Gordon Thiessen: Can a bank change? The evolution of monetary policy
at the Bank of Canada 1935-2000
Lecture by Gordon Thiessen, Governor of the Bank of Canada, to the Faculty of Social Science,
University of Western Ontario, on 17 October 2000.
* * *
I would like to thank the Faculty of Social Science here at the University of Western Ontario for
inviting me to deliver this lecture. The Department of Economics within the Faculty is known for its
long-standing interest in monetary economics, as well as its appreciation of economic history. I
thought that it would be appropriate, therefore, to combine these two elements and use this occasion to
reflect upon the dramatic changes that have taken place in the theory and practice of monetary policy
in Canada during the Bank of Canada's 65-year history.
Over this period, there has been a fundamental transformation in the way monetary policy is
conducted in Canada and in most other industrial countries. While globalization and technological
change have played an important role in this area, as in so many others, they have not, to my mind,
been the principal driving force behind this transformation. Far more important has been the
interaction of experience and economic theory. The puzzling and, at times disappointing, performance
of the economy has often served as the catalyst for major theoretical advances and policy innovations.
Although the evolutionary process set in motion by these forces has not always been smooth or
painless, it has, without question, deepened our understanding of how the economy works. It has also
taught us valuable lessons about how monetary policy should be conducted.
One of the most important lessons that monetary authorities have learned through this process of
analysis and experimentation is that there is no virtue or advantage in vague policy objectives and
complex operating procedures. Simpler and more straightforward approaches have generally turned
out to be better. Monetary policy does not need to be cloaked in secrecy or artificial intricacies to be
effective. What is needed to get the job done is one clear objective and one simple instrument.
My career in central banking - of just over 37 years - covers more than half of the period since 1935
that I am going to review today. I do not intend, however, to describe every policy development since
the early 1960s, when I first joined the Bank, nor all those from the preceding period. Instead, what
follows is a selective overview of certain events that I believe were critical to the evolution of
monetary policy in Canada. While the conduct of monetary policy will always involve a great deal of
uncertainty and imprecision, the steps that we and other central banks have taken to make it simpler
and more transparent have, in my opinion, improved its effectiveness and contribution to economic
welfare.
1. The beginning: establishing the Bank of Canada
The Bank of Canada was established in 19351 during the Great Depression. Public confidence in the
behaviour of markets, and the financial system in particular, had all but disappeared. Traditional
remedies and the natural re-equilibrating forces of the capitalist system did not seem to be having
much effect, and there was growing sympathy for more radical solutions.
Still, many observers questioned whether the creation of a central bank would be the answer to
Canada's problems. Other countries that had established central banks much earlier had suffered the
same collapse in economic activity and were experiencing similar difficulties trying to extricate
themselves from the situation. Keynes' General Theory2 would not be published for another year, but
there was already widespread scepticism about the likely effectiveness of a more aggressive approach
to monetary policy. Interest rates were at historically low levels, and the provision of extra reserves
was seen as only adding to the surplus liquidity that already existed in most commercial banks.
Nevertheless, excessive credit creation in the period immediately preceding the Depression, and the
severe liquidity problems that many borrowers had experienced once it was underway, were generally
viewed as important contributors to the collapse, if not the primary cause. Perhaps a central bank,
learning from past experience, could reduce the likelihood of a similar occurrence in the future.
Doubts about the usefulness of monetary policy in stabilizing output did not prevent the legislators
who drafted the original Bank of Canada Act from giving the Bank a broad and ambitious mandate.
According to the preamble of the Act, which is the only description that we have ever had of its basic
functions, the Bank was expected to:
. . . regulate credit and currency in the best interest of the economic life of the
nation, to control and protect the external value of the national monetary unit and
to mitigate by its influence fluctuations in the general level of production, trade,
prices and employment, so far as may be possible within the scope of monetary
action, and generally to promote the economic and financial welfare of the
Dominion.3
While the legislators seemed to appreciate that not all of these objectives were mutually consistent or
even attainable with a single policy tool,4 they may have assumed that the Bank would have more than
one instrument at its disposal. Indeed, moral suasion, interest rate ceilings and various other means of
directly influencing the volume and composition of credit had already been used extensively in
Canada. The segmented nature of our financial system, in which banking, insurance, trust and
securities activities were all carefully segregated from one another, combined with the high levels of
concentration that existed in most of these industries, contributed to the "success" of such an
approach. In any event, according to the new Keynesian orthodoxy that was soon to take hold, most of
the heavy lifting associated with economic stabilization would be performed by fiscal policy.
To ensure that the new central bank would not be subject to undue influence from either the
government or the financial sector, the architects of the Bank of Canada made it a privately owned
corporation with widely distributed shares. Neither the shareholders nor senior officers of the Bank
were allowed to work in the financial sector, and the only formal representation that the government
was permitted was through the Deputy Minister of Finance, who was expected to serve as a
non-voting member of the Board of Directors. The Bank's accountability and reporting requirements
were limited to the publication of weekly financial statements and an annual report.
Even though Parliament in 1935 was prepared to allow greater public regulation of the economic life
of the nation, it realized that some separation of money creation from the government's spending
activities was probably important. Subsequent legislation reversed some of this separation by
eliminating private equity holdings and making the government the exclusive owner of the Bank's
shares. Other restrictions, however, on the government's ability to participate in Board meetings and
influence the daily conduct of monetary policy remained in place. The issue of whose will would
prevail if there was ever a major disagreement between the Minister of Finance and the Governor of
the Bank of Canada was not explicitly addressed until much later.
The contrast between the policy environment in 1935 and that of today could not be more dramatic.
Diffuse policy objectives, uncertain reporting lines, interventionist policy measures and a distrust of
financial markets have given way to clearly defined inflation targets, improved governance and
accountability, simple operating procedures and a more open approach to policy formulation and
implementation. We now have a single long-run objective - price stability - and a single policy
instrument - the overnight interest rate. The targets for our objective and our instrument are both
publicly announced, and our actions are subject to constant scrutiny and review. The story of how this
profound transformation was brought about is the subject of the rest of my lecture.
2. How did we get here?
The changes that I am about to describe did not happen overnight or in any continuous way. They
were the result of a long, and sometimes painful, process of experience, experimentation, academic
investigation and market pressures. At times, Canada was able to trade on the experience of other
countries, but on other occasions it had to find its own way. The challenges and problems that we
encountered were often unique or unprecedented. Our proximity to the United States, coupled with our
smaller size and openness, forced us to confront many of the issues associated with globalization long
before the term became fashionable. We have always been the archetypal small open economy.
2.1 The early years: 1935 to 1950
The Great Depression may have been exacerbated or even caused by monetary policy errors in Canada
and elsewhere, but the newly created Bank of Canada had limited means of dealing with it. Financial
markets were not very well developed in the 1930s and the monetary policy instruments at the Bank's
disposal did not appear likely to be effective.5 Interest rates, as noted earlier, had reached historically
low levels and commercial banks, with few exceptions, had more than enough liquidity. No serious
effort was made, therefore, to mount an aggressive countercyclical policy. Various fiscal initiatives
were undertaken prior to the outbreak of the Second World War, but not much progress had been
made in reducing unemployment or restoring industrial output to its pre-Depression levels.
Most of the Bank's activities from 1939 to 1945 were directed towards financing the war effort. This
involved extending cash advances to the government and overseeing the sale of Victory Bonds.
Determined not to repeat the economic mistakes made during the previous war, the government tried
to finance most of its expenditures through taxes and new bond issues. Consequently, the Bank's main
responsibility immediately after the war was to keep interest rates as low as possible, to facilitate the
rollover of the massive public debt that had accumulated. In the event, the reconversion of wartime
production facilities and the absorption of decommissioned military personnel into the domestic labour
force were much easier than many had imagined.6
By the late 1940s and early 1950s, however, inflationary pressures had started to build. The Bank and
the government tried to suppress them by imposing temporary controls on certain types of bank
financing. Some of this was accomplished through explicit legislation, the rest through private
conversations between the Governor of the Bank and the presidents of the 10 chartered banks. These
actions proved to be insufficient, however, in the face of rising world commodity prices, a booming
US economy, large foreign investment inflows and increased defence expenditures to support the war
effort in Korea. All of these factors put upward pressure on the Canadian dollar and made it difficult to
control the domestic monetary expansion. With some reluctance, the government was forced to
undertake a more decisive and, at the time, revolutionary action.
On 30 September 1950, Douglas Abbott, the Minister of Finance, announced that:
Today the Government, by order in Council under the authority of the Foreign
Exchange Control Act, cancelled the official rates of exchange which, since
September 19th of last year, had been calculated on the basis of a 10 percent
premium for the United States dollar in Canada. It has been decided not to establish
any new fixed parity for the Canadian dollar, at this time, nor to prescribe any new
official fixed rates of exchange. Instead, rates of exchange will be determined by
conditions of supply and demand for foreign currencies in Canada.
With this announcement, Canada abandoned the Bretton Woods system of pegged exchange rates,
which had been established at the end of the Second World War, and allowed its currency to float
freely in international markets. The resulting appreciation would hopefully discourage some of the
inflow of funds, defuse the inflationary pressures that the economy had been experiencing, and obviate
the need to pick a new, more sustainable value for the dollar. The flexible exchange rate was expected
to remain in place only until markets had settled and a more reasonable value for the dollar had been
determined. In fact, the experiment lasted for almost 12 years and had far greater significance than
anyone could have imagined.
Canada was the only major country in the world operating under a flexible exchange rate through the
1950s and early 1960s, and was regarded as something of a renegade in international circles. By the
end of 1951, we had also eliminated all remaining controls on foreign exchange transactions and most,
if not all, controls on foreign investment inflows. Canada's financial markets were now open and
exposed to external shocks. Our experience during this period would serve not only as a model for
other industrial countries after the Bretton Woods system collapsed, but also as the catalyst for a
revolutionary advance in the theory of international finance.
Few students of Canadian economic history know that Milton Friedman played a role in Canada's
decision to float. In 1948, Friedman, then a young Associate Professor at the University of Chicago,
participated in a radio debate with Donald Gordon, Deputy Governor of the Bank of Canada, and
William Mackintosh, a Professor at Queen's University and an adviser to the Department of Finance.7
One of the topics that they were asked to discuss was whether Canada should move to a flexible
exchange rate. The Bank of Canada and the Department of Finance were both strong supporters of
fixed exchange rates, as were most governments at the time. Friedman, as you might expect, spoke
with great conviction about the advantages of a flexible exchange rate. Indeed, many of the arguments
that he presented would later appear in his classic essay, "The Case for Flexible Exchange Rates".8
Although the debate did not have any noticeable effect on policy for the next two years, Friedman's
ideas seem to have influenced official thinking in Ottawa. A number of secret memos were written
within the Bank beginning in 1948, reviewing the feasibility and even desirability of his proposal.9
2.2 Monetary policy under a floating exchange rate: 1950 to 1962
In June 1954, Graham Towers, the first Governor of the Bank of Canada, retired after 19 years of
service and was replaced by James Coyne, one of the authors of the secret memos. Like many
Canadians at the time, the new Governor had become increasingly concerned about the level of
foreign ownership in Canada and was anxious to increase national savings as a means of reducing our
dependence on foreign capital inflows. Another concern, which was not as widely shared, involved the
domestic rate of inflation. Canada had experienced a sharp escalation in consumer prices during the
Korean War, and inflationary pressures had persisted for some time after. While domestic spending
had faltered in 1954, the subsequent recovery pushed inflation well above the level that the Bank
implicitly associated with price stability. Coyne was convinced that the solution to both problems
- low savings and high inflation - was a tighter monetary policy. Higher interest rates would reduce
domestic demand and help raise national savings.
Although a rudimentary money market had started to form in Canada, with the active encouragement
of the Bank, it was not well developed. Popular wisdom, in any case, suggested that traditional
monetary policy mechanisms were unlikely to be effective, even when they involved tightening
monetary policy.10 As a result, Coyne decided to combine reductions in the supply of bank reserves
with healthy doses of moral suasion, much as his predecessor had done in earlier periods.
The Bank continued with this restrictive monetary policy stance through most of the late 1950s and
into the early 1960s. In the face of rising unemployment and weakening economic activity, inflation
dipped below 1% by the spring of 1961. Relations between the Bank and the Minister of Finance had
deteriorated sharply, and numerous government ministers had demanded a change in policy direction.
However, any desire to remove James Coyne and replace him with a more sympathetic Governor ran
up against the ambiguous nature of the legislation regarding the government's powers vis-à-vis the
Bank. The academic community also became involved in the dispute and circulated a pamphlet
entitled "The Economists versus the Bank of Canada".11 A W Phillips had just published his famous
paper on unemployment and the growth of money wages in the United Kingdom, and shown how
higher (wage) inflation was typically associated with lower rates of unemployment.12 Not surprisingly,
Phillips' work found a receptive audience in Canada, and researchers soon replicated his results with
North American data.
Much of the commentary in the popular press during this period was also critical of the Bank's
policies, and reflected the widespread view that a little more inflation was not such a bad thing
- provided it could bring higher employment and stronger output growth. James Coyne remained
unconvinced, however. While he had no formal model or elaborate regression results to put forward in
his defence, his instincts seem to have told him that any attempt to improve the economy's
performance by targeting a higher inflation rate was misguided and could only end in difficulty:
There are those who sometimes set out the false alternatives of either full
employment with inflation, or stable prices with a high level of unemployment.
They say the nation must choose between unemployment and inflation. No person
in any position of responsibility could possibly subscribe to that doctrine. It is
false. Full employment and stable prices are not only compatible, they are in the
long run inseparable.13
10
Doubts about the effectiveness of monetary policy were usually related to the presumed difficulties associated with
stimulating the economy (ie "Pushing on a string"). Policy tightening was also thought to be ineffective during this
period, however, since large interest rate increases were regarded as "unacceptable" and probably destabilizing. See the
Report of the Royal
Bank of Canada's testimony before the Porter Commission (Porter Commission Report (1964):
Commission on Banking and Finance, Queen's Printer, Ottawa).
11
Thirty prominent Canadian economists also signed a letter to the Minister of Finance calling for the dismissal of
Governor Coyne. See Gordon, H.S. (1961): The Economists versus the Bank of Canada, The Ryerson Press, Toronto,
pp v-vi.
12
Phillips, A W (1958): "The Relation between Unemployment and the Rate of Change of Money Wages in the United
Kingdom, 1861-1957", Economica 24, no 100, November, 283-99.
13
Coyne, J E (1961): Remarks to the Annual Conference of the Business Paper Editors Association, Ottawa, Ontario,
18 January 1961.
The pathbreaking work of Milton Friedman and Edmund Phelps on the vertical Phillips curve would
not be published until 1968, but their results were anticipated by Coyne in many of his speeches.14,15
He was convinced that there was no long-run trade-off between unemployment and inflation, except
possibly in the sense that lower inflation might actually lead to higher output and employment.
Experience and the new theory of rational expectations that would emerge 10 years later confirmed
this result and showed that any positive employment effects associated with higher inflation were
likely to be shortlived.
There was one critical area, however, where Coyne and many other policy analysts, both within and
outside the Bank, appear to have been misguided. Those who had questioned the effectiveness of
monetary policy in earlier years had failed to appreciate that it was likely to be much stronger than
fiscal policy under a flexible exchange rate system, especially when capital was highly mobile. The
large capital movements triggered by any change in interest rates would put significant pressure on the
exchange rate, amplifying the effects of monetary policy while undercutting the effects of any
opposing fiscal policy. Coyne did not realize that, for similar reasons, it was unlikely that a tighter
monetary policy would ever raise national savings or reduce foreign investment inflows.
Robert Mundell, in his article on "The Appropriate Use of Monetary and Fiscal Policy for Internal and
External Stability", was the first economist to explain this apparent reversal of Keynesian theory.16
Mundell's article was published in 1962, one year after Coyne had resigned in response to mounting
criticism and ongoing efforts to remove him.
The timing of Mundell's work was no coincidence. According to Mundell,17 the inspiration for his
work on policy effectiveness under fixed versus flexible exchange rates was a conversation he
happened to overhear while working at the International Monetary Fund (IMF). Wynne Plumptre,
Canada's Executive Director at the IMF, was talking to another official in the elevator about a problem
that the authorities back home had been wrestling with. The Bank of Canada had been pursuing a
restrictive monetary policy in an apparent effort to reduce domestic spending, increase saving and
limit the flow of capital into Canada. While economic activity had slowed, very little progress had
been made on improving the trade balance or reducing foreign investment, owing to Canada's strong
dollar and high interest rates. Efforts by the Department of Finance to counter the negative effects of
the Bank's monetary policy through fiscal stimulus and to return the economy to full employment had
thus far been unsuccessful. Government analysts were at a loss to explain why.
The rest, as they say, is history. Mundell had written a number of papers on international capital flows
as part of his PhD thesis, and this chance encounter seems to have been something of an epiphany.
Suddenly, many of the ideas that he had been working on were transformed into a coherent model of
the way the global economy worked in the presence of capital mobility.
2.3 Downward-sloping Phillips curves and the dash for growth: 1962 to 1970
The controversy surrounding James Coyne's departure in 1961, together with publicly expressed
government concerns that the value of the dollar was too high and that a nationalist program was
needed to reduce foreign investment, put downward pressure on the Canadian dollar. It fell from a
slight premium vis-à-vis the US dollar to roughly 95 cents (US) within a few months. Efforts to halt
the decline through aggressive intervention in the foreign exchange market were unsuccessful. On
2 May 1962, the government decided to return to the Bretton Woods system and fix the value of the
Canadian dollar at 92.5 cents (US). Unfortunately, it took some time for academics and policymakers
to appreciate the full implications of Mundell's work. Indeed, there is nothing that I am aware of in the
official documents written over the next few years that would indicate whether the Bank or the
Department of Finance fully appreciated that, by returning to a pegged exchange rate system, the
government would effectively neutralize whatever independent influence monetary policy might have
on the macroeconomy.
With domestic fiscal policy on a strong expansionary track, and monetary policy constrained by the
new exchange rate peg, the Bank of Canada would have no way of resisting the inflationary pressures
that were gradually building in the second half of the 1960s. Government expenditures in Canada were
growing at an accelerating rate with the new health care and unemployment insurance systems that had
been introduced. Similar pressures were emerging in the United States in response to the Vietnam War
and President Johnson's program for a Great Society. With a fixed exchange rate, these pressures
would inevitably spill over into Canada.
Few serious concerns about inflation, however, were expressed outside central banking circles.
Phillips and his followers had shown how a little bit of inflation might be beneficial, and monetary
authorities were encouraged to be more forgiving. "Reasonable price stability" was touted as a
preferred policy objective by the Economic Council of Canada, and "inflation-unemployment trade-off
zones" were dutifully reproduced in many of its publications.18
Another development during this period is also worth noting. It concerns the clarification of the roles
and responsibilities of the government and the Bank of Canada with regard to monetary policy. Louis
Rasminsky, who had succeeded James Coyne as Governor in May 1961, had insisted as a condition of
his appointment that the government's powers regarding monetary policy be clearly defined.19 The
Bank of Canada Act was amended in 1967 to allow the government to issue a directive to the Bank in
the event there was a serious disagreement over the conduct of monetary policy. Under this
amendment, the government would have the right to override the Bank's policy decisions. To do so,
however, the Minister of Finance would have to publish the reasons for his (her) dissatisfaction,
indicating both the new measures that the Bank was supposed to undertake as well as the period
during which they were to apply. It was generally agreed, I believe, that such a "nuclear weapon"
would only be used when there was a fundamental disagreement between the Governor and the
Minister, and that following its use, the Governor would resign. In this way, the rights of a
democratically elected government to determine policy were balanced against the needs of the Bank
for operational independence. While governments must always have the final say in important policy
matters, the Bank had to be protected from undue political influence in its day-to-day operations. A
key element that was missing from this solution was a clear measure by which the government and the
public could judge the Bank's performance.
2.4 Stagflation and monetarism: 1971 to 1981
The early 1970s began much like the 1950s. Foreign capital was flowing into Canada at an
unprecedented rate and the Bank of Canada was finding it difficult to resist the upward pressure on the
Canadian dollar. Rather than guess where the new equilibrium exchange rate might lie, the
government again decided to let the currency float. As in the 1950s, this move was regarded as a
temporary measure. Within three years, however, the rest of the Bretton Woods system had collapsed.
While Canada's decision was in no way responsible for what followed, its positive experience with a
floating exchange rate through the 1950s and the early 1970s did provide some assurance to other
countries that the new regime was at least workable.
Canada was now able to pursue an independent monetary policy. The Bank's efforts in the face of
building international inflation pressures, however, proved to be insufficient. Outdated views about the
Phillips curve, overly ambitious estimates of the natural rate of unemployment and a concern about
letting the Canadian dollar appreciate much above US$ 1, contributed to the problem. The Bank of
Canada was not unusual in this regard, and its performance did not differ noticeably from that of most
other central banks. Economic thinking among the major industrial countries was very similar, and
received wisdom was, for the most part, imported from the United States.
Although Canada's experience had, in effect, been providing the rest of the world with an example of
how an open economy operates in the presence of near-perfect capital mobility, it went largely
unnoticed. Closed-economy concepts continued to dominate most national policy discussions. While
Mundell's results were slowly filtering through the academic community, they had not yet reached the
ranks of practising economists. Little recognition was given to the effects that market liberalization
and different exchange rate arrangements might have on policy outcomes.
In the meantime, the combination of generalized excess demand in the world economy and the OPEC
oil cartel had sent inflation and unemployment soaring to postwar highs. Policymakers in Canada and
elsewhere were having difficulty dealing with this stagflation and were initially confused by the twin
phenomena of rising inflation and high unemployment. Within a short time, however, three things had
become evident. First, higher inflation was not always associated with higher output and employment.
The Phillips curve was not only vertical in the long run, but was probably upward-sloping. Second,
efforts to fine-tune the real economy were likely to end in failure. Optimism about our ability to
forecast and about the level of full employment introduced a strong inflationary bias to fiscal and
monetary policies. Third, money mattered and was the ultimate source of all sustained inflation.
Excessive government spending and other positive demand shocks could not generate ongoing
inflation unless monetary policy was prepared to validate it.
To avoid similar problems in the future, many central banks began to target the monetary aggregates.
If, as Friedman suggested, inflation was always and everywhere a monetary phenomenon, a gradual
deceleration in the rate of money growth would eventually squeeze it out of the system. Once this had
been accomplished, money growth could be set just high enough to meet the legitimate needs of the
economy - thereby ensuring long-run price stability. If the new money targets were publicly
announced and fully credible, some monetarists argued, it might even be possible to achieve this
disinflation without any significant loss in output. If this proved to be impossible, some deterioration
in economic performance would have to be accepted. A "gradualist" approach, however, would ensure
that this was kept to a minimum. While fixed money targets might not deliver the best of all worlds,
they were regarded as the safest alternative in a second-best world. Trying to forecast the future and
optimally adjust fiscal and monetary policy settings had proved not only to be impossible but also
potentially destabilizing.
Canada adopted a target for the narrow monetary aggregate, M1, in the autumn of 1975, a short time
after the United States and Germany. For a while, the strategy appeared to be working. Inflation began
to decelerate, and the economy began to recover from the 1974-75 recession. While some of this early
success could be credited to the wage and price controls that the government had introduced in late
1975, proponents of the monetarist view believed that Canada would soon be on its way to price
stability.
Initial optimism over what the monetary targets could deliver soon gave way to frustration as inflation
began to rise again in the late 1970s. A second oil shock and continued fiscal expansion added to the
inflation pressures that were already in place. By the early 1980s, inflation had returned to
doubledigit levels, and inflationary expectations were again beginning to accelerate. Research at the Bank
revealed that one of the reasons for the weak relationship between the movements in M1 and
subsequent changes in prices was the high interest elasticity of the demand for this narrow money
aggregate. The modest changes in interest rates that were required in the short run to keep M1 within
its target band were not enough to have much impact on real output or prices.20
Another, more serious problem in using M1 was the uncertain impact of financial innovation.
Technological developments had allowed financial institutions to introduce a number of new products
designed to help depositors protect themselves from high inflation by shifting their idle balances into
daily interest savings accounts. This weakened the relationship between M1 and the other
macroeconomic variables that normally influenced its behaviour, and made it difficult for the Bank to
interpret its movements.
2.5 The search for a new nominal anchor: 1982 to 1990
In 1982, after several disappointments, the Bank of Canada reluctantly conceded that the monetarist
experiment had not worked and that the Bank would no longer be targeting M1. Movements in the
monetary aggregates would continue to be monitored for any information they might provide on future
economic developments, but no aggregate appeared to be sufficiently reliable to serve as an
intermediate t