Bank of Canada governor warns of debt risks.

Canada will emerge from the COVID-19 crisis in a more fragile state than before the pandemic. Don’t take my word for it. That’s the opinion of the Bank of Canada governor.

“As much as a bold policy response was needed, it will inevitably make the economy and financial system more vulnerable to economic shocks down the road,” Tiff Macklem said in a speech on Oct. 8.

The reason: debt. Canadian households were only just beginning to get a grip on their credit habits when the central bank was forced to drop its benchmark interest rate back to near zero to offset the economic shock of the pandemic.

That vulnerability will now be tested by a recession, the effects of which could linger for a couple of years, since forecasts anticipate a long recovery period. Meanwhile, corporations and governments are amassing debt piles of their own, exposing new weak spots in the economy’s protective armour.

Macklem expressed no regret about any of the extraordinary measures that policy- makers have taken since early March. One of the lessons of the Great Recession is that the alternative to shock and awe — doing nothing, or even too little, to offset the decision to shut down vast swaths of the economy to slow the spread of the coronavirus — would have resulted in a disaster.

But the new governor is taking a clear- eyed view of the state we will be in once the danger posed by the pandemic has passed: the extraordinary policy deployed to avert a second depression in the span of a couple of decades will have severely hobbled Canada’s ability to withstand a third shock, whenever it might arrive.

“Without the fiscal and monetary policy actions, the economic devastation of the pandemic could have been much, much worse,” Macklem said in remarks prepared for the Global Risk Institute. Still, “our policy path will eventually have an impact on financial system vulnerabilities."

Governors have their strengths. Stephen Poloz, who preceded Macklem, had a unique feel for the real economy, honed by hundreds of conversations with executives while serving in senior positions at Export Development Canada.

Macklem’s formative experience was fighting the financial crisis at the Finance Department and then mopping it up as Mark Carney’s second- in- command at the Bank of Canada. He also spent a lot of time thinking about crises during a sixyear sojourn from Ottawa at the University of Toronto’s Rotman School of Management, where he served as dean until Prime Minister Justin Trudeau tapped him to replace Poloz this spring.

“The COVID-19 pandemic has made it painfully clear that how well we manage risks has a huge impact on our well- being,” Macklem said. “Globally, I don’t think it’s an exaggeration to say that the quality of risk management will increasingly influence the success and stability of societies.”

The governor spent some time on climate change, saying the banks “must understand and be transparent about their exposures” to “weather events” that “will almost certainly grow.” The central bank has no authority to make financial institutions take climate change seriously, only the power of moral suasion and the bully pulpit. Macklem said the Bank of Canada will be “accelerating” its research on how climate change will affect economic growth and financial stability.

But the core of his latest remarks focused on the more immediate threat posed by the unintended consequences of lower- for- longer interest-rate policy.

Debt will grow and could eventually become a drag on future economic activity. Households and companies will be at greater risk of default, elevating the possibility of a future financial crisis. The governor said lower interest rates will force insurance companies and pension funds “to adjust.”

He also observed that some asset prices, including those for housing, “seemed high relative to fundamentals” ahead of the pandemic, meaning there is reason to worry about what happens if those bubbles deflate.

“The bottom line is that the private and public sectors together need to be acutely aware of financial system risks and vulnerabilities as the economy recovers,” Macklem said.

That’s for sure. It’s a subject that should be the focus of constant discussion, starting now.

The financial risk that is currently getting the most attention — the federal government’s rapidly expanding debt — might be the least important, at least in the short term. The fear is mostly based on the premise that interest rates will spike, which would cause debt- servicing costs to rise, crowding out fiscal space that could be put to a better use than paying creditors.

It’s a plausible scenario, but one that would require economic growth to remain stagnant for an extended period. Otherwise, there is a deep well of cash out there that investment managers have exclusively reserved for high-quality government debt. That should keep downward pressure on borrowing costs.

The most present financial danger is probably lurking in the housing market. Low interest rates could tempt households to take on more debt than they can afford, or a prolonged “recuperation” phase following the recession could deflate the value of the assets on which so much debt currently rests.

Macklem made a point of stating that policy- makers have “several macroprudential tools,” such as the mortgage stress test, at their disposal “if too many Canadian households start to become dangerously over-leveraged.”

One problem: those bubble-squeezing tools belong to politicians, who have proved reluctant over the years to get on the wrong side of the housing lobby. The Bank of Canada can’t be certain when setting interest rates to stoke economic growth that governments will take care of the side-effects.

Another risk for the pile.