Dodge talks downturn

Former Bank of Canada Governor and Queen’s Chancellor David Dodge discusses the financial crisis and the state of Canada’s economy

Queen’s Chancellor and former Bank of Canada Governor David Dodge says Canada’s road to recovery will be a bumpy ride, but we’re prepared for what’s to come.
Queen’s Chancellor and former Bank of Canada Governor David Dodge says Canada’s road to recovery will be a bumpy ride, but we’re prepared for what’s to come.
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David Dodge had his fair share of experience with crises.

There’s something peculiarly fated about Dodge’s stint as Governor of the Bank of Canada. When he took office in 2001, most of North America was struggling with the aftermath of the Dot-Com Boom and stock markets had taken a nosedive. Then before leaving in January 2008 to become Queen’s University’s chancellor, the entire world economy began to unravel into the worst recession since the Second World War.

Speaking from his office in Ottawa at Bennett Jones LLP, one of Canada’s leading law firms where he’s a senior advisor, Dodge, ArtSci ’65, is remarkably candid in discussing the financial meltdown. It’s a significant departure from the careful speech that is obligatory in the realm of monetary policy.

In 2003, Dodge, who received his PhD in economics from Princeton University, began to see signs global financial markets were headed for disaster.

“What we were very worried about then was the growing imbalances in the world, in particular big build-up of reserves in China and Asia, and of course just a very large current accounts deficit on the part of the United States which was not being corrected,” he said.

The U.S. accumulated massive amounts of debt funded by China and other Asian countries. Large foreign investment from Asia kept the U.S. dollar high and Asian currencies very low, an imbalance Dodge said was likely to cause major problems in world markets.

“Speaking personally, I thought that the crisis would come first in currency markets rather than on the banking side,” he said.

As everyone saw in fall 2008, however, the economic meltdown wasn’t ignited by currency markets but by a shocking liquidity and credit bust that toppled banks all over the world.

“I don’t think anyone quite foresaw that,” Dodge said.

A year has passed since financial services Lehman Brothers went bankrupt. Canada has a long way to economic recovery from this recession, but it’s poised to lead the G8. Many credit this to Dodge and the Bank of Canada’s tight monetary policy heading into the financial crisis.

Dodge is reluctant to attribute Canada’s advantageous position to its monetary policy, though.

“Good monetary policy contributed to our greater stability, but certainly that wasn’t the only thing,” he said.

Instead, Dodge said it was Canada’s well-established regulatory system that created a sounder banking system and monitored insurance companies more effectively. Canada’s banking system enabled effective financial regulation moreso than in other countries because it’s made up of a few large banks—or the ‘Big Five,’ as they’re often called. The U.S. and other countries have a much more competitive banking system with hundreds of smaller banks.

“In part because of our banking system being fairly highly concentrated, there was a continuing dialogue between the regulator and the banks. So the regulator really had a better idea of what was actually going on in our banking sector,” he said.

Dodge said leverage control regulations prevented the excessive borrowing and risk-taking that was happening in U.S. investment banks and European banks.

“Fundamentally, we had a regulatory system which was better suited to ensure we didn’t get the build-up of risk that was the in the U.S. and in the U.K.,” he said.

Regulation also made a huge difference in the insurance industry in Canada, as became evident by the experience of many American insurance companies. Companies like American International Group (AIG), now mostly owned by the Federal Reserve, insured risky assets and operated under the radar of regulators.

The Canadian system kept insurance companies on a much tighter leash, Dodge said.

“We regulate the insurance industry properly, unlike the United States,” Dodge said.

Canada also managed to avoid the sub-prime mess south of the border because of much stricter mortgage laws. The U.S. housing market saw a sweeping wave of foreclosures as people had taken out very high ratio mortgages and couldn’t pay them. Canada’s banks were protected by insurance regulations.

“Our mortgage system works a lot better than the States’ because high ratio mortgages, which is the real bane of the U.S. system, are insured by law. And those insurance standards are fairly high,” he said.

Nevertheless, Canada still faces major challenges in getting its economy back on track

—challenges Dodge said come from the problems in other countries.

“We still have major imbalances in the world economy,” he said. “We have overconsumption in the U.S. and we have underconsumption, in particular, in Asia. This is a long recurring theme. Unless we somehow deal with these imbalances that are in the world, then we’re likely to run into problems again.”

Dodge said the road to recovery from 2011-onward will involve more than simply recovering from the recession. Central banks around the world have largely succeeded in turning credit taps back on by lowering interest rates. But long-term economic growth, depends on savings rates going up in the U.S., U.K., Ireland, Spain and elsewhere, and coming down in the Asian countries.

Dodge said the days of extreme leveraging are over, especially in the household sector, while Asian economies need to boost domestic consumption.

“The road to recovery over 2011, ’12, ’13 in a sense is going to be slowed by the necessary deleveraging in Europe and North America,” he said. “And it will be made difficult because it’s quite difficult for the Chinese and the Japanese to find ways to increase household consumption.”

Many common financial market practices need to change dramatically, Dodge said. Securitization—the method of bundling assets together which gave us risk-filled financial products like commercialized debt obligations

—will also have to undergo a major facelift. Despite the problems of complicated, risky assets created by securitization, banks are unwilling to abandon the practice.

“This is actually a big issue,” said Dodge. “We were allowed to develop a lot of fancy products which really contained embedded risks that people didn’t understand.

“Securitization is not going away. Indeed, it can’t go away because banks still don’t have enough capital to carry on their own balance sheets. Securitization will come back, but I think it’s going to come back in a simpler, more standardized form rather than highly individualistic products.”

Canada will struggle getting back to long-term growth because so much capital has been destroyed during the recession, Dodge said. The capital he is referring to includes things like automobile plants, saw mills, pulp mills and all of the labour power that went along with them. Recovery is going to entail major restructuring of labour skills towards very different industries than what we’re built for now.

Canadians should also be prepared for a reduction in government services. Canada, like the other G8 countries, is coming out of this recession with major deficits. Longstanding debt accounts for over 30 per cent of the Canadian government’s revenue. This means for every dollar of tax revenue, only 70 cents will go towards government services like health care, education and welfare.

While Dodge says Canada could balance the budget simply by raising the GST a percentage point, the burden of our aging population and debt is going to take a toll on our government.

Dodge is confident we’re prepared, though. Although people in Washington, Ottawa, Brussels and elsewhere are hesitant to admit to the challenges ahead for both taxpayers and governments, most are braced for the reality check of higher taxes and reduced government services, he said.

“Of course, no politician anywhere in the world wants to be honest in addressing that,” he said. “Although, my own experience is that citizens are much more sensible than politicians in that regard.”

Coming from Dodge, that’s a good sign.

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