Why 1951 matters to 2021.

Here we are in a world economic lockdown and the Post’s Kevin Carmichael and the C. D. Howe Institute’s Jeremy Kronick and Steve Ambler, who is also an economics prof at the Université du Québec à Montréal, are debating the monetary policies of 1951. What gives?

In fact, the debate couldn’t be more relevant. It has to do with limits on monetary policy when governments have big debts. Coming out of World War II, those governments that still existed had very big debts. In most places, taxes had helped pay for the war. But governments had borrowed a lot, too. Successive Victory Bond campaigns had raised lots of money in both Canada and the U. S. We haven’t had “Beat COVID” bond campaigns yet but governments are ramping up their borrowing on a scale not seen since the War.

In 1945, both Canadian and U.S. government debt was about 110 per cent of the countries’ respective GDPS. For the next six years, debt management concerns dominated what monetary policy there was. And, as a result, there wasn’t much.

What’s the problem? If the central bank — the Fed in the U. S., the Bank of Canada here — decides that for the good of the economy, interest rates need to go up, the new, higher rate makes the returns on outstanding bonds look feeble by comparison. Suppose they were contracted when interest rates were three per cent and they’re now six per cent. Who wants to buy an old three per cent bond when new bonds pay six? What happens to old bonds as a result? Their prices plummet. The only way a bond contracted for three per cent can pay six per cent is if its price falls in half. You don’t want to be holding low-interest bonds when interest rates go up.

Why was that a problem for postwar central banks? Governments had run high- pressure, celebrity- driven Victory Bond campaigns to persuade ordinary folk to part with their savings and help pay for the war. And then as soon as the war ends along come central banks to raise interest rates and crash the value of all the bonds these ordinary folk had bought? That doesn’t work morally and would have been a non-starter politically.

In fact, in 1942 the Fed had agreed to keep interest rates low and stable so as not to disturb bond prices. That helped war finance but hamstrung the Fed. Which was not such a problem under wartime price controls but was clearly a problem when controls came off. In the first three postwar years U.S. inflation averaged 10.2 per cent a year.

By 1951 the Fed wanted to free itself from its wartime commitment and, after some back and forth, the Fed-treasury Accord of 1951 did just that. But negotiations were bumpy. There’s a wonderful Fed memo of a meeting the full Federal Open Market Committee had with president Harry Truman at the White House. Truman explains the urgency of the international situation, qualifying the Korean emergency as “the greatest this country has ever faced, including the two World Wars.” The Fed Chair explains the need for flexible monetary policy. The parties agree to keep meeting. And then, the Fed note records, the White House the next day issues a press release thanking the FOMC for agreeing to keep interest rates low. There’s no doubt who the skilled politician in the room was. You write the press release, you win the meeting. Later in the year, however, the Treasury relented and the Fed was freed to raise rates.

How does this relate to 2021? Like their wartime counterparts, governments will emerge from the pandemic with much higher debts. At current low interest rates, these debts won’t be too hard to manage. In 2018-19, Ottawa’s interest payments of $23.2 billion were just under seven per cent of total federal spending. On average, Ottawa was paying a little over three per cent on its debt. Raise the debt by $100 billion and that’s another $3+ billion in interest. As they say in Ottawa these days, what’s $3 billion?

But what if prices start rising or the dollar collapses and the Bank of Canada feels it has to raise interest rates? One per cent of the pre- COVID federal debt is $ 7+ billion. You start raising interest payments by $7 billion at a time — or $8 billion or $9 billion or $10 billion after the new debt is added on — and that’s more noticeable. How comfortable will the Bank be putting a big hole in the federal deficit?

Now, if there’s no chance of inflation in our future, no worries: interest rates need never go up. But a couple of things about that:

First, our biggest problem at the moment supposedly is uncertainty. So it’s a strange time for people to be rock-certain inflation simply won’t happen.

Second, many people convinced we won’t have inflation are also convinced the pandemic means the end of globalization. But globalization is often offered up as a main reason inflation has been under control these past 30 years. In effect, competition from China disciplines domestic producers wanting to raise prices. But if borders go back up, as many people clearly want, that discipline disappears.

Olivier Blanchard, one of the world’s leading macroeconomists, says he doesn’t think we’ll have high inflation but he can’t exclude the possibility. After an informal survey of colleagues he concludes the odds for it are less than three per cent. I wonder what odds his colleagues would have given on Oct. 1, 2016, that Donald Trump would become president, or on Jan. 1 this year that within 100 days the world economy would be in lockdown.

My money says the interaction between monetary policy and budgetary policy will be a main worry for whoever takes over from Bank of Canada Governor Stephen Poloz when he retires in June. I hope it doesn’t keep her up too many nights.

There’s no doubt who the skilled politician

in the room was.