing to the rounding of figures by the Bank. 1 Repayment was required by the Bank of Canada Act, s. 25 (5). On the same day (March I I, I 935) the Finance Act and the Dominion Notes Act became inoperative, and suspension of gold payment for legal tender was continued. 2 The bills redeemed appear to have been the 2-year Treasury notes carrying 4 per cent interest which were due in Nov. 1934. By what arrangement the banks were able to keep them till March I I, 1935, and at much above the market rate of interest, is not evident.

84

BANK OF CANADA OPERATIONS AND POLICY

term securities, those of under two years to maturity. This is merely for convenience, since banking statistics are divided in that way. Figure 1 above indicates that the seasonal increase in cash in the pre-war period extended from about August to November and the decrease from November to March. The actual changes in bank cash in these pre-war seasonal periods is outlined in Table 5 below, which shows that the seasonal increase varied between about $ 20 million and $ 40 million but that the subsequent decrease (except in 1939-40) was substantially less. This secular increase arising out of a seasonal increase will be discussed again. Table 5 shows further how the Bank provided this cash, for it outlines the effect on bank cash of changes in its various assets and liabilities during the seasonal periods. Thus an increase in any of its assets tends to increase bank cash and an increase in liabilities (except, of course, chartered bank deposits) tends to decrease it. Since Bank of Canada notes in possession of the chartered banks are reckoned as bank cash, only the net changes in active note circulation must be included; the rest, together with chartered bank deposits at the Bank of Canada, form the item "Change in Chartered Bank Cash." The main assets used to provide seasonal cash were short-term government securities. They were the only factors which increased bank cash during the upswing and decreased it during the downswing in each of the pre-war years, and quantitatively their change was almost always the most important. 1 This is entirely in agreement with the Governor's statement in 1939, when referring to the seasonal swing that "at that time we greatly increase our holdings in ... [Treasury bills] .. . with the result really that the banks have more cash and we have more bills. At a latter date in the year that position is probably reversed again." 2 But other items, while not contributing regularly to the management of seasonal cash, did at times prove useful for this task. In 1935 and 1937 the movement of holdings of longs was never in disharmony with seasonal cash requirements, as is seen in Table 5, and in 1 This is true even in the period from Nov. 1937 to March 1938, when at first sight it would appear that shorts increased, while to be consistent they should have decreased. However, this increase was purely because the five-year bonds originally issued to the Bank of Canada became less than two years to maturity on March I, 1938, and the portion which the Bank still held was switched from the long to the short category. Compare for instance the month-end figures for Feb. 1938 (in Bank of Canada, Statistical Summary, 1946 Supplement, 5) with the position two days later (in Bank of Canada, Weekly Statement, March 2, 1938). See also Bank of Canada, Annual Report, Feb. 6, 1939, 6. 2 Standing Committee on Banking and Commerce, Minutes, no. 19, May 16, I 939,629.

TABLE

5

EFFECT ON BANK CASH OF CHANGES IN THE BANK OF CANADA'S STATEMENT OF ASSETS AND LIABILillES DURING PERIODS OF SEASONAL INCREASE AND DECREASE IN CHARTERED BANK CASH a

(millions of dollars)

Month-ends

July to Nov.

+

July to Nov. to March 1936 Nov.

+

-

+

July to Nov. to March 1937 Nov.

-

Short-term govt. secs.

21.2

6.7

35.9 15.5

Long-term govt. secs.

4.2

3.1

21.4

2.6

4.2

Net foreign curr. assets

1.0 1.0

Advances Active note circulation

2.2

Govt. of Can. deposits

7.1

16.2

Other deposits

0.2

0.5

1.2

Other items (net)

6.4

0.2

5.5

Bank cash net change

20.5

2.6

Nov. to Marchl938

+

+

+

Nov. to March1940

+

86.7 105.9 58.4

5.1

13.9

10.1

22.3

1.6

4.8

Nov. to March1939

38.6 22.2 11.6

2.5 55.9 11.3

+

25.2

58.6

0.9

July to Nov.

July to Nov.

0.1

37.3

3.0 5.6 17.2

14.5

+

+

1939

1938

1937

1936

1935

2.6

9.5

2.5 20.0

11.5

5.0 37.1 22.7

3.6

1.7 39.9

2.5 14.8

9.5 23.3

4.4

21.5

15.5

4.9

5.2

1.7

1.0

0.4

6.1

41.3 25.9

8.0

5.9

2.8

4.8

35.7 18.4

1.2

29.3 30.3

a Computed by the writer from statistics in Bank of Canada, Statistical Summary, 1946 Supplement, 4-6. July to November was the approximate period of seasonal increase of bank cash and November to March the seasonal decrease. Figures under a minus sign represent a decrease in bank cash, while those under a plus sign represent an increase in bank cash. The two categories of government securities actually include provincial securities but these were negligible.

86

BANK OF CANADA OPERATIONS AND POLICY

1936 contributed materially to the seasonal increase. The Bank presumably wished to exercise its newly found powers of holding more longs, and a more judicious time than the seasonal period could not be found. 1 During the 1938 seasonal upswing the Bank's holdings of longs actually decreased steadily over the whole period (see the Bank's weekly statements), probably because it wished to "work off" the longs it had taken up in June at the time of a new issue,2 and also so that it could reconstitute its short holdings which had declined following a redemption at that same time. The June increase in longs had been just sufficient to offset the effect on bank cash of the redemption of shorts held by the Bank. Perhaps the need to offset the effects on cash of stabilizing shorts during part of the period was also a reason for the decline in long holdings. 3 This decrease in longs continued into the next period, November 1938 to March 1939, and so harmonized with seasonal adjustments. In the July-November period of 1939 longs again moved in disharmony, but the amount is almost negligible relative to the security operations of that first war year, and may even have been owing to an accounting adjustment. 4 In the following downswing the apparent disharmony in the movement of longs resulted mainly from a direct sale of $ 40 million five-year bonds to the Bank of Canada on March 1, 1940; it served to offset the decrease in reserves resulting from the redemption on that same date of that part of an issue which was held by the Bank. 5 ' By the Bank of Canada Amendment Act, S. of C., c. 22, s. 13, assented to June 23, 1936, the Bank could hold long-term Canadian government securities in an amount not exceeding 50 per cent of its note and deposit liabilities, instead of in an amount not exceeding three times its paid-up capital. 2 This is fairly certain, for the new long-term issue was dated June 1, 1938, and on that same day the Bank's holdings of longs increased by $ 11.5 million, an abnormally large increase for such a short period at that time. See Bank of Canada, Monthly Statement, May 31, 1938, and Weekly Statement, June 1, 1938. 3 See below, p. 100. 4 That is, the Bank may have held some of the securities which became less than two years to maturity on Nov. 15, 1939. Indeed the Bank's weekly statements show a decrease of $ 9 million longs and an increase of $ 20 million shorts from Nov. 8 to Nov. 15, 1939. ' The redeemed issue was the one the Bank had received when it commenced operations. For record of 1940 sale of issue to the Bank of Canada, see Hon. J. L. Ilsley, budget speech, June 23, 1942, 72. For relevant variations in the Bank's holdings of shorts and longs see Bank of Canada, Weekly Statement, Feb. 28, 1940, March 6, 1940. Theoretically the same offsetting results could have been achieved by redeeming the securities held by the Bank with government deposits at the Bank. But this would have depleted those deposits, and would soon have required them to be reconstituted. To transfer them from the chartered banks to the Bank of Canada would have meant a decrease in bank cash, hence the type of operation used was the only practical possibility.

THE BANK'S PRE-WAR OPERATIONS

In general only twice did a substantial part of the seasonal cash adjustment come via the long-term bond market, and even then other motives were present. At the same time the Bank's operations in the long-term bond market never hindered the management of seasonal cash, and were used largely to offset the effect on bank cash of refunding operations. Outside of this, operations in the long-term market were generally small in terms of quantitative changes in holdings. It may well have been that seasonal cash was occasionally, and to a limited extent, provided by the Bank's accumulation of foreign exchange, but no clear pattern is discernible. Certainly the November exchange holdings were usually high, providing cash for this peak period of demand, but in two of the pre-war years (1935 and 1939) the higher holdings were offset by an increase in government deposits at the Bank; so the accumulation of exchange was probably intended for meeting an impending government commitment abroad. In 1936 foreign exchange holdings, net of government deposits, did provide November cash, but in other years it is doubtful that they did. Nor was the secular increase in foreign currency assets fitted into the seasonal pattern. 1 Its timing was decided by the state of the exchange and by the fear of war. 2 The permanent increases in foreign exchange assets came in the downswing period of 1936-7 and 1938-9, and more than 50 per cent of the increase during the upswing of 1939 was owing to an accounting adjustment following devaluation of the dollar. Besides, by that time war decided the policy, and that it fitted into the seasonal cash pattern was incidental. The increase in exchange, however, did provide a sizable portion of the secular expansion of bank cash, as will be seen later. The seasonal increase in cash could be used by the banks to expand their deposits through increased loans and investments, to increase their reserve ratio, and to offset the drain on their cash resulting from increased circulation of Bank of Canada notes. The importance of each of these (and there is no other use to which cash can be put) is best seen with reference to Table 6 below. This table shows that in three of the five periods of seasonal increases in cash the amount of that cash used for building up the year-end cash ratios was considerably larger than that required either for increased deposits 1 In this respect Table 5 is deceiving. The apparent seasonal increase in foreign currency assets in 1938 was partly owing to a transitory November increase, and the balance was offset by a concomitant increase in government deposits at the Bank. When exchange assets fell in December, government deposits fell by an equivalent amount. 2 See below, op. 102-6.

88

BANK OF CANADA OPERATIONS AND POLICY USE MADE

BY

1935

TABLE 6 CHARTERED BANKS OF SEASONAL CASH VARIATIONSa (millions of dollars) 1936

1937

1938

1939

Average

July Nov. July Nov. July Nov. July Nov. July Nov. July Nov. to to to to to to to to to to to to Nov. March Nov. March Nov. March Nov. March Nov. March Nov. March Cash needed for or released from change in deposits b +14

+3

+ 9

+ 9

+ 3

- 2

+ 6

+ 3

+30

-14

+12

0

Cash needed for or released from change in cash ratio c + 7

-5

+27

- 34

+40

-24

+30

-21

- 3

-16

+20

-20

Cash needed for or released from change in Bank of Canada note circulation d +15

-6

+17

+ 3

+JO

- 3

+ 6

- 2

+40

+ 8

+18

0

a Computed by the writer from statistics in Bank of Canada, Statistical Summary, 1946 Supplement, 4, 6, 14. Plus sign indicates cash needed; minus sign indicates cash released. Figures are based on month-end statistics, and not daily average, because the latter are not available for Bank of Canada note circulation during this period and in order to keep it consistent with Tables 5 and 7. The writer also computed the first two items of Table 6 with daily average figures and found that it would not alter the conclusions in any sense. Indeed, where their averages are 12 and 20 here they were practically the same on the basis of daily averages figures. b On the assumption of a standard 10 per cent cash ratio. This assumption is quite valid as can be verified by taking the totals of items I and 2 (which should represent net change in banks' cash) and comparing them with the figures of net changes in cash in Table 5 above. c Arrived at by multiplying the figure of deposits at the end of the period by the cash ratio at the beginning of the period, dividing by I00, and subtracting this cash figure from the figure of cash at the end of the period. d Actual clianges in circulation of Bank of Canada notes.

or for offsetting the increased note circulation. More comprehensible are the average figures which show that the amount of cash needed on the average for increased seasonal reserve ratios was approximately as high as that required for increased circulation, 1 and de' Approximately, because the average increase in note circulation from July to October, which is the peak period for circulation, amounts to $ 22 million, or $ 2 million more rather than $ 2 million less than the average for the peak period of cash needed for increased reserve ratios.The seasonal trend in cash ratios is seen by these figures of average cash ratios for the five pre-war years, from Jan. to Dec. respectively (based on daily average figures): 10.7, 10.6, 10.2, 10.0, 10.0, 10,0, JO.I, 10.2, 10.3, 10.5, 10.9, 10.5.

THE BANK'S PRE-WAR OPERATIONS TABLE 7 SEASONAL CHANGES IN CHARTERED BANKS' CANADIAN LOANS AND SECURITY HOLDINGS a

(millions of dollars)

1935

Month-ends

1936

1937

1939

1938

Average

July Nov. July Nov. July Nov. July Nov. July Nov. July Nov. to to to to to to to to to to to to Nov. March Nov. March Nov. March Nov. March Nov. March Nov. March

Change in Govt. of Canada and prov. secs

+98 +124

-30

+77

-41

+59

+ 2

+58

+I 56 -53

+37

+53

Change in other Canadian securities

+ 7 + 40

+ I

+27

+ I

- 3

-16

+ 9

-

7 -II

- 3

+12

Change in Canadian loans

+ 61 -135

+ 57

+21

-38

+43

- 35

+ 160 + 9

+65

-36

+ 5

a Computed by the writer from statistics in Bank of Canada, Statistical Summary, 1946 Supplement, 14, 15. A plus sign indicates an increase in the particular bank asset and a minus sign a decrease.

cidedly higher than that required for increased deposits. Also, whereas the downswing period almost always saw a decrease in cash required for reserve ratios approximating the previous increase, this was never the case with cash required for deposits and note circulation. 1 It is plain that the Bank used the seasonal period to bring about a secular increase in chartered bank cash which in turn allowed a secular increase in chartered bank deposits. This was the case in each of the pre-war years. Not only was the amount of cash required for increased seasonal deposits substantially less than that required purely for window dressing, but only in some years was the increase in deposits primarily the result of seasonal loans. Table 7 above, which shows the seasonal changes in the important assets of the chartered banks, indicates that in only two years did the banks have to reduce their 1 Since the low period for both deposits and circulation comes in January rather than in March, this statement might be questioned. But in fact where the figures for the average change from Nov. to March in these are 0 and 0 respectively (Table 6), the equivalent figures for Nov. to Jan. are - 3 and - 5, still much less than the previous increases of 12 and 18 million.

90

BANK OF CANADA OPERATIONS AND POLICY

holdings of government securities during the busy autumn season, while in three years they were actually able to expand their holdings of those securities. Seasonal cash not recouped by the Bank of Canada (see Table 6) was used by the chartered banks to increase their holdings of government and other securities, as is seen by the average figures in Table 7, and after 1938 also to support an increase in loans. Thus, seasonal cash was always amply provided by the Bank, primarily by operations in the short-term securities market (mostly Treasury bills), although operations in the long-term and foreign exchange markets occasionally gave incidental assistance. The bank cash thus provided was used as much for building up cash ratios as for offsetting the drain through circulation, and that used for increased deposits was on the whole decidedly less than for either of the foregoing. The seasonal factor as such (increased loans and circulation) presented no important problems and was probably taken care of in much of a routine manner through the artificially liquid Treasury bill market. This conclusion springs from the ease with which yearend window dressing was accomplished, from the large proportion of seasonal cash used for that window dressing, from the low relative increase in seasonal deposits, 1 and from the fact that the banks were able to expand their holdings of government securities during some of the seasonally active periods. As we have seen, the Bank readily assisted the chartered banks in building up their year-end cash ratios, a practice which did little harm to monetary control at the time. Finally, by not recouping all the seasonal cash the Bank used this seasonal period to pursue its easy money policy in an unobtrusive and effortless manner. And what a difference this was from pre-Bank days when fitful and clumsy efforts at easy money by special arrangement and government decree invited protracted debates on the inevitableness of serious currency inflation, thus losing through decreased business confidence much of the gain fromcheapermoney. 2 1 The increase in seasonal deposits varied between approximately 2 per cent and 10 per cent of the level of deposits at the beginning of the seasonal periods, during the pre-war years. 2 In Nov. 1932, by special arrangement, the government sold$ 35 million two-year 4 per cent Treasury notes to the chartered banks with the understanding that the chartered banks would subsequently use them as collateral for borrowing cash under the Finance Act (see Monetary Times, CXXXIX (Nov. 1932), 5, 8). Then in June 1934 an amendment to the Dominion Notes Act was required to increase the fiduciary issue by $ 52 million and expand bank cash (see Monetary Times, Annual Statistical and Review Number, 1934, 57, 58, 68). The Governor was right, when speaking of the 1932 case, that "the very fact that such a transaction had to take place in that form made it obvious that a central bank must be organized in Canada." See Standing Committee on Banking and Commerce, Minutes, no. 12, 1939, 365.

THE BANK'S PRE-WAR OPERATIONS

91

Temporary Non-Recurring Influences on Cash

The Bank of Canada must attempt to maintain a certain stability in bank cash at all times. The manner in which this was done from month to month is easily discernible from the monthly variations in the Bank's assets and liabilities, and need not be described here, for the different variations were mostly of small proportions and hence of limited interest. Of more interest is the way in which the Bank offset large influences on cash. The Bank's first operation of this type came on the day it commenced business. As already noted, it bought $ 35 million Treasury bills from the government to enable the latter to refund an equivalent quantity of bills held by the chartered banks. This offset the banks' loss of cash resulting from the repayment of Finance Act advances. The next important offsetting operation came in July 1935, when the Bank's gold was revalued by $ 73.5 million. Of this amount $ 63.0 million was to go to the newly formed Exchange Fund Account and $ 10.5 million to the chartered banks. 1 The Bank's weekly statement of July 10, 1935, suggests that the Fund's portion was used to buy about $ 12 million government shorts and about $ 40 million government longs from the Bank of Canada, and the balance of about $ 11 million used to build up the government's deposits at the Bank. All this therefore resulted in no increase in bank cash. The portion going to the chartered banks did increase bank cash by the full amount, but for only a short period, for within a week the Bank had partially offset it by selling shorts and by the end of the month it was almost entirely offset by building up government deposits at the Bank of Canada. 2 In this way cash was controlled during a month when the demand for it was relatively low. In the following months when the seasonal demand began, the increase in cash was to a considerable extent provided by a transfer of government deposits to the chartered 1 Revaluation and establishment of Exchange Fund legislated under the Exchange Fund Act, S. o/C., 1935, c. 60. Amount going to chartered banks was in compensation for gold held by chartered banks against liabilities abroad prior to transfer of gold to the Bank. 2 By the end of the month the total net increase of $ 72.5 million in foreign currency assets was offset principally by a decrease of $ 55.2 million in government securities and an increase of $ 24. 7 million in government deposits at the Bank of Canada. This increase in deposits was obviously consciously directed toward offsetting, for it occurred when there was no increase in government deposits at the chartered banks at all. Also, it raised government deposits at the Bank to a level not exceeded till Nov. 1939. See Appendix B.

92

BANK OF CANADA OPERATIONS AND POLICY

banks. 1 All in all a neat operation for the fourth month of business. The movement of government funds was potentially the most important factor disturbing bank cash in this pre-war period. However, the way it was handled not only left bank cash relatively undisturbed but at times actually assisted in the control of bank cash. In February 1936, government deposits at the chartered banks increased by $ 42.4 million while those at the Bank of Canada decreased by $ 9.3 million, and thus gave the banks cash with which to buy securities, as was the Bank's policy at the time. 2 Nor was this just a month-end peculiarity, for the government's funds at the chartered banks remained high, while from week to week its deposits were kept low at the Bank. 3 In September 1936 the government floated a new issue (dated September 15) which caused its total deposits to increase by about $ 78 million during that month. Of this amount, $ 70 million was kept at the chartered banks, and only $ 8 million at the Bank of Canada, so that bank cash was relatively undisturbed. Similarly, from the end of December 1936 to the end of February 1937, government deposits increased by $ 101.1 million, of which $ 89.9 million were kept at the chartered banks and only $ 11.2 million at the Bank of Canada. Bank cash was therefore not disturbed, indeed the amount transferred to the Bank of Canada helped to reduce it at a time when the demand for it was not strong and when the banks' cash ratio was still a comfortable 10.3 per cent. In a similar manner the relatively large variation in government cash during June 1938, May 1939, and July 1939 was made to take place largely in the government's deposits at the chartered banks, with the variation in its deposits at the Bank of Canada in approximate harmony with cash management. War finance began in October 1939, and government deposits at the chartered banks increased by $ 174 million, while those at the Bank of Canada showed hardly a change and thus did not decrease bank cash, which was in fact urgently needed by the banks to take up the new issues. It is plain from all this that the policy of keeping government deposits at 1 From the end of July to the end of Aug. government deposits decreased by $ 21.1 million at the Bank of Canada and increased by $ 22.9 million at the chartered banks. See Appendix B. 2 The Bank allowed a slight increase in cash not only in February but also in March and April, so that an easy cash policy is evident. Also, the banks' cash ratio was already quite low (IO.I in Feb.). 3 See Appendix B for month-end changes in government deposits at the chartered banks and the Bank of Canada, and see Bank of Canada, Weekly Statement, Feb. and March, for weekly figures of government deposits at the Bank of Canada.

THE BANK'S PRE-WAR OPERATIONS

93

both the chartered banks and the Bank of Canada enabled government funds to move without disturbing bank cash and occasionally contributed to the actual management of bank cash. This has been the case throughout the Bank's history. The Bank's temporary increases and decreases in holdings of net foreign currency assets were most often offset (when necessary) by an equivalent movement in government deposits at the Bank. This was logical since the Bank managed the government's payment of foreign commitments. Offsetting the permanent increase in the Bank's holding of foreign exchange was obviated by the Bank's desire to expand cash in pursuance of its easy money policy. Foreign exchange operations, therefore, posed no important problems for cash management in the pre-war years. Practically no offsetting action was required as a result of operations in the securities market, for no attempts were made to "peg" the price of government bonds. Some stabilization appears evident in the temporary depressions in the bond market in late 1938 and 1939, but both depressions came, by sheer good fortune, at a time when the seasonal demand for cash was high and so resulted in no significant excess of cash. Had they come during the slack season the results might have been different. The only important offsetting as a result of securities operations came when the government redeemed maturing issues. On June 1, 1938, the government's refunding operation reduced the Bank's holdings of shorts by $ 9.4 million. The Bank offset this by purchasing $ 11.5 million longs (probably of the refunding issue) on the very same day. 1 On May 15, 1939, government refunding again reduced the Bank's holdings of shorts, this time by approximately $ 24.9 million, and again the Bank offset this by buying longs amounting to $ 23.4 million. 2 These two operations were probably a reflection of the Bank's previous deliberate accumulation of issues nearing maturity. And lastly, on March 1, 1940, refunding reduced the Bank's shorts by about $ 56.2 million, and the Bank at the same time increased its longs by$ 44.0 million. 3 In this way bank cash was left relatively undisturbed, the Bank maintained its holdings of government securities, and the government did not have to deplete its deposits at the Bank. 1 For refunding statistics see Hon. Chas. A. Dunning, budget speech, April 23, 1939, 17. 2 See Bank of Canada, Weekly Statement, May IO, 1939, and May 17, 1939. For refunding see Hon. J. L. Ralston, budget speech, June 24, 1940, 22. 3 See budget speech, June 24, 1940, 22, and Bank of Canada, Weekly Statement, Feb. 28, 1940, and March 6, 1940.

94

BANK OF CANADA OPERATIONS AND POLICY

The Bank seldom had to act directly as lender of last resort. Advances appeared on the chartered banks' balance sheets only twice, each time a small amount and to the same bank. Borrowing between balance sheet dates was also infrequent, only six instances in the pre-war period, five of which came during the first few months of the Bank's operations. There are two reasons for this infrequency. First, it was a period of easy money when the banks would naturally be in a liquid condition. Second, by maintaining the liquidity of the Treasury bill market, the Bank of Canada provided a kind of lender of last resort facility to any bank which had bills, a method preferred by the chartered banks since the odium of borrowing from a central bank was thereby circumvented. In summary, the Bank seldom had to engage in extensive offsetting operations. This was because of the way government cash was divided between the Bank of Canada and the chartered banks; because there was no concerted effort to "peg" bonds and any stabilization that there was fortunately came during the busy season; because purchases of foreign exchange could often quite logically be offset by equivalent movements in government deposits at the Bank; and because the Bank's easy money policy allowed a permanent increase in holdings of foreign currency assets and government securities. When offsetting was required it was achieved quite successfully by operations in the securities market, especially by taking up longs during refunding, and by appropriate management of government deposits. Co-operation on the operational level between Bank and government was an important and continuing feature. Bank Policy through Permanent Cash Management

The Bank of Canada pursued its easy money policy by expanding bank cash. Bank Rate remained constant at 2½ per cent. Table 8 below shows that from March 31, 1935, to March 31, 1939, chartered bank cash increased by about $ 52.6 million, or by about 26 per cent. Almost all the increase of $ 68 million in note circulation and $ 52.6 million in net bank cash was provided by the net operations in the gold and foreign exchange markets. Holdings of government securities increased by only $ 7.7 million. This does not mean that the Bank was relatively inactive in the securities market, for it will be remembered that when gold was revalued by $ 73.5 million in July 1935 the Bank offset this almost entirely by selling securities, amounting to about $ 52 million, to the new Exchange Fund

THE BANK'S PRE-WAR OPERATIONS TABLE

95

8

EFFECT ON BANK CASH OF CHANGES IN THE BANK OF CANADA'S STATEMENT OF ASSETS AND LIABILITIES FROM MARCH 31, 1935, TO MARCH 31, 1939°

(millions of dollars)

Increasing bank cash Govt. of Can. & prov. securities Net foreign currency assets Advances Active note circulation Capital and rest Government of Canada deposits Other deposits Other assets minus other liabilities

Decreasing bank cash

7.7 121.3 68.0 1.9 2.2 6.2 1.9

Total Deduct

130.9 78.3

Net increase in chartered bank cash

52.6

78.3

a Computed by the writer from statistics in Bank of Canada, Statistical Summary, 1946 Supplement, 4, 5, 6, 7, 14, 15. The period March 1935 to March 1939 was chosen because by beginning and ending on the same month the slight seasonal influence is minimized, and also because it eliminates the effect of war finance during the later part of 1939, which cannot rightly be considered a part of pre-war monetary policy.

TABLE

9

CHANGE IN CHARTERED BANKS' HOLDINGS OF CANADIAN SECURITIES AND LoANS FROM MARCH 31, 1935, TO MARCH 31, 1939°

(millions of dollars)

Change in Govt. of Canada and provincial short-term securities

+ 115

Change in Govt. of Canada and provincial long-term securities

+ 286

Change in other Canadian securities

+ 94

Change in Canadian loans

47

a Computed by the writer from statistics in Bank of Canada, Statistical Summary, 1946 Supplement, 14, 15.

BANK OF CANADA OPERATIONS AND POLICY

Account. After that date new purchases more than offset that huge sale, so, realistically speaking, bank cash and note circulation were provided to a further extent of $ 52 million by purchases of securities. This, however, still leaves $ 69.3 million provided by gold and foreign exchange operations. 1 Easier money and an increase in foreign currency reserves were thus achieved concomitantly. It is also to be noted that a decline in bank cash through a trend increase in government deposits was avoided by allowing the proportion of total government deposits which were kept at the Bank of Canada to decrease steadily as total government deposits increased. 2 The chartered banks used all this net increase in cash for expanding deposits and not for increasing their reserve ratios. These deposits were created, as Table 9 above indicates, entirely by the purchase of securities, mostly government securities. Canadian loans actually decreased, although this was primarily owing to the liquidation in 1936 of about $ 95 million government guaranteed advances, so that commercial loans on the whole expanded to a limited extent. 3 The $ 68 million increase in Bank of Canada note circulation (Table 8) was not owing to a secular increase in total circulation, for the chartered banks were required to reduce their note issues. 4 Thus only $ 40 million resulted from a net increase in circulation while $ 28 million was required to offset the net decrease in circulation of chartered bank notes.5 The Bank of Canada's principal contribution to raising national 1 Of this $ 69.3 million, $ 21.5 million was the approximate amount by which the 1935 revaluation was allowed to have an almost immediate influence on bank cash, and $ 47.8 million was the approximate amount of foreign currency assets actually purchased by the Bank since that revaluation. 2 This is clearly seen by the trend in the monthly average of the percentage of total government deposits kept at the Bank of Canada for the years 1935 to 1939, which were : 46.1 per cent, 38.9 per cent, 37.5 per cent, 31.9 per cent, and 27.1 per cent. See Appendix B. 3 For this decrease in government indebtedness guaranteed, compare Hon. Chas. A. Dunning's budget speech of May 1, 1936, 23, with that of Feb. 25, 1937, 27. See also Standing Committee on Banking and Commerce, Minutes, May 23, and Nov. 21 , 1939. For annual classification of chartered bank loans, see Bank of Canada, Statistical Summary , 1946 Supplement, 18-19. 4 By the Bank Act, S . of C., 1934, c. 24, the chartered banks' note issue was immediately limited to the unimpaired paid-up capital, and beginning on Jan. I, 1936, it had to be reduced annually by 5 per cent for five years and by 10 per cent for the next five years. By the Bank Act, S. of C., 1944, c. 30, the remaining issue and reissue rights were withdrawn and the banks were required to pay an amount equivalent to the notes outstanding as at Jan. I , 1950, to the Bank of Canada. 5 Computed from statistics of active circulation of Bank of Canada notes and circulation of chartered bank notes, in Bank of Canada, Statistical Summary, 1946 Supplement, 4, 6, 14.

THE BANK'S PRE-WAR OPERATIONS

97

income consisted of expanding bank cash by purchasing securities and foreign exchange, and it was indirectly assisted in this by the government which kept its deposits more or less constant at the Bank over the period, even though its total deposits increased. This policy increased the chartered banks' demand for securities, and it is generally agreed that it reduced interest rates; it also increased the quantity of money, aided the flotation of new securities by governments and corporations, made refunding easier and financially advantageous, and may have tended to keep the Canadian dollar from going to a premium (through foreign exchange accumulation). 1 This easy money policy was not a departure from pre-Bank policy, for money had been increasing and interest rates declining before the Bank appeared. But it differed greatly from the former policy in the smooth, seemingly confident, and purposive manner with which it was implemented. Doubt does not exist over the direction or the techniques of prewar monetary policy, but rather over the degree to which easy money was pursued. Was money sufficiently easy? The Governor has stated in evidence that he believed it was. Briefly, he pointed out that monetary expansion under the circumstances would mainly lower interest rates and increase cash balances. The former would reduce debt charges, aid refunding, and encourage investment, while the latter would tend to increase spending because of the increase itself and also because of the lower rate of return on that type of liquid asset. But, it was pointed out, there are limitations to this expansion. Canadian interest rates cannot break through the floor set by American rates, so that monetary expansion will lead finally to the export of capital with resultant devaluation. Also, increased deposits create the potential for speculation and sudden general inflation. On both these accounts inflation becomes a threat, and this before anything like full employment has been reached. The Bank's views on compensatory government spending were the same. Income thus generated would leak through imports, and therefore produce devaluation, which in turn would not bring net benefits. Besides this, deficit spending would entail loss of business confidence, and could not offset the abnormally low demand for the 1 For some discussion of monetary policy during this period see especially Standing Committee on Banking and Commerce, Minutes, 1939, or extracts of same in Memoranda and Tables Respecting the Bank of Canada (Ottawa, 1939); Courtland Elliott, "Bank Cash," Canadian Journal of Economics and Political Science, IV (Aug. 1938), esp. 447-59; contribution by J. T. Bryden and W. T. G. Hackett in "Interest Rates in Canada," ibid., III (Aug. 1937), 421-48.

98

BANK OF CANADA OPERATIONS AND POLICY

primary products exported. 1 In conclusion the Governor stated: "In my opinion, the amount of monetary expansion which has taken place in Canada to date, viewed in relation to actual conditions, has been sufficient to offer all the incentive to a high level of economic activity and prosperity which monetary policy can be expected to offer in a country where non-monetary factors are so important. " 2 This was sound reasoning, largely irrefutable. But two crucial facts remained. First, there was no sign of inflation in equities (after late 1936) or commodities, or in the sense of a flight from the currency. Second, the balance ofpayments remained extraordinarily strong. The first fact the Governor countered by pointing out that "the potentialities of inflation under appropriate circumstances have increased. That is something for the future to determine." The second, by the argument that Canada was exporting raw materials ("Quasi capital"), that the level of consumption imports had been maintained, and that therefore the external credit balance should be used for imports of capital goods or repatriation of debt. Since the absence of profitable opportunities precluded the first, the second was the best policy. 3 In view of the low standard of living and the latent pessimism throughout the period, as well as the increased control over bank credit and some indirect control over stock market activity, the fear of the various forms of inflation may have been over-emphasized. Also, if further expansion would have substantially reduced the waste of unused manpower and capacity, the question of a greater net loss of capital goods on external account would not now be considered a serious obstacle. Moreover, since devaluation would perhaps have aided, at least temporarily, the most depressed areas (primary producers), and since 9 per cent devaluation against U.S. dollars (but not against sterling) did come in September 1939 and stayed for almost seven years (under quite different circumstances of course), the fear of the effect of further expansion on the balance of payments may have been exaggerated. In this connection two points are worth noting. First, although the foreign trade multiplier 1 This view has on various occasions been fortified by analysis of Canada's relations with the United States with the foreign-trade multiplier approach. Cf. Edward Marcus, "The Effectiveness of Canadian Fiscal Policy," Journal of Finance, Chicago, Dec. 1952, and the references there noted. 2 See Standing Committee on Banking and Commerce, Minutes, March 31, 1939, 88; Ibid., 84, and no. 18, May 15, 1939; March 31, 1939, 88, and no. 18, May 15, 1939; March 31, 1939, 84-5, 770; no. 19, May 16, 1939, 151; April 21, 1939, 150-1; March 31, 1939, 88. 3 Standing Committee on Banking and Commerce, Minutes, no. 19, May 16, 1939, 643, 836.

THE BANK'S PRE-WAR OPERATIONS

99

in the Canadian situation would in itself lead us to a probably correct conclusion that domestic compensatory spending and monetary expansion is relatively closely circumscribed, official policy should not be based on this alone; it must note the actual trend in national income of Canada's customers and not just the induced effect on them of increased Canadian imports. Such trends may explain in part the strong Canadian balance-of-payments position in spite of the monetary expansion which took place. Second, in 1941 an economic analyst could argue that the devalued Canadian dollar at that date would not be revalued because of the benefits accruing to certain industries. 1 It may well have been, therefore, that monetary expansion and compensatory spending were too closely circumscribed because of an overly conservative estimation of the nearness of devaluation itself and an over-emphasis of the disadvantages flowing from a devaluation should it in fact develop. Hindsight, of course, is invaluable and it must be remembered that not only businessmen but also governments were averse to great expansion either through the Bank alone or through the budget. 2 And for what it is worth, monetary expansion was as great as in other countries. 3 In future similar conditions, more will probably be expected from the central bank itself, although not much more; but considerably more will be expected from fiscal policy working through monetary expansion. STABILIZING THE FINANCIAL MARKETS

The Government of Canada Bond Market It was intimated earlier that no attempts at stabilizing the bond market frustrated the control of bank cash. This, however, did not mean either that there was no need for stabilization or that the Bank See A. F . W. Plumptre, Mobilizing Canada's Resources/or War(Toronto, 1941), 204. One need only compare any or all of the pre-war budgets with the sentiments concerning the role of the government as expressed in the post-war White Paper on Employment and Income (Ottawa, 1945) to appreciate the change that has taken place. Pre-war budgetary deficits were presented apologetically, as being forced largely by social circumstances and something to be got rid of, and, even before full employment, never a positive policy of compensatory spending. The White Paper gives government deficits a positive and wholly honourable role in economic policy. 3 See Standing Committee on Banking and Commerce, Minutes, March 31, 1939, where expansion of deposits from 1926 to 1938 in the following countries is listed as follows: Canada 23 per cent, United States 6 per cent, United Kingdom 26 per cent, Australia 22 per cent, and Sweden 23 per cent. 1 2

100

BANK OF CANADA OPERATIONS AND POLICY

was completely uninterested in the stability of the government bond market. In September 1935, six months after the Bank began operations, this market suffered what was described, quite rightly at the time, as the sharpest slump in prices since Britain went off gold in September 1931. 1 From August to September the monthly average yield of short-term Government of Canada bonds rose from 2.04 per cent to 2.76 per cent, and longs from 3.48 per cent to 3.87 per cent.2 Neither by way of newspaper comment nor by the trend in the Bank's weekly securities holdings is there any indication that the Bank attempted to stabilize this disturbance. One can speculate widely on the reasons for this, but it seems reasonable that at that time the Bank's duty of ensuring an orderly bond market was not yet clear. 3 It is significant that its legal power to hold long-term securities in large amounts did not come till late 1936, and the Bank's attempt at gaining a closer connection with the market by submitting daily lists of bids and offers did not come till early 1938. In the first quarter of 1937 bond prices fell steadily, with the yield on longs increasing from 3.09 per cent in January to 3.47 per cent in March. 4 This trend, however, was caused mainly by market switching from bonds to stocks, and so was sufficiently gradual to obviate any smoothing operations by the central bank. 5 Indeed, since the Bank had, earlier in 1936, suggested higher margin requirements for speculative loans 6 it would have been contradictory to ease the switch from bonds to stocks by smoothing the market. Then in May 1938 the Bank began to give the chartered banks and bond dealers its bids and offers on all issues every morning. 7 Some years later the Governor explained this move by informing 1 See the Financial Post, "Tumbling Bond Prices Hit Refunding Plans for Government Loans," Sept. 21, 1935. 2 See Stanley E. Nixon, J. T. Bryden, and W. T. G. Hackett, "Interest Rates in Canada," in E. M. Rosengren, ed., Readings in Money and Banking (Toronto, 1947), 241, 244, reprinted from the Canadian Journal of Economics and Political Science, III (Aug. 1937), 421-48. 3 The very fact that the Bank was still severely limited in its holdings of longs indicates that, in that market, stabilization to any important extent had not been contemplated. When this limitation was removed in mid September 1936, the Bank increased its holdings of longs. (See Bank of Canada, Weekly Statement, Sept. 9, 1936, and Sept. 16, 1936.) Besides this limitation, the chartered banks' cash ratio was already comfortable (10.6 per cent). • Bank of Canada, Statistical Summary, Jan. 1938, 7. ' The inverse correlation between bond and stock prices was noted at the time. See "Bond Markets," Financial Post, April 24, 1937, 5. 6 See below, 106. 7 See "Will Higher Interest Rate Help Soaring Prices," Financial Post, Jan. 10, 1948, 1.

THE BANK'S PRE-WAR OPERATIONS

IOI

a parliamentary committee that "we were not in very close touch with the market. We thought it would make our touch closer" . 1 This appears to be the first indication that the Bank wished to be in a position to influence the market itself as well as to use it for controlling bank cash. It may have previously hoped to establish such contact by orthodox means, but with the deteriorating international situation of 1938, it felt obliged to adopt this expedient. The technique served its purpose well until January 1948, when at a particularly judicious moment it was discontinued. By that time the Bank's transactions were sufficiently large, it was believed, to maintain close contact with the market by orthodox means. The adoption of this technique in May 1938 seems to have been particularly fortunate, for in the following September news from Czechoslovakia "broke" the bond market. 2 During September and October the Bank increased its government securities holdings by about $ 41 million, and although some of this was in any case required for seasonal purposes, cash ratios none the less went higher in September and October of 1938 than in equivalent months of any other pre-war year. But they were not excessively higher and it was fortunate that the slump in the bond market coincided with seasonal cash demands. In September and October of 1939 all bond prices fell sharply, the reaction to war. The yield on Government of Canada theoretical 15-year bonds rose from 2.95 per cent to 3.7 per cent during those two months, while that on theoretical 2-year bonds rose from 1.33 per cent to 2.22 per cent. 3 By about mid October stability returned and yields declined. The Bank helped to stabilize the disruption by substantial purchases of securities and by rather interesting advice to the market. As early as September 9 a financial paper reported that "evidences of active support by the Bank of Canada of the highgrade market were present. " 4 During these two critical months the Bank bought $ 82.9 million shorts. In September it bought $ 11.5 million longs, but in October was able to sell $ 8.6 million of these. Sometime during this period, probably in early September, the Bank requested dealers not to deal in short sales of Government of Canada 1 See Canada, House of Commons, Special Committee on Prices, Minutes of Proceedings and Evidence, May 27, 1948, 3353. 2 See "Bond Markets" Financial Post, Sept. I 7, 1938, 5. 3 See Bank of Canada, Statistical Summary, 1946 Supplement, 26. 4 See "Bond Markets," Financial Post, Sept. 9, 1939, 5. Reference to this support also appears in "Interest Rates to be Checked," ibid., I, and in "Bond Markets," ibid., Dec. 30, 1939, 5.

102

BANK OF CANADA OPERATIONS AND POLICY

and provincial securities.' This may have had a substantial effect, one cannot tell, and the advice was not withdrawn until artificial support was no longer required. And one of the main reasons for the sudden imposition of exchange control in September 1939 was to protect the Canadian bond market from disruptions springing from a flight of capital. By these methods the Bank aided in preventing development of anything like panic in the market. At the same time because of the sudden increase in note circulation (also in part a reaction to war), the increase in deposits resulting from the sale of new Government of Canada securities directly to the chartered banks, as well as the normal seasonal increase in business activity,2 bank cash was not unduly increased. The above indicates the approximate extent of Bank participation in major bond market disruptions. It must also be remembered that the Bank was frequently in the market for small amounts, as its weekly statements indicate, and in that way probably effected a certain stability in very short-run movements; indeed the Bank's Governor, referring to efforts at improving and broadening the short-term market, has said that "the Bank of Canada has been a constant trader in government of Canada securities since we opened our doors in 1935. " 3 It has also been suggested that the Bank at times has engaged in switching operations in order to influence the pattern of rates without affecting bank cash. 4 However, the extent or importance of these operations cannot be estimated. The Foreign Exchange Market

Although the Bank had no stabilization fund during this period it none the less handled large amounts of foreign exchange. It had, of course, the country's official gold holdings and it could buy, and subsequently sell, foreign exchange by using its own resources of Canadian dollars, limited only by the 25 per cent reserve requirement against its notes and deposit liabilities. But most important of all, it was the government's agent for disposing of the country's large annual production of gold, and for meeting government commit' This request does not seem to have been reported at the time it was made, but unofficial notice of its withdrawal appears in "Bond Markets," Financial Post, Sept. 9, 1939, 5. 2 See Appendixes A, Band C, statistics for Sept. and Oct. 1939. 3 Standing Committee on Banking and Commerce, Minutes, March 18, 1954, 701. 4 See Plumptre, Central Banking in the British Dominions, 233.

THE BANK'S PRE-WAR OPERATIONS

103

ments payable in foreign currencies. 1 These necessitated large exchange operations. The Bank's objectives in the pre-war foreign exchange market were to take care of foreign commitments of the government, to build up official reserves, and perhaps to exert some stabilizing influence. The first of these seems to have been of primary and continuous importance, as was forecast by the Governor two days before the Bank commenced business and affirmed several times after that. 2 Before government commitments became due the Bank often accumulated foreign exchange, and when payment was made the government's account at the Bank was debited accordingly. This procedure is seen in the correlation between the movement of government deposits at the Bank and the Bank's holdings of foreign exchange, especially when these decreased, and was referred to repeatedly in the contemporary press. 3 Gold sales were continuous and commitments frequent, so Bank participation in the market could be constant and any short-run stabilization aims it might have, well hidden. 4 Also, this undivided attention to government affairs abroad must have been an improvement over the pre-Bank arrangement. 5 There are four reasons why the Bank should want to build up the official reserves of foreign currency assets. First, the chartered banks' net foreign currency assets had declined sharply, especially call loans abroad following the 1929 debacle and again following the establishment of the Canadian Treasury bill market in 1934; this had to be reckoned a decrease in the country's reserves of foreign exchange. 1 The Governor explained that the government bought all the domestic gold and the Bank of Canada acted as agent for marketing it. The government used the U.S. dollars so received to pay off interest and other commitments in the United States. The government instructed the Bank to sell any surplus for Canadian dollars. When the Bank bought gold it bought it from the government. See Standing Committee on Banking and Commerce, Minutes, no. 5, April 14, 1939. 2 "Bank of Canada Ready for Opening March 11," Financial Post, March 9, 1935; G . F. Towers, Address before the Canadian Club, Toronto, as reported in the Toronto Daily Star, Jan. 6, 1936; also G. F. Towers, Address before the Montreal Junior Board of Trade, March 14, 1938, as reported in the Financial Times, March 18. 1938. 3 For press references see Financial Post, July 13, 1935, 4; Sept. 7, 1935; Oct. 12, 1935, 8; May 6, 1939, 17. • See Bank of Canada, Weekly Statement, for the frequent variations in the Bank's holdings of exchange. And see Canada, Department of Trade and Commerce, Trade of Canada (Ottawa, 1950), I, 499-500, for monthly net exports of non-monetary gold. For monthly gold production see Bank of Canada, Statistical Summary, 1946 Supploment, 65. ' For the substantiated laudatory comments of a post office official see the Montreal Daily Star, Jan. 8, 1937.

104

BANK OF CANADA OPERATIONS AND POLICY

Second, the unsettled international situation after early 1938 might suggest the necessity of extra precautionary reserves. Third, the Bank had to maintain a 25 per cent reserve of gold against its notes and deposit liabilities. Fourth, increased reserves would serve as a precaution against the potential outflow of new short-term inflows of capital which took place. The first reason does not seem to have been weighed heavily for there was no special effort to increase reserves in 1935 and 1936 (except by revaluation in July 1935) when the balance of payments was in a relatively strong position and when the chartered banks' latest decline in foreign call loans was still taking place. Besides, the pre-1929 position was not restored during this pre-war period and the Governor expressed the opinion that the increase which had taken place was sufficient. 1 It is interesting that this liquidity position was restored in the war and post-war periods by operations of the Bank as agent for the government. Nor did the necessity of a 25 per cent reserve against the Bank's note and deposit liabilities appear a pressing reason for increased gold reserves, for even without any increase in gold holdings after the 1935 revaluation the reserve would still have been over 70 per cent up until war came. The Governor has, however, mentioned it as a possible reason for the increase that did take place. 2 In the last half of 1936 the Canadian dollar began to strengthen 3 and during the first half of 1937 some of the inflow, it has been suggested, was "hot money. " 4 The Bank reacted to this new development by beginning to buy foreign exchange in January and especially by buying, for the first time, foreign government securities beginning in mid June and amounting to$ 10 million by the end of the month. No sudden reaction occurred in the exchange market, the Bank did not have to sell all its recently acquired exchange, and its monthly average holdings of exchange were $ 12.4 million higher in 1937 1 Before a parliamentary committee the Governor was asked: "Do you think we are making the maximum use of our gold resources in the way we have used them?" The Governor replied; "Yes, I do. In recent times we have added to our gold stocks in the amount of $ 25,000,000. I think our action in that respect should be determined by what we believe to be the needs for reserves, after taking all factors into consideration; that there would be no point in carrying reserves in excess of what one believed to be the requirements." (Standing Committee on Banking and Commerce, Minutes, May 6, 1939, 424-5.) 2 See Bank of Canada, Annual Report, Feb. 10, 1940, 7. 3 See Bank of Canada, Statistical Summary, 1946 Supplement, 126. 4 See the Philadelphia Inquirer, July II, 1937, '"Hot Money' Worries Canadian Treasury." But see also "Central Bank Adds to Foreign Assets Safeguards Dollar," Financial Post, June 26, 1937, I.

THE BANK'S PRE-WAR OPERATIONS

than in 1936. 1 Then in the last half of 1938 war clouds appeared, British and European capital began to move into Canada,2 the exchanges again strengthened, and the Bank bought exchange in an amount more than suflicient to meet immediate commitments so that its December 1938 holdings were$ 16.7 million higher than the December 1937 holdings. As in 1937, this probably smoothed the market and provided resources for meeting a future outflow without exchange disruption. The exchange rate strengthened until early August 1939, and the Bank was a net buyer all the time. Now, however, another motive for the Bank's action was clearly present-extra reserves in case of war. This has been stated by the Governor, 3 and is evident in that the Bank began to increase its gold holdings and not just its foreign exchange holdings, and it continued to buy even when the exchanges deteriorated sharply from early August to mid September 1939, at which time the rate was fixed. Certainly there was no concerted effort to stabilize the dollar during the disruption caused by the threat of war. It has been pointed out that government business gave the Bank constant contact with the exchange market. This may well have had a day-to-day stabilizing influence, a broadening effect, on the market. But, as in the equivalent case of the bond market, it cannot be measured. The Governor stated definitely that "Canada never took any action whatever in the exchange market to produce any given level for the Canadian dollar. " 4 Statistical evidence certainly supports this, although it must be qualified to the extent that the secular increase in holdings of foreign currency asset had some slight dampening effect on the market. Even this, however, is better looked on as a stabilizing influence during the transition to a different level, for the Bank confined its net purchases almost entirely to periods when the Canadian dollar was strengthening and no evidence exists that the Bank attempted to arrest a trend. On the whole, the Bank was fortunate in its foreign exchange operations. The strong balance-of-payments position throughout the period kept the mark,et remarkably steady. During peace "hot money" flowed in and not out, so the Bank was able to exert a stabilizing influence and build up reserves at the same time. When See Bank of Canada, Statistical Summary, 1946 Supplement, 5. See Plumptre, Central Banking in the British Dominions, 418. 3 See Bank of Canada, Annual Report, Feb. 10, 1940, 7. • See Standing Committee on Banking and Commerce, Minutes, no. 2, March 24, 1939, 23. 1

2

106

BANK OF CANADA OPERATIONS AND POLICY

war became imminent and "hot money" did flow out, the problem was soon settled by over-all exchange control, although not before the dollar had depreciated. The Bank built up reserves mainly when the exchanges were strong and the evidence suggests that the net accumulation was meant primarily as a protection against the potential outflow of the new capital inflows, and during 1939 as a precaution in case of war. It has been argued that the Bank should perhaps have increased its exchange reserves more, in view of the reduced short-term exchange assets of the banking system. 1 The resultant degree of devaluation (if any) would have been favoured by many industries; devaluation did come, and stayed for over six years; and the foreign exchange liquidity position of the banking system (including government) was restored in later periods. Thus it may well be that the Bank was over cautious in its pre-war exchange rate and exchange reserve policy. 2 In fairness it must be said that any reasonable increase in reserves would not have obviated the emergency arrangements of the war period, although it has been suggested that it may have eased control problems. 3

The Stock Market In mid 1935 stock market activity increased and continued to do so until about the first quarter of 1936. A slight slump occurred, but the market soon recovered and a more substantial increase in activity began. During the 1936 part of this increase, the Bank suggested to the stock exchanges and chartered banks that they increase their margin requirements. This was done and the first Bank effort at moral suasion appeared an unqualified success. But was it? Stock market activity continued and did not reach its peak till the first quarter of 1937. On February 23, 1937, the Governor commended the move of the stock exchanges (but not of the banks), See Plumptre, Central Banking in the British Dominions, 420-1. More reserves held by the Bank would have required more monetary expansion, and although some slight further expansion would probably have done no harm (see above, p. 98) the amount necessary for any appreciable increase in exchange reserves would have been dangerous. Thus offsetting would have been necessary, and the Bank had not sufficient securities to spare for such an operation. It could, however have been done by the government buying the exchange out of its ordinary revenues, and holding it itself (in substance the war and post-war arrangements), for in that way the only increase in bank cash would have been that to support any necessary increase in deposits re5ulting from any new government bond issues required. 3 See Courtland Elliott, "The Role of Capital Imports" in J. Douglas Gibson, Canada's Economy in a Changing World (Toronto, 1948), 251-2. 1

2

THE BANK'S PRE-WAR OPERATIONS

107

and deemed it necessary to add: ". . . I feel sure that they [the stock exchanges] will have the co-operation of other lenders if ... further increases become necessary. " 1 Several days later the Minister of Finance pointed out that "to control speculative credit the effective co-operation of stock exchanges and banks will be needed," not adding that such "effective" co-operation existed.2 Not long after, the banks made public their view .that they were "willing" to cooperate with stock market officials to discourage speculation by increased margins, higher costs, and by flatly refusing to lend, but that it should be remembered that other sources of funds existed. 3 And lastly, in the next Annual Report of the Bank the Governor plainly expressed the opinion that the reduction in stock brokers' loans had been offset by the increase of similar loans by the chartered banks. 4 It would seem from all this that although the banks and stock exchanges responded satisfactorily in the matter of margins, the Bank was not satisfied that sufficient restriction through direct availability of chartered bank credit had existed. It seems probable (although not definite) that the Bank had requested such further restriction during the boom and that that request, together with the statement of the Minister, prompted the somewhat defensive statement of the banks. In any case no proof existed at this stage that the Bank's moral influence was sufficient to control chartered bank speculative loans. The trend in the stock exchanges required no further Bank intervention during the pre-war period. THE BANK AND GOVERNMENT FINANCE

The point was made earlier that the Bank can quite legitimately aid government finance when such assistance does not prejudice effective monetary management. It was further pointed out that if the Bank wished to retain some control over the liquidity position of the chartered banks and also to underwrite the liquidity position of Treasury bills, other means would be required to supply periodic funds to the government. It is therefore of some interest to inquire into the manner in which the government was supplied with funds, and its implications for effective cash management. Bank of Canada, Annual Report, Feb. 23, 1937, 16. Hon. Chas. A. Dunning . budget speech, Feb. 25, 1937, 7. 3 See "Curb on Speculation is Heartily Endorsed by Chartered Banks," Financial Post, March 6, 1937. • Bank of Canada, Annual Report, Feb. 22, 1938, I 1-12. 1

2

108

BANK OF CANADA OPERATIONS AND POLICY

During 1935 many of the short-run variations in government requirements were met by the Bank of Canada, for the Bank's weekly statements show thirteen increases in advances to the federal government. 1 Most of the advances outstanding were of relatively small amounts, under $ 4.5 million, and so did not harm control of cash. In two weeks in August the amount rose to $ 9.3 million but immediately decreased to $ 1.3 million. In the last two weeks of October and first two weeks of November, the amount rose to a high of $ 29.2 million, but since it was the period of high seasonal demand for cash and since the amount was subsequently repaid, it again did not frustrate cash management. Until about August 1935, the Treasury bill procedure had not crystallized, and bills outstanding increased and decreased often, sometimes in large amounts (over $ 20 million) and so followed the requirements of government finance. But after August the now familiar procedure of relatively stable amounts outstanding began, and bills could no longer follow the month-to-month government cash requirements. After this (in 1935), cash was provided, occasionally in relatively large amounts, by Bank advances as already mentioned, and by the proceeds of long-term public issues. Indeed, since the government budget was running a deficit, temporary requirements became permanent requirements, which permitted cash to be supplied by longer-term issues-one each in June, September, October, and November. 2 In 1936 there apparently were no Bank advances to the federal government and indeed these seldom appeared again until late 1951. Government cash was supplied by a gradual increase in total Treasury bills outstanding (since this market was now being developed), five separate increases in all totalling $ 45 million. The budget again showed a deficit, and long-term issues could provide cash in June and September. 3 But there was a distinct difference from 1935, a difference which persisted throughout the rest of the pre-war years; since neither Bank advances nor Treasury bills now followed the ups and downs of government short-term requirements, other means had to be found, and this was done by maintaining much larger government deposits. Thus where the average government deposits were $ 37.6 million in 1935, they were $ 58.2 million in 1936, even 1 For these and subsequent weekly figures see Bank of Canada, Weekly Statement, March 1935 to Dec. 1939. 2 See Hon. Chas. A. Dunning, "Loan Flotations 1935-1936," budget speech, May 1, 1936, 19. 3 See Hon. Chas. A. Dunning, budget speech, Feb. 25, 1937, 22.

THE BANK'S PRE-WAR OPERATIONS

though expenditures were running no higher in the latter than in the former year.' (This is also a practice which persisted for a long time, for although the sale of deposit certificates and other short-term securities to the chartered banks occasionally provided temporary assistance, the month-to-month requirements were usually taken care of by the higher average level of government deposits. In 1951, 1952, and 1953, however, when deposits fell to a low level, advances from the Bank of Canada again appeared.) The general pattern did not change in 1937, 1938, and 1939. Bank of Canada advances to the government were insignificant (only three in 1937 for small amounts and short periods), and Treasury bills outstanding remained virtually constant, with only a $ 5 million increase over the period, and a slight variation in amount outstanding in mid 1937. Budget deficits were the rule and long issues provided cash in June 1938, and February, May, and October of 1939. 2 Because Treasury bills outstanding remained more constant than in 1936, and Bank advances were exceedingly rare, short-run variations in cash requirements had to be absorbed even more than formerly by government deposits. It is, therefore, not surprising that the average government deposits were considerably higher in 1937, 1938, and 1939 than they had been in 1936 (even relative to total government expenditures). In September 1939, cash was required to meet a maturing issue and other current expenditures as war began. A direct sale of $ 200 million two-year notes to the banks was arranged, a method which was much used in connection with deposit certificates and other short-term issues in later years. The Bank also appears to have begun the practice of accumulating issues nearing maturity. On June 1, 1938, and between May 10 and May 17, 1939, the Bank lost $ 9.4 and $ 24.9 million respectively, offsetting it with purchases of longs. Those dates coincide with dates when redemptions took place, and the variations are large for those years, pointing to a loss through redemption. Thus, mainly because of the larger amounts of government funds on deposit, the acquisition by the government of cash through selling long-term issues (since deficits existed), and the extraordinary sale of short-term issues to the banks, the Bank was able to maintain the liquidity of Treasury bills, to discontinue short-term advances 1 Cf. Appendix B and government expenditures as recorded in the Appendixes to the budgets. 2 See Hon. Chas. A. Dunning, budget speech, April 25, 1939, 171, and Hon. J. L. Ralston, "Loan Flotations 1939-40," budg~t speech, June 24, 1940, 22.

I IO

BANK OF CANADA OPERATIONS AND POLICY

to the government, and to retain control over the liquidity position of the chartered banks even when underwriting Treasury bills. Direct assistance to the government did not frustrate cash management. It has been argued elsewhere that the Bank's policy of permanent cash expansion was fitted primarily to the needs of government finance. 1 Subsequently it was pointed out, quite rightly, that the evidence for this was not conclusive, and further that it is impossible to say whether it was intended as a policy of low interest rates to relieve the depression, or was intended for the benefit of government.2 But the essential point, it seems to this writer, is that it was a period when no difference existed between the two objectives. Depression requires low interest rates, and it also requires extraordinary government spending (if not on the basis of sophisticated theories of compensatory spending, then on the basis of the minimum demands of social conscience). That the Bank could, and did, serve both these purposes without contradiction in objectives seems to be the important point, and was owing to the economic circumstances of the period. The Bank performed relatively satisfactorily all the functions required of it in this pre-war period. There were a number of reasons for this. First, it was a period requiring expansion of cash, which for many reasons is less difficult technically and politically than stability or contraction of cash. Second, an increase in foreign exchange reserves was desirable and this was made easy by the strength of the Canadian dollar and because offsetting operations were obviated by the concomitant policy of cash expansion. Third, no difficult and drastic action was required of the Bank because the exchanges did not deteriorate quickly (except when war came) and the bond market remained generally strong. When bonds weakened temporarily they fortunately did so mainly in autumn when the demand for cash increased in any case. Fourth, it was a period when the objectives of fiscal policy, debt management, and monetary management were in complete harmony; the generally depressed conditions forced deficit spending, and required low interest rates and abundant bank cash. Fifth, the Bank dared to be novel in technique; it developed and underwrote the Treasury bill market, it issued lists of its bids and offers to the government bond market, and it began to exercise its persuasive influence. 1 See Courtland Elliott, "Bank Cash," Canadian Journal of Economics and Political Science, IV (Aug. 1938), 454. 2 See Plumptre, Central Banking in the Dominions, 237-8.

THE BANK'S PRE-WAR OPERATIONS

III

Only in the degree of some of its policies could important doubt exist, and even here the inconclusiveness of the criticism indicates the extent to which the Bank attained the objectives required of it. Finally, it seems that the Bank recognized its objectives, forged appropriate tools, developed suitable techniques, and proceeded with what may have been judicious caution.

CHAPTER V

The Bank and the War THE w AR transformed the Bank from a precocious youth to a maturing adult. It was no longer sufficient to offset the modest demands for seasonal cash, to watch the generally strong financial markets, and to pursue easy money according to a policy of learned caution. Overnight a preconceived plan of comprehensive exchange control had to become a living fact, a plan originating at the Bank and affecting all Canada. Also, not only had potentially greater shocks to the bond market to be avoided or minimized but unprecedented government finance demanded stable and high bond prices. Cash management became a much larger task as war finance and foreign aid produced their periodic unsettling effects. The success of monetary policy was soon to be measured not by its assistance in creating employment, but rather by its contribution to channelling real resources to the war effort and to providing residual government finance. War finance was a huge undertaking and the Bank, both directly and indirectly, soon became a dominant agent for assuring its success. It ceased to be a useful adjunct and became a vital necessity. The Bank's important indirect contributions cannot be discussed in detail here for that would lead us far into the fields of foreign exchange control and wartime debt management because of the Bank's de facto management of the Foreign Exchange Control Board and its activities in the National War Finance Committee. 1 But the monetary implications of both foreign exchange controls and war 1 For operations of the Foreign Exchange Control Board see especially Allan 0 . Gibbons, "Foreign Exchange Control in Canada, 1939-51," Canadian Journal of Economics and Political Science, XIX (Feb. 1953), 35-54. Also Louis Rasminsky, "Foreign Exchange Control : Purposes and Methods," in J. F. Parkinson, ed., Canadian War Economics (Toronto, 1941), 89, and A. F. W. Plumptre, Mobilizing Canada's Resources for War (Toronto, 1941), 183-97. For the organization and operation of the National War Finance Committee, as well as for a complete statistical record of the war loan drives see Canada, National War Finance Committee, Statistics and Information on Dominion Government Public Borrowing Operations from September 1939 to December 1945 (Ottawa, Dec. 1945).

THE BANK AND THE WAR

113

loans must, of course, be carefully noted. Our task is to inquire into the nature and technique of wartime cash management, stabilization of the financial markets, and aid to government finance. The Bank's preparation for meeting problems inherent in the transition from war to peace must also be outlined. BANK POLICY AND BANK CASH

Because of the importance of maintaining stable bond prices, providing residual government finance, and controlling as much as possible the liquidity of the general public, bank cash required delicate management. Factors tending to reduce cash or increase the demand for cash had to be carefully controlled in order to prevent the banks from having to dump securities, for it was important to avoid even a breath of a suggestion that interest rates were going to rise. On the other hand, the banks could not be permitted to become aggressive buyers of government securities if monetary expansion was to be kept to a minimum. Seasonal Cash

Seasonal cash demands in the real sense (arising from increased commercial loans and note circulation) were relatively much less important during the war than before the war. The index of seasonal note circulation (Figure 3 above) levelled out significantly as a result of the persistent secular increase throughout each of the war years. It is true that the seasonal movement of bank cash during the war (Figure 1 above) appears to have been almost as great, relatively speaking, in the autumn period, and decidedly greater in the spring, than in equivalent seasonal periods before the war. But this is a delusion. In 1940 and 1941 there was practically no seasonal "hump" in bank deposits, as Figure 4 below shows, and almost the entire seasonal increase in cash during those years was used to build up year-end cash ratios. This window dressing continued to constitute an important proportion of autumn seasonal cash until the end of 1943; after that cash ratios were so high throughout the year that it became unnecessary. 1 1 Thus the daily average cash ratio for years 1940 to 1945 inclusive were as follows: 10.6, 10.5, 10.5, 10.9, 11.8, 11.4. In 1944 and 1945, cash was actually released in the autumn by decreased cash ratios because the summer ratios were so high. The method for analysing the seasonal influences is the same here as in the preceding chapter, so the detailed tables are not included again.

114

BANK OF CANADA OPERATIONS AND POLICY

The pronounced peaks in deposits began to appear in the spring of 1942 and recurred twice yearly, once in the spring and once in the autumn. They were caused almost entirely by purchases of deposit certificates by the chartered banks and by loans made in connection with victory bond sales drives, and are therefore explained by war finance rather than by seasonal influences. 1 The decreased seasonal influence is also suggested by the over-all trend in chartered bank

6000

6000

5000

~000

4000

JOOO

2000

19)9

19 2

19 J

19 5

FIG. 4. Canadian deposits at the chartered banks, chartered bank Canadian loans and holdings of Government of Canada and provincial securities (millions of dollars; for statistics and sources see Appendix B).

loans during the war, for these increased only by about 21 per cent, while total chartered bank assets increased by 88 per cent.2 In general the decreased relative importance of commercial bank loans and the damped seasonal swing in note circulation reduced even further the importance of demands for seasonal cash. Such minor seasonal factors as remained were entirely inundated by war finance from 1942 to 1945, and by window dressing from 1940 to 1943. 1 If one subtracts the chartered bank loans used for purchasing victory bonds from the total chartered bank loans, the sharp fluctuations in loans shown in Figure 4 disappear. Statistics of these loans for the month in which each drive was officially terminated are given in National War Finance Committee,Statistics and Information, 16. 2 Based on the increase from 1939 to 1945 in the yearly average of month-end figures, given in Bank of Canada, Statistical Summary, 1946 Supplement, 9.

THE BANK AND THE WAR

115

Temporary Influences on Cash

War finance in its many forms made temporary influences on bank cash of great importance, infinitely more so than before the war. Sales of securities to the banks and the Bank of Canada, increases in bank loans in connection with victory bond purchases, temporary accumulation of foreign exchange by the Bank of Canada and redemption operations all required accommodating or offsetting operations by the Bank. Before the pronounced peaks in deposits began in early 1942, there were two instances of the government selling securities directly to the chartered banks. In October 1939 an issue of $ 200 million of 2 per cent two-year bonds was sold directly to them; the Bank supplied the required cash by buying short-term securities, some of which it was able to sell after November. In January 1941 the chartered banks bought a $ 250 million issue from the government. Since the banks' cash ratio was already high owing to the previous seasonal increase, the Bank did not supply cash at this time, and thus effectively reduced the chartered banks' cash ratio to a normal level. Very important was the accommodation of the increase in the demand for cash arising out of sales of deposit certificates to the banks and expansion of loans for bond purchases, which as noted above produced biannual peaks in bank deposits. First it is necessary to examine more closely the nature of these temporary humps in the trend of deposits. The fluctuations in deposits shown in Figure 4 are reproduced in real magnitudes in Table 10. That is, this table shows the absolute increase and decrease of each hump in the trend of deposits, and it also shows the factors mainly responsible for the fluctuation, as well as the accommodating cash changes and the quantitative equivalents of cash ratio changes. It is clear from this table that increased chartered bank loans and holdings of securities were predominantly responsible for the increase in deposits, but that the following decrease in deposits (always much less than the previous increase) was accounted for almost entirely by a decrease in loans alone. Figure 4 shows further that the increase in chartered bank security holdings preceded by two or three months the periodic increase in loans. This was because between victory loan drives the government was financed substantially by bank credit-deposit certificates mainly but also some other short-term notes. Then, when the victory loan drive began, the banks extended loans to the public for bond purchases and the victory loan proceeds enabled

TABLE 10 EXTENT OF AND MAIN CAUSES FOR FLUCTUATION IN WARTIME DEPOSITS AT THE CHARTERED BANKS; EQUIVALENT MOVEMENTS IN BANK CASH; AND CASH TAKEN OR RELEASED BY CHANGES IN BANK CASH

RAnosa

(millions of dollars) Periods of deposit fluctuations (month-ends)

Jan. 1942 to May 1942

June 1942 to Jan. 1943

Jan. March June Nov. March May Nov. Jan.

Aug. 1944 March 1945 Feb. 1944 Aug. 1943 Jan. 1943 to to to to to Aug. 1944 March 1945 Aug. 1945 Feb. 1944 July 1943 Jan. May Aug. Nov. Feb. June Aug. Nov. March May May July Nov. Feb. June Aug. Nov. March May Aug.

Changes in Canadian deposits

210 -196

558

-238

655

-150

487

-247

Changes in govt. sec. holdings of banks

- 31 - 26

393

- 13

405

- 59

266

23

Changes in Canadian bank loans

175 - 90

100

-136

128

- 27

146

-247

Changes in bank cash

53 - 62

69

- 48

94

- 35

61

- 11

Cash taken or released by cash ratio changes

34 - 41

11

- 23

30

- 18

10

Aug. 1945 to March 1946 Aug. Nov. Nov. March

644 -168

556 -274

656

-379

789 -218

11

229 - 18

268

- 57

157

120 -112

293 -184

252

-291

478 -282

42

17 - 42

78

- 41

323

41

17 - 32

62 - 48 - 13

9

127

65

6

0 - 23

30

a Computed by the writer from statistics in Bank of Canada, Statistical Summary, 1946 Supplement, 16-19, and 1950 Supplement, 8, 9. Minus sign indicates a decrease, no sign an increase.

THE BANK AND THE WAR

117

the government to redeem a fractional portion of the securities previously sold to the banks. 1 To have managed cash so that the banks would have sold securities in the market, in an effort to damp down monetary expansion further, would have meant the termination of bond price stability. Increases in government security holdings of the chartered banks and not increases in chartered bank loans were responsible for the secular increase in bank deposits during the war. These periodic demands of war finance required a concomitant movement of bank cash. The extent to which this demand for cash was satisfied by Bank of Canada operations and by movements in the cash ratios is best seen with reference to Table 10. It shows that, during the upswing period of each of the four humps from January 1942 to February 1944, no part at all of the deposits was automatically accommodated by reduced cash ratios. Indeed, each period saw a definite increase in cash ratios during the upswing and usually a decrease during the downswing. It seems probable that the banks were individually protecting themselves from a sudden adverse movement in their cash positions during these periods of substantial deposit movements. After early 1944, however, the situation was reversed, mainly because the banks began to maintain a rather higher cash ratio throughout the year. 2 From then on almost every periodic increase in deposits saw a decrease in the cash ratio, and almost every periodic decrease in deposits saw an increase in the cash ratio. Thus, whereas before 1943 the movement of the cash ratios augmented the task of the Bank of Canada, the movement after that date actually decreased the required size of offsetting operations. It is tempting to conclude that the latter procedure should have been adopted sooner, but such a conclusion would, for several reasons, seem hasty. First, since cash management over these humps actually entailed only purchases and not sales of securities by the Bank of Canada (as will be seen later), it was probably not a difficult task. Second, and more important, the latter system encouraged greater instability in the cash ratios which, although not very harmful under the artificial conditions of wartime control, could prove a serious problem for monetary management in the future. 3 1 For statistics of deposit certificates in war finance see E. P. Neufeld, Bank of Canada Operations, 1935-1954 (Toronto, 1955), Appendix E. 2 For further discussion of this change in cash ratios see below, p. 135 3 The writer is not suggesting that these higher reserve ratios were adopted to make Bank offsetting easier, but merely to show that they had that effect. Later it will be seen that they probably resulted from the central bank's easy money policy.

TABLE 11 EFFECT ON BANK CASH OF CHANGES IN THE BANK OF CANADA'S ASSETS AND LIABILITIES DURING WARTIME PERIODS OF INCREASES AND DECREASES IN DEPOSITS AT THE CHARTERED BANKS 0

(millions of dollars)

Month-ends

Jan. to March

+

Short-term govt. secs

140.9

Long-term govt. secs.

5.6

Net foreign curr. assets

22.8

Advances Active note circulation

March to May

-

Other items (net) Bank cash net change

+

+

-

286.9

12.6

1.0

12.6

17.3

6.2

9.6

52.8

62.2

-

108.6

-

58.1

25.4

+

Aug. to Nov.

-

6.7

30.6 11.3

12.9 47.5

11.1

0.9 47.9

46.3

38.9

32.0

1.6

6.4 21.0

9.2

2.1

94.1

35.1

-

125.9

50.5

27.1

Nov. to Feb.

+

7.9 42.2 26.3 0.5

9.8

13.4

+

1.7

2.3 23.6

68.5

+

11.5

4 Aug. 1943 to Feb. 1944

May to July

70.7

0.2 2.3

22.1

+

Jan. to May

27.6

0.4

25.9

18.5

-

3. Jan. 1943 to July 1943

Nov. to Jan.

14.2 117.9 88.9

1.0

June to Nov.

44.2

Govt. of Canada deposits 72.2 Other deposits

2 June 1942 to Jan. 1943

l Jan. 1942 to May 1942

Period

0.5 43.6 26.0

5.8

15.4

1.7

15.0 60.8

10.5

TABLE 11 (continued)

Feb. to June

Month-ends

+

June to Aug.

-

+

Aug. to Nov.

-

+

Short-term govt. secs.

14.3

45.9

19.2

Long-term govt. secs.

67.2

17.7

35.1

Net foreign curr. assets

-

0.5

Advances Active note circulation

Other deposits

Bank cash net change

48.5

1.5 35.4

10.2

36.8

-

67.0

27.6

62.2

12.3

13.9

32.3

41.2

-

+

Nov. to March

-

20:3

45.4 69.5

5.0

5.0 5.0

2.5

9.9 12.3

7.3 17.5

25.2 77.5

40.4

+

128.1

136.6

1.0 126.5

14.9

19.8

11.9

+

Aug. to Nov.

50.5

75.2

1.5

9.5

16.8

141.8

1.5

7.9

41.5

-

1.5

43.1

41.0

+

1.6

45.7

3.9

-

May to Aug.

1.6

31.9

26.4

+

March to May

57.9

-

48.7

0.5 16.0

56.0

Govt. of Canada depo its

Other items (net)

-

Nov. to March

-

8 Aug. 1945 to March 1946

7 March 1945 to Aug. 1945

6 Aug. 1944 to March 1945

5 Feb. 1944 to Aug. 1944

Period

61.7 9.5

6.2 64.1

6.3

a Computed from statistics in Bank of Canada, Statistical Summary, 1946 and 1950 Supplements. During the first half of each period deposits at the chartered banks were increasing, and during the second half they were decreasing. Statistics under a minus sign indicate a decrease in bank cash. Those under a plus sign indicate an increase in bank cash.

I 20

BANK OF CANADA OPERATIONS AND POLICY

In spite of the accommodating movement of cash ratios in the later war period the Bank had to provide some cash in each of the upswing phases outlined in Table 10. Table 11 helps to determine the means by which it accomplished this, for it shows the variation in the Bank's assets and liabilities during the upswing and downswing phase of each of the wartime fluctuations in deposits. But it gives only part of the story, and supplementary information is needed to provide a complete explanation. In all the periods, the Bank operated in both the short-term market and the long-term market to provide cash in the upswing phase. This is seen correctly on Table 11 for periods I, 3, 5, 6, and 8, but it is also true for the other periods. Thus in period 2 the table indicates that the Bank increased its holdings of shorts by $ 286.9 million and decreased its holdings of longs by $ 117.9 million. But after allowing for an accounting switch from longs to shorts of $ 100 million on October 15, 1942, and of$ 93 million on September 1, 1942, the Bank actually purchased about $ 94 million short-term securities and $ 74 million longs. 1 In period 4 the table shows that the Bank's holdings of shorts decreased by $ 1. 7 million and its holdings of longs increased by$ 125.9 million . But on October 15, 1943, the Bank lost $ 72 million shorts by converting them into the longterm bonds of the fifth victory loan issue.2 After making adjustments for this conversion it is seen that the Bank actually bought about $ 70 million shorts and about $ 54 million longs from the market. The figures for period 7 must be adjusted. Table 11 shows an increase of $ 141.8 million shorts and a decrease of $ 75.2 million longs, but it is clear that the Bank actually bought both shorts and longs in the market after allowing for an accounting switch from longs to shorts of about $ 100 million on May I, 1945.3 Thus it holds true that the Bank provided periodic cash during the whole of the war period by operations in both the short- and the long-term markets. This, as will be noted again, is a most interesting change from the pre-war period, when cash of roughly this type was pro' For original sale of these securities to the Bank of Canada see Hon. J. L. Ilsley, budget speeches, June 23, 1942, 72, and March 2, 1943, 64, and the Financial Post, Oct. 3, 1942, 4. That the same quantities of these issues originally sold to the Bank were still held by the Bank as they became less than two years to maturity is suggested by the Bank's statements for Aug. 31 and Sept. 2, 1942, and fo1 Oct. 14 and 21, 1942. 2 See National War Finance Committee, Statistics and and Information, 21. See also Bank of Canada, Weekly Statement, Oct. 13 and 20, 1943. 3 On May I, I 945, a large short-term issue became less than two years to maturity and the Bank apparently held about $ JOO million of these. See Bank of Canada statements for April 30 and May 2, 1945.

THE BANK AND THE WAR

121

vided primarily by the automatic mechanism of the artificial shortterm Treasury bill market. While cash for the upswing phase of each period was for the most part provided by security purchases, the decrease in cash for the succeeding downswing phase was never brought about by equivalent sales of securities by the Bank; the persistent secular increase in note circulation was so large that in most periods the decrease in cash was achieved mainly by not offsetting completely this drain on cash. The restrictive effect of increased note circulation was supplemented in certain of the downswing phases by other, for the most part uncontrollable, factors. In periods 2, 6, and 8 an increase in "Other deposits" and in period I a decrease in sterling holdings helped to decrease cash. So large was the tendency for cash to drain away that the Bank had often to offset it even in phases when deposits were decreasing. It did this mainly by purchasing either short- or long-term securities or both. Before the war the Bank did not provide periodic cash by operations in the long-term securities market, for its transactions in that market were usually small and aimed primarily at keeping in touch with the movements of the market. What made this change possible during the war? First of all the government bond market expanded tremendously, making it still more suitable for central bank operations. But more important, perhaps, whereas before the war the Bank had to sell securities during the downswing phase of the seasonal periods, it did not have to do this during the downswing phases of the wartime fluctuations in deposits. As noted above, it merely had to allow note circulation to have its effect on bank cash, and not even all of its effect. In short, the Bank had to buy securities most of the time and therefore it might as well buy longs as shorts. Indeed, such buying was necessary if the Bank wished to remain an effective force in all sections of the bond market. Also, since increased holdings of longs did not hinder central banking operations, the advantage of greater profits from that source was not to be ignored. The accommodation of these fluctuations in deposits was only one of a number of tasks confronting the cash manager in the Bank of Canada. Another important task was to offset the effects of accumulation and decumulation of foreign exchange by the Bank. Up to the end of 1940, this was mainly in connection with the transfer of Bank of Canada gold and foreign exchange holdings to the Foreign Exchange Control Board and the government's repatriation

I 22

BANK OF CANADA OPERATIONS AND POLICY

of securities from the United Kingdom. Only after that did shortterm Bank of Canada financing, through temporary accumulation of sterling, become important. In May 1940 the Bank sold $ 27.7 million foreign exchange and $ 225.8 million gold to the F.E.C.B.; the sale was settled and the effect on bank cash offset by a direct sale of securities to the Bank of Canada by the government. 1 The Bank accumulated $ 80.3 million foreign exchange from August 30 to December 4, 1940, as the government was repatriating securities, and the effect on bank cash was offset to the extent considered necessary by an increase of $ 44.3 million in government deposits at the Bank of Canada. From December 4 to December 18, 1940, the Bank's exchange holdings dropped by $ 55.7 million, and the effect was entirely offset by a $ 59.8 million reduction in government deposits at the Bank. Although the F.E.C.B. was permanent custodian of exchange reserves (as government manager of the Exchange Fund Account), it was necessary at times for the Bank to accumulate foreign exchange temporarily when government funds were low.2 It was in fact a form of short-term government finance. Thus, as the Canadian government sanctioned foreign aid to the United Kingdom, Canadian dollars had to be made available to the F.E.C.B. These dollars were received from the original resources of the Exchange Fund Account which amounted to $ 83.9 million in September 1939, and, much more important, from advances extended to it by the Minister of Finance. 3 This would not, in itself, require offsetting by the Bank, for the transfer of deposits from the government to the F.E.C.B., to the United Kingdom importer, and finally to the Canadian exporter might well take place without on balance changing Bank of Canada accounts and so without disturbing bank cash. It is true that the F.E.C.B. invested its surplus cash in Treasury bills which it sold to the Bank when it required funds, but since this was apparently always a marginal amount with the large accumulations taking place 1 Foreign exchange was sold to the F .E.C.B. under Foreign Exchange Acquisition Order, P.C. 1735, April 30, 1940; authorization for the sale of gold to the F.E.C.B., for the relevant purchase of securities by the Bank of Canada, and for temporary suspension of the Bank's gold reserve requirements was provided under The Exchange Fund Order, P.C. 1734, April 30, 1940. 2 The Exchange Fund Account, it must be remembered, was (and is) kept quite separate from the accounts of the Bank of Canada. Therefore, when the Bank's foreign exchange holdings increased it was providing short-term finance to the Account, or to the F.E.C.B. which administrated the Account. 3 For statistics of original Exchange Fund resources, and advances by the government to the Fund, see F.E.C.B., Report to the Minister of Finance, March 1946, 37-8.

THE BANK AND THE WAR

123

in another manner, it also did not require any appreciable offsetting by the Bank. Offsetting action was necessary because between victory loans the government did not have sufficient cash to advance to the F.E.C.B. and so the Bank of Canada was required to purchase foreign exchange temporarily from the F.E.C.B. to make Canadian dollars available to the latter. This method of financing began in early 1941 and lasted throughout most of the war period. From February 12 to June 25, 1941, the Bank purchased $ 258.4 million of foreign exchange (actually all these exchange purchases were primarily sterling). During February of this period purchases were offset by increased government deposits at the Bank, for the government's cash resources were still sufficient for this purpose. But during March and April these cash resources dwindled and the Bank then had to offset its exchange purchases by selling securities, mostly shorts. In May and June the proceeds of the first victory loan became available and it was again possible to offset the Bank's exchange purchases by higher government deposits at the Bank. 1 In this way cash ratios were kept under control and there seems to be no evidence, as has been suggested, that the securities market was insufficiently broad to absorb the required securities. 2 Between June 25 and July 2, 1941, the F.E.C.B. repurchased about $ 294.3 million of this exchange, which was offset by a decrease of government deposits at the Bank amounting to $ 197 .6 million and by a net purchase of $ 104.6 million securities by the Bank (all shorts). From August 13 to October 1, 1941, the Bank accumulated $ 108.8 million foreign exchange. This was offset by switching $ 101.8 million government deposits from the chartered banks to the Bank of Canada, even though it was a period when total government deposits were decreasing rapidly. 3 When about $ 93.4 million of this was repurchased from October 1 to October 8, 1941, it was offset by a decrease in government deposits of $ 103.5 million. The very large increase of foreign exchange holdings from October 8, 1941, to March 25, 1942, was offset until about February 25 by a 1 For these and further statistics of Bank of Canada deposit liabilities and foreign exchange and security assets, see the Bank's monthly and weekly statements for the relevant period. 2 See Plumptre, Mobilizing Canada's Resources/or War, 196. Both the daily average and month-end cash ratios for the month when the Bank was offsetting exchange purchases by security sales show no important increase. Most important during these same months (March and April 1941), the Bank accumulated $ 84.5 million foreign exchange and sold $ 89.1 million securities. 3 See Appendix B.

124

BANK OF CANADA OPERATIONS AND POLICY

similarly large sale of securities (well over $ 300 million, mostly shorts), and then when victory loan funds came in, by an increase in government deposits at the Bank in March. 1 The sudden decrease of$ 189.1 million in exchange holdings from March 25 to April 1, 1942, was offset entirely by reduced government deposits at the Bank, but the rest of the Bank's exchange holdings had to wait, for the government was short of cash. Gradually, however, the rest, amounting to $ 284.7 million, was repurchased from April 1 to June 10, 1942, and paid for mainly (and thus offset mainly) by a direct sale of securities to the Bank by the government, 2 and partly by cash on hand. Thus the Bank's security holdings increased by $ 177.5 million and government deposits at the Bank decreased by $ 82.2 million. From that time until this offsetting ceased to be a problem (around November 1944), movements of government deposits proved a sufficient means for offsetting the influence on cash of exchange accumulation by the Bank. The main operations were as follows: May 12 to July 14, 1943, exchange holdings increased by $ 64.9 million, and from July 14 to 21, they decreased by $ 65.0 million; from July 31 to October 31, 1943, they increased by $ 68.0 million, and from October 31 to December 31, 1943, they decreased by $ 67.9 million; from June 30 to September 20, 1944, they increased by $ 119.5 million, and from September 20 to September 27, they decreased by $ 71.5 million; from September 27 to November 8, 1944, they increased by $ 32.7 million and from November 8 to November 15, 1944, they decreased by $ 80.3 million. As already stated, these movements were in each case closely offset by concomitant movements in government deposits at the Bank of Canada. The foregoing has made it clear that, whenever possible, the Bank (in co-operation with the Department of Finance) offset its foreign exchange operations by varying the government's deposits with it. This proved to be a most useful technique, as it already had in a minor way during the pre-war period. When this type of offsetting was not possible, the Bank operated primarily in the short-term 1 This increase in government deposits not only offset further exchange increases but also an increase of $ 175 million shorts from March 4 to March 11. The size of this security purchase in such a short period, and also perhaps the size of the original sale of securities, suggests some kind of special arrangement with members of the market, but nothing to this effect has come to light. 2 The Bank actually bought $ 192.8 million securities on June 2, 1944, from the government to enable the repurchase of sterling by the F.E.C.B. See Bank of Canada, Annual Report, Feb. 9, 1943, 6-7.

THE BANK AND THE WAR

125

market to effect the appropriate offset. This is of some significance for it indicates that when offsetting action required both the sale and subsequently the purchase of securities in relatively short periods of time, the Bank did not use the long-term securities market but confined itself to shorts. Previously it was shown that the Bank provided temporary cash through longs only when the cash could subsequently be recouped by other means, that is, when it did not subsequently have to sell the newly acquired longs. This throws considerable light on the place of long-term security operations in Canadian central banking at that time. The history of the period also indicates that the short-term market was quite capable of absorbing large quantities of securities in relatively short periods. The sale of securities to the Bank of Canada for cash (as distinct from conversion operations) was not allowed to disturb bank cash. On May l, 1940, $ 250 million in one-year 1 per cent notes and$ 75 million in Treasury bills were sold to the Bank directly, but the proceeds were used largely to purchase gold and foreign exchange held by the Bank. The balance of about $ 75 million was offset by increased note circulation and increased government deposits at the Bank, and only a small increase in cash resulted. On June 2, 1942, $ 100 million of 2-year 1½percent notes dated April 15, 1942, and another issue of$ 92.8 million of 21/ 2-year 11/ 2per cent bonds (leftovers of a second victory loan issue) were sold to the Bank, but since they were in payment of sterling temporarily held by the Bank they did not affect bank cash. 1 No further direct sales to the Bank for cash took place during the war. The Bank of Canada advanced $ 25 million to the government on September 23, 1940, $ 3 million on September 27, and$ 4 million on September 30; but the total of $ 32 million was repaid on October 1, 1940, so that the effect of these advances on bank cash was purely transitory. 2 The disruption to bank cash of redemption of securities held by the Bank of Canada was insignificant, mainly because the maturing securities were inevitably converted into new issues. This was the case with the three issues which had originally been sold to the Bank for cash (as mentioned above), but it was also true of maturing long-term securities held by the Bank and not always sold originally 1 That these particular issues were sold to the Bank was made clear in an answer by the Minister of Finance to a question put by another member of parliament. See House of Commons, Official Report of Debates, 1943, II, 1050-1. 2 See House of Commons, Standing Committee on Banking and Commerce, Minutes of Proceedings and Evidence, March 30, 1954, Appendix B, 905.

I 26

BANK OF CANADA OPERATIONS AND POLICY

directly to the Bank. On March 1, 1940, the Bank's loss of securities through the redemption of a 5-year issue was offset by a direct sale to the Bank of $ 40 million of 5-year bonds. 1 On June 1, 1940, a similar sale of the same security amounting to $ 24 million offset the redemption of some 4-year bonds held by the Bank. A $ 200 million issue of 2-year bonds that had been sold originally to the chartered banks matured on October 16, 1941. By this date the Bank of Canada apparently held about $ I 00 million of these and the effect on bank cash of their redemption was completely offset by the Bank taking up $ 100.3 million of 11/z per cent 3-year bonds. A direct sale of $ 56 million of 2-year bonds to the Bank on July 2, 1943, offset the redemption of a similar quantity of securities now held by the Bank but originally sold to the chartered banks. A long term issue matured, and another was called on October 15, 1943; these were made convertible into the fifth victory loan bonds and the Bank did convert $ 72 million of them, offsetting all its apparent loss through redemption. Similarily, on October 15, 1944, a longterm issue matured and another was called, and the Bank converted $ 42.5 million of them into the seventh victory loan bonds. And lastly, on July 2, 1945, a large issue of 2-year 1t per cent notes matured. The Bank's loss of this issue was completely offset by a sale of $ 70 million of Treasury bills to it by the goverment, 2 thus combining an officially desired increase in total Treasury bills outstanding with an offset to the cash effects of the redemption. This co-operation between the government and the Bank, the former making securities available (appropriate in timing and amount) and the latter accepting them, ensured that redemptions would not cause large fluctuations in bank cash. The remaining important potential disruptions to bank cash were the movements of government funds and bond stabilization operations. It was established in the preceding chapter that the potential effects on cash of the former were forestalled by permitting the movement of funds from the private to the public sector to take place largely within the chartered banking system. This was again the case throughout the war period, as can readily be seen by compar1 All these statistics of bond issues, redemptions, and conversions were obtained from the statistical appendices to the various budget speeches and from National War Finance Committee, Statistics and Information, while the amount of securities held by the Bank at maturity was sometimes estimated with the aid of the relevant monthly and weekly Bank of Canada statements. 2 See Department of Finance, Press Release, Ottawa, July 3, 1945. The Treasury bills were sold to the Bank on the basis of the last average tender rate.

THE BANK AND THE WAR

127

ing the trend of government deposits at the chartered banks with those at the Bank of Canada, and it was all the more important because of the vastly expanded size of such transfers. Bond stabilization caused no noticeable expansion of bank cash over most of the war period because it was achieved without large participation in the market for such purposes.' But it will be seen later that from 1944 until the end of the war the Bank seems to have underwritten lower bond yields, in the process of which large monetary expansion occurred. Since it apparently intended to establish these lower rates primarily by its own and chartered bank purchases of securities, the question of offsetting the increase in cash resulting from its purchases does not arise. But the question of the appropriateness of such a policy does, and this is taken up later. 2 The Bank did not have to act as lender of last resort on any large scale during the war. The chartered banks did not show a Bank of Canada advance on their balance sheets during the whole of the war, and up to mid 1944 (no further information being available) there was only one instance (May 1943) when a chartered bank borrowed and repaid the advance between balance sheet dates. 3 The Bank made numerous small advances to the two Quebec savings banks, almost always subsequent to the various victory loan drives at which time these banks probably experienced greater variation in their cash reserves than they were ordinarily accustomed to. These advances were relatively small, seldom exceeding $ 3.5 million outstanding at any one time, and usually extended over several or more months. 4 They were no hindrance to cash management. During the war then, all the important temporary influences on bank cash were successfully offset so that bank cash remained relatively undisturbed. The success of government deposit variation as a control technique and the remarkable breadth of the short-term securities market were of special importance for they made it possible for the Bank to offset successfully the large variations in its holdings of sterling. Temporary cash was frequently supplied by the long-term market (quite different from the pre-war period), but only when the subsequent decrease in bank cash could be achieved by means other than selling longs. If both buying and selling was required, then shorts were used. Direct sales of securities to the Bank for cash did not expand bank cash unduly and similar sales served to offset the possible effects on bank cash of redemption operations. Lender-ofSee below, pp. 141-4. 2 See below, pp. 139-41. 3 See reference above, p. 66, n. I. • See reference in ibid., and Bank of Canada, Weekly Statements, 1939-45.

1

128

BANK OF CANADA OPERATIONS AND POLICY

last-resort facilities were almost never required by the chartered banks, and in only small amounts and for special wartime reasons by the Quebec savings banks. Bank Policy through Permanent Cash Management

During the period when the influence of war was dominant the Bank provided permanent cash and offset influences on cash entirely by security purchases. As shown in Table 12, the Bank bought $ 1647.4 million in securities which offset the increase in Bank of TABLE 12 EFFECT ON BANK CASH OF CHANGES IN THE BANK OF CANADA'S STATEMENT OF ASSETS AND LIABILITIES FROM SEPTEMBER

30, 1939,

TO MARCH

31, 1946°

(millions of dollars) Decreasing bank cash Govt. of Canada & prov. short securities

1,141.1

Govt. of Canada & prov. Jong securities

496.3

Industrial Development Bank stock Net foreign currency assets

Increasing bank cash

10.0 270.I

Bank of Canada advances

1.0

Active note circulation

819.0

Govt. of Canada deposits

111.0 77.7

Other deposits Other assets minus other liabilities

.9 Total Deduct

Net increase in chartered bank cash

1,279.7

1,647.4 1,279.7 367.7

a Computed by the writer from statistics in Bank of Canada, Statistical Summary, 1946 Supplement, 6, 7, and 1950 Supplement, 8, 9. The period to March 31, 1946, is covered so as to include the permanent but not the transitory influences of the ninth victory loan of late 1945. The element of error, through seasonal influences, by beginning and ending on different months is relatively insignificant because of the magnitude of the secular change over the period and the smallness of the seasonal influence itself.

THE BANK AND THE WAR

129

Canada note circulation of $ 819.0 million,1 the sale of gold and foreign exchange of $ 270.1 million, the increase in government and other deposits at the Bank, 2 and movements in certain other minor accounts. It also increased bank cash by a net amount of $ 367.7 million or by 133.6 per cent. In the pre-war period much of the cash had been provided by purchases of gold and foreign exchange. Most, but not all, of the net increase in cash was used by the chartered banks to support their deposit increases amounting to $ 3,186 million. 3 This increase resulted mainly from increased holdings of government securities, for increases in loans and "other" securities were small. The details are given in Table 13 below. Of the TABLE 13 CHANGE IN CHARTERED BANK HOLDINGS OF CANADIAN SECURITIES

30, 1939, TO (millions of dollars)

AND LOANS FROM SEPTEMBER

Govt. of Canada and provincial short securities b Govt. of Canada and provincial long securities Other Canadian securities Chartered bank loans

MARCH

+ + + +

31, 1946°

$

%

1,225

275

1,295

177

14

6

259

24

° Computed by the writer from statistics in Bank of Canada, Statistical Summary, 1946 Supplement, 14, 15, and 1950 Supplement, 8, 9. b These total increases in Government of Canada and provincial securities were in reality probably all Government of Canada securities. Thus the statistics available show that from December 31, 1939, to March 31, 1946, the chartered banks' holdings of Government of Canada securities increased by $2,421 million, while their holdings of provincial securities decreased by $75 million. And it is unlikely that the banks bought provincial securities in the three months previous to December 31, 1939, although statistics are not available. (Figures here computed from those in Bank of Canada, Statistical Summary, 1946 Supplement, 14, and Sept. 1952, 145, and in the monthly chartered bank return to the Minister of Finance, for March 31, 1946, in Canada Gazette, May 4, 1946.) 1 Of this $ 819.0 million, $ 743 .0 million represented a net increase in total note circulation and $ 76 million represented the replacement of chartered bank notes in circulation (see above, p. 96, n. 4). 2 The amount of government deposits as at March 31, 1946, was well above the average so that the figure on Table 12 is exaggerated in the sense of representing a secular trend. Throughout the war the average deposits at the Bank remained low, so that the proportion of government deposits at the Bank to total government deposits continued to fall as it had prior to the war. In 1939 they averaged 27.2 per cent while in 1945 they averaged 11. 7 per cent. This trend obviated considerable offsetting by the Bank. 3 See Bank of Canada, Statistical Summary, 1946 Supplement, 14, and 1950 Supplement, 8.

I 30

BANK OF CANADA OPERA TIO NS AND POLICY

$ 367. 7 million increase in bank cash a significant portion was used to raise cash ratios. In early 1944 the banks began to maintain a higher cash ratio, so that whereas the 1939 daily average ratio was 10.4 per cent the 1944-6 ratios were 11.8 per cent, 11.4 per cent, and 11.4 per cent. If the increase is taken as from 10.4 per cent to 11.4 per cent, then of the $ 367.7 million net increase in bank cash, approximately $ 58 million was used by the banks to raise their cash ratios. The significance of this will be discussed later. In order to understand and appreciate the policy which underlay the management of permanent cash during the war it is necessary to recognize immediately certain fundamental facts. A first premise of the central bank's wartime policy was to support, by cash increases, the chartered banks' expanded deposits arising from government borrowing. 1 The government on its part decided early on a pay-as-you-go policy and resolved to borrow only residual amounts from the banking system. Further, it was realized that there would be an initial period of continuing unemployment when monetary expansion would be appropriate, but that when full employment was reached it would no longer be appropriate. This point was reached in about mid 1941. In reality, however, monetary expansion was not thus divided, as will be seen, because of the necessities of war and because of the nature of transitional and post-war policy. Two principal tasks therefore confront us: to determine the nature and effects of permanent cash policy during the period of unemployment and to contrast it briefly with the policy during full employment; to trace the actual periods of monetary expansion, to note its effects in each period, and to rationalize the policy which underlay such cash management. From the end of August 1939 to the end of June 1941, the approximate period during which employment increased and for practical purposes reached its maximum level, chartered bank loans increased by $ 320 million. But of this amount about $ 100 million were advances to the Canadian Wheat Board (government guaranteed) 2 1 To quote the Governor of the Bank of Canada: "The government found it necessary to conduct these operations. The management of the Bank of Canada knowing that, knew also their appropriate policy was to buy sufficient securities so that the cash reserves of the chartered banks would be sufficient to support the operations of the dominion government." (Standing Committee on Banking and Commerce, Minutes May 23 . 1944, 165.) 2 On March 31, 1941, there were $ 101.0 million of these outstanding, mainly in connection with the purchase of 1939 and 1940 wheat. See Hon. J. L. Ilsley, budget speech, April 29, 1941 , appendix, 28. See also A. F. W. Plumptre, Central Banking in the British Dominions (Toronto, 1947), 170.

THE BANK AND THE WAR

131

and $ 159 million were in connection with the first victory loan drive of June 1941. 1 So in this period of remarkably increased economic activity, commercial bank credit did not play a very large part, on balance, in that it increased by only about $ 60 million. When full employment was reached, chartered bank loans tended to decline (see Figure 4). A number of reasons have been given for this decline: the dull state of the financial markets; improved corporate earnings which allowed self-financing; the liquid position of some firms as war began; and extensive government financing of industrial expansion. 2 It is important to note that during this expansionary period, when increased bank loans were not at all frowned upon by the central bank, no great expansion occurred. The forces mentioned above, together with a myriad of direct controls on material and equipment (especially after full employment was reached), were sufficient in themselves to damp down commercial bank credit, and inflationary expansion of such credit was no problem to the central bank throughout the war. Monetary expansion during this period of under-employment was effected largely through the government borrowing directly from the banking system. As noted previously, in October 1939, securities totalling $ 200 million were sold to the banks and $ 250 million more were sold in January 1941. There was no expansion through the banks' buying securities from the market; indeed, Bank of Canada cash management was such that the banks tended, on balance, to sell securities in the market. In general the Bank's policy during this period of less than full employment was to permit expansion of commercial bank loans, and to initiate desired monetary expansion by accommodating government borrowing from the chartered banks, but to limit the full effects of the latter as well as to discourage chartered bank purchases in the securities market by maintaining a judicious control over bank cash and cash ratios. From this time on, however, the multiplied demands of war finance as well as the government's interest rate policy (the latter especially after 1943) caused even greater monetary expansion, with major reliance being placed on direct controls for combating inflation. Paradoxically, therefore, there was less monetary expansion during the period of less than full employment than there was during full employment. See National War Finance Committee, Statistics and Information, 16. See J. Douglas Gibson, "The Banking Figures in Wartime," Canadian Banker, April 1942. Also the Bank of Nova Scotia, One Hundred and Tenth Annual Report, Dec. 31, 1941, 23; Royal Bank of Canada, Proceedings at the Seventy Third Annual Meeting, Jan. 8, 1942, 6; "Bank Investment Grows," Financial Post, March 21, 1942. 1

2

132

BANK OF CANADA OPERATIONS AND POLICY

The actual trend of monetary expansion can be divided into three periods: from September 1939 to December 1940 when government demands for bank credit were relatively small and when the Bank was able to maintain close control over monetary expansion so that the banks actually sold securities in the market; from December 1940 to December 1943 when government demands for bank cash required an easy cash position most of the time but sufficient control was maintained so that the banks bought few securities in the market; and from December 1943 to March 1946, when government demands for bank credit were on balance much smaller than previously, but when the banks bought many securities in the market, in part very probably as a reaction to the Bank's transitional and post-war easy money policy. During the first period, September 30, 1939, to December 31, 1940, there was no need for the government to borrow from the banking system after the $ 200 million issue in October 1939, as this provided the desired monetary stimulus to the economy. The absence of further government needs and the inherent strength of the bond market made it possible for the Bank of Canada to maintain firm control over bank cash, allowing only the amount considered propitious for increasing economic activity, even to the point of encouraging the banks to sell considerable securities in the market. Thus the banks sold $ 91 million Dominion and provincials in the market during the period, after adjusting for their direct purchases from the government. 1 The Bank's policy during this period seems appropriate both in direction and in degree. From December 31, 1940, to December 31, 1943, the demands for bank cash from sales of securities directly to the banks, as well as from the periodic loans for purchases of victory bonds, were so insistent that an easy cash position was required during most months of each year. 2 However, it cannot be said that the cash supplied to the chartered banks by the Bank of Canada was excessive, for the chartered banks' cash ratio remained reasonably stable, the chartered banks bought only a small amount of securities in the market, and the bond market did not strengthen over the period. More specifically, during this period the chartered banks increased their holdings of Government of Canada securities by $ 1,339 million 1 Statistics from Bank of Canada, Statistical Summary, 1946 Supplement, 16. Some or all of this decrease may of course have been the result of redemptions but in that case the Bank's policy did not allow their replacement, which had the same monetary

effect. 2

See also Gibson, Canadian Banker, April 1942.

THE BANK AND THE WAR

1 33

(holdings of provincials remained steady); they were asked to purchase about $ 1,165 million directly from the government so that on balance they bought only $ 174 million from the market (including any Treasury bill increases, of which the amount outstanding increased by $ 100 million over the period). 1 This net increase does not in itself appear excessive, a subjective judgment which is fortified by the trend in the bond market. During this period the yield on Government of Canada theoretical 5-year bonds increased slightly (see Figure 5 below), from 2.12 per cent to 2.24 per cent, while longer issues tended slightly downward. In general, bonds remained more or less stable. It is safe to conclude that the cash provided by the Bank until about December 31, 1943, was sufficient to meet the demands of war finance, to maintain relatively stable cash ratios, and to act as a stabilizing influence on the bond market without initiating any important trend. In each of its important aspects the Bank policy would seem to have been correct under the conditions which existed at the time. Somewhat more doubtful is the efficacy of the policy pursued during the third period of wartime monetary expansion, that is from December 31, 1943 to March 31, 1946. There were four important developments in this period: Bank Rate was reduced, the chartered banks' cash ratios increased appreciably, the chartered banks bought large quantities of securities on the open market, and bond yields dropped sharply. Effective February 8, 1944, Bank Rate was reduced from 2½ per cent to 1½ per cent, the first change since the Bank began operations. This was intended primarily as a first move to counter expected post-war deflationary forces. It was a bold move, not comparable with official action either in the United Kingdom or United States. 2 No one doubted that the existing low rates would continue for the duration of the war and this move was aimed directly at assuring 1 The net increase in holdings of Government of Canada securities is given in Bank of Canada, Statistical Summary, Sept. 1952, 145-6, loans against victory bond purchases being excluded. The change in holdings of provincial bonds is arrived at by subtracting this total from total change of Dominion and provincial bond holdings, found in Bank of Canada, ibid., 1946 Supplement, 16. Statistics for securities purchased directly from the government (cash sales only, not conversions) are from the various appendices to the wartime budget speeches and from the writer's compilation of deposit certificates, the original data for which came from the Bank of Canada. Thus from Dec. 31, 1940, to Dec. 31 , 1943, deposit certificates outstanding increased by $ 715 million (all of which were held by the chartered banks), while on Jan. 2, 1941, a $ 250 million issue and on July 2, 1943, $ 200 million of bonds were sold for cash to the chartered banks. 2 See also above, p. 66, n. 4.

I 34

BANK OF CANADA OPERATIONS AND POLICY

the country that the same policy would continue when peace came. Several days after this move the Governor explained: ... It ... seems appropriate that the Bank should, by reducing its Rate, signify its intention to continue the kind of monetary policy which has brought about the current level of interest rates. A policy aimed at higher interest rates would only become intelligible if, after war shortages are over, consumers' expenditure and capital development were to proceed at a rate which would overstrain our productive capacity. I see no prospect of such a situation arising in a form which would call for a policy of raising interest rates. 1

Two other aspects related to the Bank's thoughts on interest rate policy at this time must be noted. First, the Bank seems to have developed a somewhat permanent bias towards low interest rates during the war. This is indicated by the sentiment expressed in the last sentence of the above quotation as well as elsewhere,2 and it is indicated and explained by the Bank's belief (quite understandable at this time) that the transitional period of shortages would be followed by one in which deflationary forces would be the real threat, and that with the greatly expanded public debt higher rates would result in "chaos" in the bond market. 3 This would constitute much more than a transitional bias towards low interest rates and one which would not be dispelled by the first signs of inflationary forces. The second point to note is that the Bank believed itself capable of maintaining these low rates and that past experience had led it to believe that it could do so with relatively small market operations. The Governor said: ... Suppose a considerable number of people do want to get cash for their savings in the form of Bonds and Certificates. We have the machinery to deal with any situation of this kind which may develop-and deal with it in a way which will avoid serious upsets or disturbances-in a way which will keep faith with the millions of small investors who are supporting the savings programme during the war years. 4 Bank of Canada, Annual Report, Feb. 10, 1944, 5. See quotation, above, p. 66, also G. F. Towers, speech at Moncton, April 21, 1944. 3 For the Bank's belief in the importance of post-war deflationary forces see G. F. Towers, address before the Magazine and Periodicals Group of the Canadian Publishers War Finance Publicity Committee, Toronto, Jan. 13, 1944, and speech at Moncton, April 21, 1944; Bank of Canada, Annual Report, Feb. 8, 1946, 10. The Bank's fear of chaos in the bond market was expressed by the Governor before a House Committee in 1948, so it must certainly have been in its mind at this time. See below, p. 185. 4 Towers, speech at Moncton, April 21, 1944. Also Towers, address before the Magazine and Periodicals Group, Jan. 13, 1944. This quotation, by the way, comes the closest to being a pledge to bondholders by the Bank or the government, an issue which arose periodically in the later post-war period when bond prices fell. See below, p. 186. 1

2

THE BANK AND THE WAR

135

Several months later the Governor said in evidence: . . . The Bank of Canada has had a material influence in the rates of interest on government bonds in the open market, so to speak; but it can exercise that influence on the basis of comparatively small dealings and comparatively small changes in cash. 1

Thus the Bank announced the continuance of low interest rates; it seems to have developed a relatively permanent bias toward such rates; it felt itself capable of maintaining them; and past experience had led it to believe that this could be done with fairly small operations. The second major development in this late war period was the relatively permanent increase in the chartered banks' cash ratios which began in January 1944. In ten out of twelve months of 1944 the banks' cash ratio was higher than at any time since the Bank began operations. The yearly cash ratios for 1944, 1945, and 1946 were 11.8 per cent, 11.4 per cent, and 11.4 per cent, while in previous years they had for the most part been between 10.2 per cent and 10.5 per cent. The year 1943 was a transitional year, with 10.9 per cent. 2 These higher cash ratios were begun mainly in January 1944 when the Bank did not recoup the extra cash that had been required during the victory loan of late 1943. Indeed, the Bank bought securities in January 1944 so that bank cash actually increased, while in previous war years there had been no such January increase at all. The Bank made continuance of these ratios possible mainly by buying securities whenever necessary. Why should the Bank facilitate such fluctuations in cash ratios in view of their well-known disadvantages to central bank control? Two viewpoints of the Governor help to explain. First, he believed that the Bank should provide cash sufficient to establish the cash ratios at which the banks were aiming, and if that changed the Bank should vary its accounts accordingly. Second, expansion would not be considered to have taken place until cash ratios were higher than those desired by the banks. To quote the Governor's evidence before a Commons Committee: " ... if the banks in general were aiming at a ratio of 15 percent we w,ould know that. We therefore would not consider we were taking any expansionary action unless we had put the ratio above 15 percent." And again: " ... if they [the chartered banks] should decide that it should be 11 per cent or 12 Standing Committee on Banking and Commerce, Minutes, June 27, 1944, 678. See Bank of Canada, Statistical Summary, 1946 Supplement, 17, 19, and 1950 Supplement 7, 9. 1

2

136

BANK OF CANADA OPERATIONS AND POLICY

per cent or 15 per cent, if they thought that favourable we would of course not have the slightest objection, we would simply adjust our policy to conform to that; that is, by buying more securities. " 1 Theoretically the Governor is right, for it is not the building up of idle cash that is expansionary but rather its utilization for expanding deposits. But the essential point, surely, is that if every whim of the commercial banker for increased cash is satisfied, that banker may later be satisfied with a lower cash ratio through increased deposits and not reduced cash. True, the Bank might then take offsetting action but the initial increase in deposits may already have been harmful, and also the path back to a former level of deposits might well prove difficult. The lag between commercial bank action and central bank reaction could prove a costly one, and the uncertainty of commercial bank intentions engendered by fluctuating ratios would make the task of the central bank more difficult. But assume that the Governor actually meant that increased cash ratios would be condoned and accommodated only if the chartered banks had a legitimate reason for such an increase. There is some indication that this might have been the case for the Governor explained : "This expansion in banks' cash reserves has been somewhat more than enough to maintain the pre-war ratio of cash to deposit liabilities; a higher average cash ratio is appropriate in view of large temporary swings in the cash position of individual banks arising from a greatly increased volume of turnover in their customers' accounts. " 2 This does indicate that the Governor really believed that a change in the banks' cash ratio had to be justified. But was the reason given a valid one? In 1942 when the banks' cash ratio was 10.5 per cent, the estimate of the velocity of current account deposits was 25.14 per cent. In 1944, 1945, and 1946 when the cash ratio increased to 11.8 per cent, 11.4 per cent, and 11.4 per cent, the velocity of current account deposits actually decreased to 23.31 per cent, 23.61 per cent, and 23.05 per cent. 3 The need for increased reserve ratios because of increased turnover does not on the face of it appear evident, and their existence must be rationalized in another way. This will be attempted after the third and fourth important developments have been discussed. The third important development of this late war period (and actually early post-war period), was the increased purchases of securities Standing Committee on Banking and Commerce, Minutes, June 30, 1944, 720. Bank of Canada, Annual Report, Feb. 10, 1945, I I. 1 Dominion Bureau of Statistics, Cheques Cashed in Clearing Centres, 195 I, Table 6.

1

2

137

THE BANK AND THE WAR

in the market by the banks. Their total holdings of Government of Canada securities increased by $ 1,123 million (holdings of provincials decreased by $ 51 million), practically all of which were long-term securities. Since over the period the banks bought only $ 25 million of securities from the government, all of which were the short-term deposit certificates, it is plain that they purchased in the neighbourhood of $ 1,100 million longs from the market. 1 This is indeed a major change from the previous three years when they purchased $ 174 million from the market and from 1940 when they were actually selling securities. Monetary expansion after 1943 till the end of the war period therefore resulted in higher cash ratios and in the banks' purchasing large quantities of securities from the market. The fourth important development was the sharp decline in government bond yields beginning in January 1944 and lasting till March 1946 (see Figure 5 below). Yields on the various theoretical Government of Canada bonds for the beginning and end of the period under review, as well as their percentage change, are given in Table 14. The greatest percentage change was in the 5 to 9 year range and it is precisely this range of long-term bonds in which the chartered banks were primarily interested. 2 These four major developments help explain the purpose of the Bank's policy during the last part of the war. Toward the end of TABLEI4 YIELDS ON THEORETICAL GOVERNMENT OF CANADA BONDS a Perpetual

15-year

9-year

5-year

2-year

Dec. 1943

3.17

3.00

2.76

2.24

1.55

March 1946

2.73

2.60

2.26

1.65

1.38

14

13

18

26

II

Percentage decrease

a Banlc of Canada, Statistical Summary, 1946 Supplement, 27, and 1950 Supplement, 20. 1 These statistics computed along the same lines as described p. I 33, n. I, with the exception that the figures for provincial bonds came from the month-end return to the Minister of Finance of the chartered banks for March 1946. Previous to the 1944 Bank Act revision, no monthly statistics of chartered bank holdings of provincial bonds were available. 2 See Bank of Canada, Annual Report, Feb. IO, 1945, 11. Also some banks reported their security holdings (not including Treasury bills and deposit certificates) averaging around 4 1/2 to 7 years to maturity.

I 38

BANK OF CANADA OPERATIONS AND POLICY

1943 increasingly more attention was paid by official authorities to post-war problems. It was clear that the government considered its role in maintaining future economic equilibrium to be a much more positive one than it had in pre-war years, a change endorsed by the Bank of Canada. 1 The Bank began to play its part in early 1944 when it decided that it was necessary to assure businessmen of low interest rates for their post-war reconstruction and development plans, and bondholders of the continuing soundness of their investment. This it did by reducing Bank Rate, and it then proceeded to make this rate "mean something" by supplying the banks with more free cash than they had ever had before. As was to be expected, the banks turned to the bond market and bought assiduously, with a strong resultant pulling influence on bond prices; the bonds in which the chartered banks would be most interested rose more in price than the others. This policy continued until even some of the commercial bankers became uneasy. One bank reported as follows in the later part of 1946 when referring to some part at least of the period under review: ... We should realize that the increase in deposits was associated in large measure with the further acquisition of Government securities by the banks which in turn reflected the central bank's policies. We should realize, too, that the scale of the banks' security purchases contributed further to easy money conditions and to increasing capital values. The marked further increase in bank deposits is thus closely related to Government financial policy and represents a striking enlargement in the amount of liquid funds in the hands of the general public and business.2

It would almost seem that the Bank desired not just a continuance of the already low interest rates but an actual decline in them, for it enabled the banks to buy large amounts of securities from the market even after any arguments about the necessity of indirect aid to war finance ceased to be valid; and it kept the banks' reserve ratios higher than they had ever been during the Bank's experience. 3 1 See especially the final outcome of this thinking in the government's White Paper, Employment and Income with Special Reference to the Initial Period of Reconstruction (Ottawa, 1945). Also G. F. Towers, speech before the Canadian Manufacturers' Association, Toronto, June 10, 1943, and address to the Canadian Association of Personnel Publication Editors, Toronto, March 20, 1945, which are in harmony with the White Paper. 2 The Bank of Nova Scotia, One Hundred and Fifteenth Annual Report, Oct. 31, 1946, 21. 3 But see G. F. Towers "Canada's Central Bank," an address to the Institute of Chartered Accountants of Ontario, Toronto, April 21, 1949, 9, where, when referring to the strengthening of bond prices beginning in the autumn of 1945, the Governor said: " ... This trend was not due to central bank action but rather to support from non-banking investors."

THE BANK AND THE WAR

139

(It is to be remembered that in late 1945 the United Kingdom Chancellor of the Exchequer was making a concerted effort, freely admitted, to reduce bond yields.) 1 These higher reserve ratios seem to make sense only as a continuous inducement to the banks to buy securities in the market. The Bank may have found that the chartered banks were insufficiently sensitive to a slight easing in their cash position and that in the circumstances they would react satisfactorily only if their cash position was very easy. The Bank may also have been surprised to find that, contrary to its experience in the immediate past, a very large cash expansion was now required to bring about the bond prices it desired. Three points might possibly be mentioned in refutation of this general interpretation: that the chartered banks themselves desired the higher cash ratios, that it was impossible for the Bank to control bank cash, and that the expansion was required to maintain stability and confidence in the greatly expanded government bond market. With regard to the first, the chartered banks have given no indication that they desired higher cash ratios, have offered no justification for them, and, as we have seen, the reason for them suggested by the Bank does not, on the face of it, appear convincing. Nor does the writer feel that fluctuating reserves can in any case be regarded with equanimity. On the second point, it will be recalled that the Bank could in fact have sold more securities, indeed merely bought less, so that it was not at the mercy of the banks and the market. This is especially true since the markets were strong. The third point, the necessity to maintain stability in the bond market, is met partly by the answer to the second, for the general lack of alternative forms of investment even during the process of transition to peacetime conditions made the market anything but weak. 2 It does not seem likely that merely to have maintained stability in the market would have required the expansion which took place, for that expansion actually helped to push yields down. But was this policy appropriate or not? It must be remembered that in 1944 the problems of transition from war to peace had to be studied and solutions sought. The shift of a million men in the services, as well as those in war industries, to peacetime occupations appeared to be a monumental task. Associated with this was the required shift of plant and equipment to peacetime production and See R. S. Sayers, Modern Banking (3rd ed., Oxford, 1951), 203-20. Cf. "Lower Interest Rates for 1945," Financial Post, Dec. 30, 1944, 9, 13, and "Investment This Week," ibid., Dec. 22, 1945. 1

2

140

BANK OF CANADA OPERATIONS AND POLICY

the need to ensure high investment and production as an offset to reduced expenditures in the public sector. And the decline in bond prices following World War I had not been forgotten. Under these conditions there is no question that correct central bank policy was the maintenance of low interest rates and that the Bank's advance announcement of this was a courageous step. Most observers were in favour of such a policy. 1 The question, however, still remains whether the Bank was right in (apparently) pressing for actually lower rates, and, in the process, impairing the almost traditional custom of stable chartered bank cash ratios, establishing an artificially low level of interest rates (alternatively, artificially high capital values), and greatly increasing the liquidity of former bondholders. Even granting that neither the actually smooth transition nor the subsequent inflation could possibly have been foreseen, it seems that the Bank erred on the side of too great monetary expansion. Interest rates were already low and it is difficult to understand how a further lowering would appreciably encourage direct investment in view of the risk differential between bond investment and direct investment. It was the assurance of continuing stable bond prices and not higher bond prices that was important to businessmen and bondholders. Besides this, the liquidity position of the private sector was already high, and despite the advent of either future inflation or deflation the immediate problem was to discourage consumer expenditures. In view of the direct controls on consumption which still existed, this expansion of private liquidity might be justified if it was a great spur to direct investment during the transition. But again the risk associated with direct investment at that time would seem to overwhelm the marginal influences of greater liquidity. Moreover, as long as bonds remained stable the potential direct investor could make the required shift in his investment without any financial loss. It may have been for reasons of debt management rather than for any great hope of increasing investment that the Bank desired lower rates. Also, the Bank may have initially misjudged the expansion necessary for attaining the rates which it considered necessary for reasons of debt management. The conflict between the Bank as debt manager and the Bank as monetary manager was beginning to appear-a new experience for the Bank. 1 Cf. Financial Post, May 27, 1944, 3, where a conducted survey shows most businessmen, financiers, editors, and professors contacted were in favour of low interest rates for the transition period.

THE BANK AND THE WAR

141

It seems that the Bank attempted to lower interest rates and that it erred in this policy. The Bank may have misjudged the amount of expansion required; discounted too heavily the risk of impairing the custom of stable cash ratios; relied too much on continuing direct controls for combating the potential inflationary effects of the increased liquidity of the public and business; and over-emphasized its role as debt manager. But it certainly gave the business world low rates for the transition. The observation that during the pre-war period of unemployment the Bank erred on the side of too cautionary expansion, while in the late war period of full employment it erred on the side of too liberal expansion must not be pressed too far. But it does seem that the Bank became convinced during the war that quite large doses of monetary expansion during periods of expected unemployment would not be as disastrous to the balance-of-payments position as it had itself argued in the pre-war period. The following chapter on the post-war situation will show that the balance of payments was still a thing to be reckoned with and that part of the trouble might be placed at the feet of the Bank. As it was, the post-war period began with artificially low interest rates, a greatly increased public liquidity in part as a result of the former, and a cash position which allowed the banks ample leeway for movement. STABILIZING THE FINANCIAL MARKETS

The Bond Market

Stable bond markets were a vital necessity for a maximum war effort. That they were attained, and at low yield levels, was an achievement of the Bank equal in importance to the farsightedness it displayed in developing, during peacetime, a comprehensive system of exchange control. It might well be called its second important prestige-generating accomplishment. Three main tasks confronted the Bank in connection with its wartime management of the bond market: it had to soften the initial impact of the declaration of war; it had to bring permanent stability to the bond market in order to facilitate large borrowing operations; and it had to convince the market that low interest rates would prevail during the war. The first of these, as was noted in the preceding chapter, it achieved by buying securities in the market, by requesting dealers not to deal in short sales of Government of

142

BANK OF CANADA OPERATIONS AND POLICY

Canada and provincial securities, and by instituting a comprehensive system of foreign exchange control. In this way the initial impact of war on the market was successfully and quickly overcome. As might be expected the second and third tasks were not performed as quickly as the first, but by the end of 1940 it became clear that stable and low rates would rule (trends shown on Figure 5 below). Before this, however, there was general uncertainty in the market as to what the rate pattern would be, and also as to what the financial authorities believed or desired it to be. In the budget speech of September 12, 1939, there was a vague reference to borrowing "at rates as low as possible," and to the fact that no material change was expected to attract the peoples' savings. 1 On March 10, 1940, it was reported that doubt still existed as to what rates would be, and this was repeated in the following month. When the British Chancellor of the Exchequer stated in late April 1940 that he did not expect to pay more than 3 per cent, the Financial Post stated that this was "the strongest statement yet in support of the existing pattern of rates." Groping around for some further indication of official policy on interest rates, the same paper pointed to the probability that the Governor's reference to "equality of sacrifice" intimated a continuance of the existing low pattern. It added that it was becoming clearer that the authorities were determined to stabilize interest rates. This development continued and on December 21, 1940, it was reported that Canadian investors did not think that interest rates would rise. The following week an investment analyst expressed the opinion that interest rates would remain steady in 1941. 2 After this there was little doubt that the existing pattern of low rates would continue for the duration . This progressive establishment of confidence in low rates is also illustrated by the trend in the yields at date of issue of new wartime long-term bonds. The first war loan of February 1940 yielded 3.25 per cent at date of issue, the second war loan of October 1940 yielded about 3.13 per cent, the first victory loan of June 1941 yielded about 3.1 per cent, and this trend continued until the fourth victory loan of May 1943, which yielded 3 per cent. After that, all issues yielded 3 per cent at date of issue. 3 Hon. J. L. Jlsley, budget speech, Sept. 12, 1939, 5. See "Bond Markets," Financial Post, March 10, 1940, 5, April 13, 1940, 5, April 27, 1940, 5, Dec. 21 , 1940, 5, and Dec. 28, 1940, 9. 3 The first war loan had a coupon rate of 3.25 per cent and all long issues after that had a coupon rate of 3 per cent. But the yields mentioned in the context were computed by the writer after allowing for variations in the issue price, call price, a nd maturity 1

2

THE BANK AND THE WAR

143

The foregoing does show that the market was not "talked" into lower rates; neither the government nor the Bank offered market forecasts based on their own wishful thinking. The market itself became convinced of the permanency of stable and low rates primarily because it began to appreciate the stabilizing force of the Bank in the market and because it finally judged existing rates to be appropriate for modern war. The positive action of the Bank in the market at the outbreak of war was generally appreciated, and during the period of uncertainty the Financial Post reported the probable presence of central bank support in the market at various times. More definitely and specifically it reported on October 19, 1940, that "prices of high-grade government issues hold strong, an important factor being the Bank of Canada's 'peg' on the price of the second war Loan at 98 3/s, compared with the offering price of 98¼." In December the same paper judged the control machinery a success in maintaining low rates, and reported an investment analyst who believed that low rates would continue and that "Bank of Canada operations are the greatest single factor in today's Canadian bond market. " 1 The Bank of Canada had established its ability to stabilize the market and later comments openly accepted this fact. 2 That stabilization of these rates did not require large open-market operations on the part of the Bank is suggested by the trend in the Bank's security holdings and bond yields as shown on Figure 5, and was the opinion of observers and members of the market at the time; indeed, as has been seen, it was pointed out by the Governor. This continued to be the case until the end of 1943. But after that, the Bank seems to have begun an attempt to actually lower rates, having apparently deduced from its previous experience that it could not only stabilize the market but also choose, to some extent, the level at which it was to be stabilized, all presumably without undue monetary expansion. However, it soon became manifestly clear price, and for the length to maturity of the various issues. For statistical information on these issues see National War Finance Committee, Statistics and Information, Table 4. '"The Bank of Canada Weekly Statement," Financial Post, Feb. 7, 1940, March 23, 1940, "Bond Markets," Aug. 31, 1940, and Oct. 19, 1940; and "Bonds Seen Holding Steady in 1941," Dec. 28, 1940, 9. 2 The Financial Post, Aug. 30, 4, reported complete confidence in government finance and after two years of war a reversal of the pattern of interest rates from what had been expected. On Oct. 25, 194 I, 5, it stated that the "Canadian bond markets have for some years been under the effective control of the Bank of Canada." And on Jan. 24, 1942, 2, it reported financial men as believing that the 3 per cent rate on government bonds would be held without difficulty, for while the Bank has operated in the market to maintain stable prices it has not used more than a fraction of its potential power.

144

BANK OF CANADA OPERATIONS AND POLICY

that large monetary expansion was in fact required. Then in the post-war period, as will be seen, the Bank had to let interest rates move up because of the extent of the monetary expansion which would have been required to hold them down, even though it still believed strongly in low rates. This does seem to suggest that during the late war period (as here defined) the Bank may not have appreciated fully the difference between stabilizing bond prices at a level more or less consistent with market opinion and stabilizing them at a level to a certain degree of its own choosing and one which the market would not necessarily interpret as being appropriate.

1200

. C

.

8

0 C

1000 ';

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4.00

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