Business insolvencies hit 36-year record: Bank of Canada's interest hikes are collapsing the economy - as predicted

This is not how it needs to be.

In the very first post I wrote, I said the most important thing we need to do address Canada’s economic challenges was for the Bank of Canada to change it’s monetary policy, as recommended in August by former advisor to the Bank of International Settlements, William White.

The Bank of Canada has announced its changing policy - but not until 2025, which given the disastrous harm it is doing right now to the economy, will be too late.

The Bank of Canada’s policies to fight inflation, having created a massive “everything bubble” in assets for decades are now actively cratering the Canadian economy, are now causing some of the worst bankruptcy rates since past financial crises.

• “consumer insolvencies in Canada increased 23% last year, the fastest rate of increase in 14 years.

• “business failures marked the biggest annual increase based on 36 years of records from the Office of the Superintendent of Bankruptcy (OSB).”

• Bell Canada (BCE) will be cutting its workforce by 9%, which is approximately 4,800 positions

A new report from the Canadian Association of Insolvency and Restructuring Professionals (CAIRP) found that business insolvencies nationwide rose 41.4% in 2023 from the previous year.

That number of business failures marked the biggest annual increase based on 36 years of records from the Office of the Superintendent of Bankruptcy (OSB).

In addition to federal and provincial governments clawing back the financial supports they extended to businesses during the pandemic, many Canadian companies are also struggling with higher debt servicing costs due to a rise in interest rates, noted the report.

In all, 4,810 businesses filed for insolvency in 2023. Newfoundland and Labrador had the highest percentage increase in insolvencies at 141.7%.

British Columbia at 65.4% and Nova Scotia at 55.6% also experienced a high number of business failures in 2023.

This is what was predicted by in the summer of 2022 by Economic Historian and former financial Executive Edward Chancellor, who in a July 2022 interview said

And you say it was wrong that central banks tried to combat this kind of deflation at all cost?

By aggressively pursuing an inflation target of 2% and constantly living in horror of even the mildest form of deflation, they not only gave us the ultra-low interest rates with their unintended consequences in terms of the Everything Bubble. They also facilitated a misallocation of capital of epic proportions, they created an over-financialization of the economy and a rise in indebtedness. Putting all this together, they created and abetted an environment of low productivity growth.

… By pursuing this policy of ultralow interest rates for so long, they have created a lot of fragility in the economy and the financial system. We used to refer to monetary policy after the financial crisis as «kicking the can down the road», remember? Well, they kicked the can for so long that we forgot that they were just delaying the day of reckoning. It will turn out to be largely impossible to normalize interest rates without collapsing the economy.”

How and why this is happening

There are a couple of reasons why the Bank of Canada is following this path.

One is ideology: their economic models are from the 1970s, and they don’t even include or measure essential parts of the economy like debt and banks. We are still stuck with 1970s levels of information gathering and technology, from an age where calculations and spreadsheets were still largely done by hand.

As a consequence - despite incredible advances in modelling, access to data and information technology we are still dealing with macroeconomic models that are based on ideas from the 1920s and before.

To give an indication of how crude the modelling is, instead of modelling the interactions of many different individuals and organizations in the economy with different amounts of money and debt, our mainstream, orthodox macroeconomics treats the entire economy as if it were one, giant, aggregate person.

Mathematically speaking, that one, giant collective person is the economy. They are the one business owner, the one consumer, the one employee, the one boss. It is a definition that assumes total equality and total distribution of wealth and taxes.

The results are not just misleading, they leave economists and policymakers blind to what is happening. If every person but one in the entire economy has their wages frozen, but the last person gets a massive raise, it will be seen as a rise in GDP that is shared by everyone.

Why the failure to model banks and debt is so hazardous

There is a technical reason for the bad (or non-) modelling of banks and debt.

One is that neoclassical economics treats supply and demand as the be-all and end all, and that money is just a medium of exchange, and that our entire system is basically barter with money being used in place of objects being traded.

One of the reasons for ignoring banks is that they are considered to be a wash, because of the idea that you put your money in the bank and the bank lends it out to someone else.

It’s as if your bank is account is a two-sided drawer, where you put money in one side, and people borrow it from the other. In this model, the bank is a neutral middleman - mathematically an “equals” sign. Because the dollars loaned and borrowed cancel each out, so it seems like a wash. So banks aren’t modelled. The explanation for how banks increase the money supply is that when someone takes out a loan, they put it in another bank, which lends it out. This is supposed to “stretch” the use of money - as if money is a car share service, where when you are not using your money, someone else is.

This is not how banks or bank lending actually works.

As is recognized, banks lend out a multiple of their reserves on hand at any time. That is, if a bank is required by regulators to maintain a 5% reserve and they have $5-billion in reserve, they can issue $95-billion in loans, with variations based on interest rates, the market, etc.

This treats all money like “cold hard cash” as a physical entity that has to be moved from place to place. Despite the fact that the money value of almost all cash transactions is a fraction of all money in the economy. According to a 2022 report, there “There is $112 billion worth of physical money in circulation, averaging out to $3,000 a person” in Canada. The rest of the “non-physical” money is expressed as a number in someone’s account at a bank or other financial institution.

Because counterfeiting is a crime, and it’s illegal to create your own money, we think of the money supply as extremely fixed. Banks work differently, by “extending credit” to customers. As researchers at the Bank of England wrote,

“When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.”

The idea of creating money out of nothing may seem baffling, but the details of how this happens, especially now that mortgages are packaged up and sold as investments.

One is that the bank can create and extend the credit whether there are reserves for it or not.

One of the ways this bit of financial juggling happens is that banks extend credit - and write the money into the borrowers’ account.

One reason is that, as described in Michael Lewis’ “The Big Short” mortgages are often no longer held by banks. The bank issues the mortgage, but they don’t hold it. An investment company will come along and give them money for it. Then that mortgage will be bundled up with many others, and it will be further sold to investors as a way of receiving stable income - because of all the people who are paying their mortgages every month. These “mortgage-backed securities” are what crashed the economy.

The other is how can banks could possibly be able to extend credit they don’t have?

One is that even an individual can “create” new money as credit with an “IOU” (I owe you). If you give someone a piece of paper that says “IOU $50” and sign and date it, it is legally enforceable.

Mortgages are just that - they are a promissory note by the borrower. When you take our a mortgage, you are promising that you will pay a certain amount a month over a number of years - and it is secured against an asset - property that can be seized and sold, so the money can be recouped.

In fact, despite the fact that if you were to lend someone $500,000, it would be a liability, banks do not treat their mortgage loans as a liability - they are treated as an asset.

The problem here, as we will see, is that this feedback loop is what so seriously distorts the market, and makes private debt so destabilizing. Banks issue more credit, driving up housing and property prices, which means they can offer more credit.

This creates the illusion that the housing market and mortgages are lower risk than they are, and over the long term, it creates fundamental problems.

One is that housing owned for personal use in particular, is a cost for the owner.

It does not generate ongoing income, the way owning an apartment building or multiple houses does. Rather, bigger loans from the bank are going to inflate the price of existing assets, and changes in interest rates can make a difference of tens or hundreds of thousands of dollars for a single home buyer.

It is not a “productive investment” and it’s not going into creating new value, the way investing in a new business does, which will generate revenue to pay for itself.

Instead, you can only capture the gain by selling the asset, so people start buying up real estate as an “investment” not for the purpose of buying houses and living in them, or buying rental properties for the ongoing rents.

Instead, easy access to growing amounts of debt means that prices start going up fast, so investors start buying assets because they can get short-term gains. If interest rates are 1% and real estate is going up by 10% a year, people can make huge short-term returns by buying real estate one year and selling it the next, using borrowed money.

This “flipping” and debt is what ultimately creates financial crises - because banks are extending credit beyond their own limits, while asset prices are going up.

Because their own lending creates the illusion of safety, banks are also less likely to lend to productive businesses. New and growing businesses are seen as less certain - even though they can actually generate ongoing revenue, and investments in new capital machinery increases productivity.

This sets up a feedback loop of increased debt to inflate existing assets, which deliver high short-term returns while investments in the “real economy” and the creation of valuable new productive assets are neglected.

Because it is all based on extended private credit, the money is not available, right now: the value of the mortgages is based on the expectation that the person will be paying it back for 10, 20 or 30 years.

When the bubble bursts, people start defaulting and the price of housing drops. This is an issue for banks as well as investors. It’s more than the fact that if people default on their mortgages, the stream of money flowing into the bank ends. If the price of houses drops, it means neither the homeowner nor the bank can sell off the asset and pay back what is owed.

If this happens across the economy, it is how housing bubbles turn into financial crises. It is not a “bank run” where people are suddenly pulling their money out - it is an asset crash and defaults.

Many economists are blind to this, because they treat money and value as something that can’t be destroyed, including capital.

The reality is that capital can be destroyed - your assets can be a complete loss or write-off.

Buying Power: Lower interest rates mean bigger loans, not cheaper loans

This is one of the most important parts of understanding the role of interest rates on loans. People talk about lower interest as “lowering the price” of borrowing - that “borrowing is cheap.”

The assumption appears to be that if someone wanted to borrow $300,000 for a house when interest rates were 5%, they will now just borrow $300,000 at 2%, and save a bunch of money.

That is not what happens. Instead, the size of the loan is based on your ability to service it with monthly payments.

When interest rates drop, it does two things: the people who could borrow money before can borrow much more, and people who couldn’t borrow at all, can qualify for loans. When people talked about the folks who were qualifying for “sub-prime mortgages” that drove the Global Financial Crisis, one of the categories were “NINJA” loans - which stood for people with “No income, no job, no assets.”

The reverse of this is that higher interest rates mean smaller loans to fewer people.

This has a huge impact across the entire economy - and also because different interest rates apply to different individuals based on their credit rating, people with more money will, generally, be able to borrow more.

This is explained here, and it’s important to note what a huge impact it has on an individual buyer:

https://www.consumeraffairs.com/finance/how-interest-rates-affect-buying-power.html

They summarize

• “Higher mortgage rates mean buyers can afford less.

• Fixed 30-year mortgage rates more than doubled between December 2020 and July 2022, according to Freddie Mac.

• Even small rate increases can significantly reduce your buying power.”

“Rising mortgage rates can have a significant impact on buying power. A 1% increase in rates can add hundreds of dollars to a monthly payment and make it difficult to qualify for a loan in the first place.”

They further explain, with a borrower whose income is $4500 a month, or $54,000 a year.

Increasing interest rates from 4% to 5% decreases the loan you are offered, and the house you can buy, by $46,939.

But for about 25 years, after a series of economic crashes and disaster, interest rates have been pushed ultra-low to “stimulate the economy” because since the 1970s, that has been seen of as a way to encourage growth with limited inflation, while discouraging fiscal measures, on which inflation is blamed.

Some of those crises were listed in a speech by Governor of the Bank of Canada, Tiff Macklem - the dot-com crash of 1999; the terrorist attacks of 9/11 and ensuing wars in Afghanistan and Iraq; the 2008 financial crisis; and the pandemic, to name a few.

What people fail to recognize is the way monetary policy through manipulating interest rates has created a colossal debt burden by driving up the price of housing, which is a necessity of life.

What is more, the financial impacts are far greater than almost any burden created by government. We are talking about policy changes that can add hundreds of thousands of dollars in debt to a single individual, or hundreds of dollars a month in new debt payments.

That is an absolutely colossal impact at the individual and system level.

During this “bubble” phase - which is driven by dropping interest rates, this money drives “development” including all the jobs associated with real estate, construction, finance, insurance, basic materials as well as furnishings. It also means higher revenue for governments - helping them balance their budgets, temporarily.

The debt of middle- and working class folks is being used to inject billions or trillions of dollars into the economy - largely into investments that by their nature, will not help them pay off that debt.

The normalization of interest rates is essential, because the added burden of debt that goes along with ultra-low interest rates is massive.

The issue is that when it turns out that people can’t actually pay back the massive loans that banks assured individuals they could afford, the system starts to break down, not because of an external “shock” but because it is inherently unstable, because so much of the money and contracts in the economy are based on extended credit - not on income.

When central banks increase interest rates, the money flowing into the system is sharply reduced, at every level. Businesses and individuals with the same income will now only qualify for much smaller loans, and some will be cut off entirely.

The result is a sharp slowdown of money into the economy more generally. Speculators and flippers may go broke, and all the industries and flow of money that were dependent - or became reliant - on the billions of dollars flowing into the economy because of mortgages - will be stranded.

That is why the latest remarks by the Governor of the Bank of Canada are distressing, because they show a complete disconnect with the actual effects of monetary policy, and have learned no lessons whatsoever from the past 30 years.

Macklem claims

Housing supply has fallen short of housing demand for many years. There are many reasons why—zoning restrictions, delays and uncertainties in the approval processes, and shortages of skilled workers.5 None of these are things monetary policy can address.

But wait, you say. Monetary policy has big effects on the housing sector. It does. Because most people need a mortgage to buy a house, changes in the policy rate affect demand for housing very quickly. But the effects of monetary policy on the supply of housing are much more limited.

Consider how shelter costs changed through the pandemic. When the Bank of Canada lowered the policy rate in 2020, the combination of low mortgage rates and a desire for more living space increased the demand for housing a lot. Supply increased far less, and housing prices rose more than 50% in two years

It is absurd to claim that the 50% increase in housing prices is because of “a desire for more living space.”

The low interest rates drove a speculative frenzy, and provincial governments made it worse by living the freeze on evictions during the pandemic.

There are two issues here. One is that the Bank of Canada is denying its destructive and disruptive role in creating a housing crisis in Canada, through policy errors that have been recognized by experts like Edward Chancellor and William White.

The other is the false claim that there is nothing the Bank of Canada can do - that, apparently, while monetary policy can break things, they can’t, or won’t fix it.

The fact is that there are many things the Bank of Canada can do, and does do. In the last 30 years, and especially during the pandemic, the Bank of Canada and other central banks acted as lenders of last resort.

They bought tens of billions of dollars (globally, several trillion dollars) that was printed in order to prop up the asset prices of bonds whose value was collapsing. This “quantitative easing”

This was a pattern that was established after the 2008-2009 Global Financial Crisis, when governments and central banks bought “toxic assets”.

Those “toxic assets” were the mortgages issued to people who couldn’t pay. So central banks printed money to make sure investors who made bad bets still got paid, even as the people who had taken the loan were foreclosed on and lost their homes.

So how is it that central banks can harness their infinite powers of money creation, but only ever for bailing out the financial sector, which created the crisis in the place by extending credit it didn’t have to inflate the price of assets?

The consequence of this is that Canada is facing a private debt crisis - more accurately, an insolvency crisis, which is that many people and businesses are teetering on the bring of bankruptcy, and the Bank of Canada is doing everything it can to push people over the brink.

The Bank of Canada’s “monetary stimulus” of manipulating interest rates is to blame for the crisis. The question is how to undo it.

William White has recommended debt restructuring, and that is exactly what the Government of Canada, the provinces and the Bank of Canada should all be working on right now.

Canada, and developed countries, need a Marshal Plan, like the one that rebuilt Europe and North America after the Second World War.

The Marshal Plan included finance targeted for industrialization as well as monetary changes that reduced people’s debts in Germany, while similar post-war relief programs reduced debts for farmers, provincial governments and municipalities. The Federal Government agreed to cancel the provinces’ Depression-era debt.

In a paper I presented in 2017, I pointed to the historic and instrumental role that the Bank of Canada played in helping Canada get out of the Depression as well as assisting in financial Canada’s post-war industrialization.

There are a number of options open to policy makers.

“there is no shortage of theory and evidence from history that demonstrates that central banks not only can, but did play a role in reducing inequality and growing the economy, both in Canada and the U.S. Ryan-Collins’ study of Canada’s experience provides empirical and historic evidence that a central bank can intervene in the economy, supporting both government and private investment, without significant inflation. Andricopoulos has argued the case for monetized deficits to bring down private debt. In 2014, William H. Buiter argued that ‘there always exists– even in a permanent liquidity trap – a combined monetary and fiscal policy action that boosts private demand – in principle without limit. Deflation, “lowflation” and secular stagnation are therefore unnecessary. They are policy choices’ (Buiter 2014).”

Yes, there are things that the Bank of Canada could do as part of a “Marshal Plan” and the solution needs to be fiscal:

• “Monetized deficits” - that means that the Bank of Canada could support provincial and federal governments by buying their bonds directly, instead of trying to manipulate the market by buying government bonds that have already been issued. Especially with a focus on investing in infrastructure. Until 1980, 20% of all government debt was held by the Bank of Canada. 15% of the U.S. War Effort in World War II was paid for through monetized deficits.
  Provinces could borrow from the Bank of Canada, and repay the Bank of Canada.

• Debt restructuring: the reality is that many Canadian individuals and businesses are in debt because of the Bank of Canada’s bad monetary policy. It should be possible to calculate the difference between what the debt would have been if interest rates were normal, and what they are, and the Bank of Canada can work with financial institutions and individuals to adjust the debt. The Federal Government should set up debt compromise boards for individuals, and farmers.

• Do not reinflate the asset bubble: invest in new productive industries, with equity investments instead of debt, as well as green industries.

• Further, there should be measures to undo some of the other damage caused by easy money and ultra-low interest rates, which is to undo some of the mergers and acquisitions that have resulted in an overconcentration of ownership and less competition.

• If need be, central bank currencies and bank accounts for individuals.

Canada’s economy as a whole, and many developed economies, have been over reliant on housing and real estate speculation, which has caused our housing bubble and unbearable debt.

The Bank of Canada is causing a recession and bankruptcies in Canada. It doesn’t need to be, and it shouldn’t be. We need to unwind and prune back the excess debt that flowed into non-productive asset bubbles, and invest instead in productive industry as well as environmental recovery.

• DFL