July, 1995 Vol 1, No. 2
July, 1995 Vol 1, No. 2
A GUIDED TOUR OF CANADA'S FINANCIAL SYSTEM
Our Real Economy has Been Swamped by Financial Tides
How do Financial Markets Work? How Can We Take Back Control?
A key factor behind Canada's current economic problems (including our large debt and slow growth) has been the dominant influence of our financial system. Economic events are being dictated by what happens in financial markets--the trading pits or computerized markets where key financial outcomes (such as interest rates, the value of the dollar, and the prices of stocks and bonds) are determined.
The people and companies who control these markets have the power, under our current financial system, to maximize the value of financial wealth (such as stocks, bonds, and currencies). To achieve this goal, they are enforcing policies which are highly damaging to the rest of the economy: policies like high interest rates, slow economic growth, and zero-inflation.
This edition of Economic and Social Action will explore what is going on in our privatized, erratic financial system.The Issue: Financial Instability & Our Economy
_ To create jobs and pay off our deficit, we must have lower interest rates and more rapid economic growth.
_ But the financial system, as it is presently structured, benefits from very high interest rates and global money movements.
_ The owners of financial wealth are capturing a larger and larger share of the economic pie. Workers, governments, and even corporations in the real economy are all getting less.
_ Far-reaching changes in our financial system will be needed to correct the problem. Eventually we will need public banks and pools of social capital to stimulate investment and create jobs at home.Adding up the Costs
The consequences of financial instability for most Canadians have been devastating, and are going to get worse unless we change the way the financial section of our economy works. For example, thanks to very high interest rates over the last 15 years, we have experienced a more-or-less permanent state of economic recession since the early 1980s (see Table 1).
Growth has been much slower, and unemployment much higher, than in the preceding decades. Real wages have been stagnant or even declining; workers and unions have been under sustained economic pressure.
Canada's deficits and debt have exploded, despite ongoing cutbacks to programs. With high interest rates and slow growth, deficits automatically increase (since tax revenue declines during a recession, but government expenses on social programs and interest payments skyrocket).
At least 85 percent of the current federal deficit, and at least 75 percent of the growth in federal debt since 1985, are directly attributable to the dramatic and permanent rise in real interest rates that began in the early 1980s. These figures are even higher if the indirect effects of high interest rates (by causing slower economic growth) are considered.
And this drain on the public treasury is continuing, despite the current emphasis on spending restraint (see Figure 1). For example, of all the funds that will be saved by 1996-97 from the federal government's huge cuts to public programs, fully 85 percent will be paid right back out to financial investors, thanks to almost $9 billion per year in additional interest payments.
Most importantly, there has been a huge transfer of income and power from those who do not own financial wealth (including most workers), or who are in debt (such as most homeowners), to those who do own financial wealth (especially the very rich).
Despite the growth of pension plans and other more "democratic" forms of financial wealth, it is still estimated that the richest one percent of our population owns about 25 percent of all financial wealth. They are the ones, by far, who have benefitted the most from the new power of the financial system.The Real Economy and the Paper Economy
In essence, there are two ways for an investor to make profit in our economy. Increasingly, these two ways are coming into conflict.
An investor can start a company: open a factory, buy machines, hire workers, and develop and sell an actual commodity (a product or a service). This is known as the real economy. Unions have to battle it out with employers in the real economy, over issues such as fair wages and working conditions. But at least these employers are creating jobs and producing things of real value.
But an investor can also make money by engaging in the sale and re-sale of purely financial assets (such as stocks, bonds, or currencies). Profit is made by selling the asset at a higher price than was paid for it, or else by collecting guaranteed interest or dividend payments. This is the financial economy or the paper economy. No real good or service is produced. Paper is shuffled, and interest coupons are clipped.
How Financial Markets Really Work Who Controls the Interest Rate?
There are many different interest rates: short-term versus long-term; the "prime" rate for large customers, versus higher rates for smaller customers; the very low rates paid by banks on savings accounts, versus the very high rates received by banks on credit card balances.
Individual rates are set by the various financial institutions in the course of their day-to-day business. But the Bank of Canada (Canada's central bank, loosely controlled by the federal government) sets some key "trend" interest rates, which exert influence over all the other rates charged. The most important trend rates are the Bank of Canada rate (set every Tuesday), and the overnight lending rate (which the Bank of Canada charges on its routine loans to commercial banks).
Thus the Bank of Canada could reduce domestic interest rates. But it must also keep an eye on where private financiers are putting their money. If money flows out of Canada because interest rates are too low, Canada's dollar comes under pressure.What Determines the Value of the Dollar
There are both real and speculative factors which affect the exchange rate. On the real side, the dollar will rise if Canada's exports are strong, if the prices of our exports rise, or if foreign direct investment in Canada is growing. These real forces change slowly over time.
But it is the speculative forces which cause the dollar to rise and fall each day. Basically, many investors gamble every day on whether the dollar will rise or fall--just like they do with the prices of company stocks on the stock market. If they think the dollar is going rise (no matter what the reason), they will buy dollars--thus increasing the value of the dollar!
In speculation, it doesn't really matter whether the real economy is doing well or not. More important is trying to outguess other speculators. In the global foreign exchange market, more than $1 trillion now changes hands every day, and 95% of this total is speculative.Inflation and the Paper Economy
Nothing frightens the speculators who run the paper economy more than the prospect of inflation. Remember, they make their money buying and selling paper, rather than producing real goods and services. Inflation, in essence, undermines the value of all paper assets. So financiers are passionately opposed to anything that might increase inflation (such as pro-growth macro policies).
In the real economy, on the other hand, modest inflation (of say 5% or less) is at worst a minor irritant. Sure, it means that we have to make sure our wages and pensions are indexed. But if real employment and output can be expanded at the cost of mild inflation, it is clear that the benefits of faster growth outweigh the costs of mild inflation.
The battle over high interest rates and zero-inflation is thus a battle between the paper economy (which desperately fears inflation) and the real economy (which could actually benefit from mild inflation). When the financial system is working well, there may not be a conflict between the financial economy and the real economy. The financial economy can help to channel capital into real, productive investments by real, productive companies.
But financial investors have obtained super economic powers in recent years--thanks to various factors:
_ technological and institutional changes, which allow banks to transfer finance from industry to industry and from country to country in seconds.
_ government deregulation, which has given banks and financial institutions much greater freedom.
_ right-wing economic policies, which have deliberately promoted high interest rates and slow growth.
With this new power, the paper economy has come to dominate the real economy. Banks, speculators, and financiers can make higher profits from shuffling paper than most real companies can possibly hope to make from producing and selling a real product (see examples in Table 2).
More and more profit is siphoned away from productive investors to financial investors. From 1960 to 1980, for example, the gross rate of return on capital (relative to Canada's fixed capital investments) averaged over 30 percent; about 70 percent of this was kept by "real" investors (see Figure 2). During the 1990s, however, even though the total return to capital has increased, "financial" investors now take over half of the total. The return to real investors has actually declined.
Even major industrial companies are trying to cash in on the paper economy. For example, General Motors and General Electric both made more profits from their internal financial subsidiaries last year than they did from manufac- turing real automotive or electrical products.
The end result: weak investment in the real economy, perpetual slow growth, and chronic unemployment.Who's Feeling Confident?
Governments and business leaders say we need high interest rates and low inflation to increase "investor confidence". And, indeed, purely financial investors will be very confident, if they can earn high financial returns in a stable, no- inflation environment.
Financial investors praised the last federal budget for exactly this reason. It did nothing to challenge their overwhelming economic power. It took for granted that Canadian taxpayers will continue subsidizing bond-holders (paying out $50 billion per year in interest payments by 1996-97). It helps to perpetuate permanently high interest rates.
Financial investors have a lot to be confident about! So their funds stay in Canada, and the value of our dollar increases slightly (see "Primer" box). Contrary to promises, however, interest rates do not fall substantially: by June short-term rates were still above 7 percent, far too high given the shaky state of the economy.
But what about the real economy? Does this financial confidence translate into concrete economic benefits? Far from it. In fact, the enhanced confidence of the financiers is mirrored by evaporating confidence among real Canadian investors and consumers--who are, after all, the ones who still must produce and purchase the real goods and services that make our economy work. In the first three months of 1995, just as the federal budget was coming out, Canada's consumer confidence index declined to its lowest level in 18 months. And why not? Canadians watch as the federal government lays off 45,000 workers (equivalent to the complete shutdown of GM and Chrysler in Canada). Interest rates are high, the economy is slowing, yet the Bank of Canada still talks about how unemployment may already be "too low".
Consumers know that all of this is bad news for the real economy--regardless of how "confident" financial investors feel. They hunker down, prepare for tough times, cut back on their own spending. And since consumption accounts for 80 percent of Canada's real economy, this pessimistic attitude, combined with government cutbacks, could easily translate into another recession. In 1994, total consumption (private and public) grew by only 2.1 percent, held back by stagnant wages, high interest rates, and consumer pessimism. In 1995, it now appears this pessimism has turned into an outright recession.
Real investors, too, are not feeling especially "confident". Unlike financiers, they care more about whether they can actually sell the product that they make--not about whether our government is being "fiscally responsible".
Another recession at this point in time would be a social catastrophe for Canada--causing despair, poverty, suicide, and violence. It would also be a fiscal catastrophe for our government (since tax revenues would collapse, but UI and welfare spending would increase). Like the last recession, this one would be purely man-made: resulting from the manipulation of interest rates to ensure that full employment remains a distant dream, and to keep unions on the defensive.How to Take Back Control
Resolving Canada's economic problems (including high unemployment and our huge public debt) will require a whole new approach to managing our financial system. In the short-run, much could be accomplished simply through a new attitude by government: instructing the Bank of Canada to modestly lower interest rates, letting the dollar fall a bit, and trying to keep more of our debt at home in Canada (where it is less vulnerable to international financial pressures).
Ultimately, however, we will need to be prepared to put powerful new controls over the financial system itself, in order to rein in financial markets and put the real economy first. Here are some policies we can fight for:
_ Re-institute controls on private banks--such as requiring them to keep deposits with the Bank of Canada, exercising greater control over the interest rates they charge, and limiting their international activity. These controls were eliminated by the Tory government in the early 1990s.
_ Establish a public investment bank, to channel low-interest capital into investments in the real economy (especially Canadian manufacturing). This could also act as a public "window" on the banking industry, and could force commercial banks to cut their own rates.
_ Put limits, where possible, on international financial flows. For example, we could force registered pension plans (which, after all, get a large tax subsidy from Canadian taxpayers) to keep their funds in Canada.
_ Eventually we must build up pools of publicly-owned financial capital (such as social investment funds, public insurance plans, and credit unions) which would boycott the casino activities of the paper economy, in order to attain stable growth and full employment in our real economy.
These demands are far-reaching, and will be fiercely resisted by the banks and the financial investors. But they are essential if we are ever to get a handle on the problems that are hampering our economic and social progress.
THE PERMANENT RECESSION:
Before and After
|Real Short-Term Interest Rate||1.1%||6.1%|
|Real Interest Rate on Federal Debt||3.9%||7.7%|
|Economic Growth Rate||5.0%||2.4%|
|Federal Deficit (as share of GDP)||0.3%||4.5%|
|Annual Change, Real Wages1||2.4%||-0.8%|
|Share of Capital in GDP2||11.1%||13.8%|
|NOTES: 1. Change in average weekly wages
less change in CPI.
2. After-tax corporate profits plus interest and investment income, divided by GDP.
THE REAL ECONOMY AND THE PAPER ECONOMY
Where would you rather invest?
|Average long-term interest rate, 1994 (no risk)||8.63%|
|Average return on equity, Canadian non-financial business, 1994 (risk)||7.40%|
|Annual return on capital, John Henry currency speculation fund, 10 days during 1995 Mexican peso crisis||3240%|
|Annual return on capital, General Motors, 1994||2.5%|
|Change in average compensation, top 5 Canadian bank presidents, 1994||47%|
|Change in average hourly wage, Canadian workers, 1994||1%|
|SOURCES: Statistics Canada, The Wall Street Journal, corporate annual reports.|