Canada’s bankruptcy chief has joined the rising chorus of those warning  about the excess debt load of Canadian households. James Callon, who heads the Office of the Superintendent of Bankruptcy Canada, concedes that bankruptcies are down somewhat over the last year. Yet he cautioned that,  ”the number of consumer insolvencies filed in Canada was still 22.5 percent higher than the pre-recession level of 2007–2008.”
We Austrians think the Bank of Canada (B0C) is largely to blame for the debt binge by keeping interest rates below the natural level. This is the level that a purely free market among borrowers and savers would establish. The resulting rate would correspond to the over-all rate of time preference, that is, the relative value to individuals of present versus future goods. Since the central bank is constantly intervening in the money and bond markets, nobody can really be sure what the natural rate of interest is. That being the case, we cannot be certain either whether, at any given juncture, the BoC is setting interest rates too high or too low.
So how can we gauge, with some reasonable degree of probability, how the BoC is performing? One way around this problem of the non-observability of natural interest is the Taylor rule. Named after John Taylor, a Stanford University economics professor and a fellow at the Hoover Institution, the rule specifies an appropriate interest rate for the central bank by factoring the relationship between actual and target inflation, on the one hand, as well as current versus potential output, on the other. Here is a simplified version of the equation on the assumption of a 2% inflation target:
r = p + 0.5y + 0.5 (p – 2) + 2
where r is the appropriate interest rate for the central bank; p stands for the inflation rate; y is potential real GDP growth minus current real GDP growth.
What the equation signifies is this: the greater the inflation rate, the higher the interest rate needs to be. And vice-versa. So too, the more the economy is operating above capacity, the higher the correct rate. And, again, vice-versa.
The Taylor rule obviously reflects Keynesian assumptions of an inflation-growth trade-off.  Neither does it reflect the rate of time preference which interest fundamentally embodies. Still, we have to remember that borrower demand for loanable funds will reflect the projected rate of return on investment projects. The higher this rate of return, the more borrowers will seek out loans. When the economy is operating below capacity, it is plausible to believe (though we can’t admittedly be certain of this in all instances) that potential returns on investment projects are higher than normal, if only because the start-up costs of such projects will be unusually low due to the relative cheapness physical and human resources.Â
Applying Canadian data to Taylor’s simplified equation, inflation is currently at 2%, the target level. The consensus view (according to the Economist magazine) is that Canada’s GDP will grow at about 3% in real terms in 2011. That’s probably about the potential growht rate. So if we plug in the numbers, p=2 and y=0, that leaves us with a correct interest rate of 4%. Even if, to play it safe, we lower our growth estimates by 1% (hence y=- 1), the appropriate rate would be 3.5%. Contrast this with the overnight lending rate that the BoC controls. That’s currently at just 1%.
Indeed, the BoC has been operating below what the Taylor rule indicates ever since the first quarter of 2009. Mark Carney has got a lot of work to do.
