Taking a public interest in interest

Understanding interest rates is part of basic training in intellectual self-defence. Corporate propaganda has been very effective in shutting down discussion of what is, at heart, a social policy: how much should we pay to borrow from each other?

The basic interest rate is set by the Bank of Canada. It is the most important price in the economy. Every business cost contains interest charges. Housing price booms are driven by interest rate declines. And while cheap money is no guarantee of economic prosperity, high rates send people directly to the unemployment line.

Ten years ago the Department of Finance and the Bank of Canada ended their game of interest rate chicken. The Canadian economy had been stagnating since the signature of the free trade deal in 1988. High interest rates were needed to fight inflation, or so the central bank said. What it meant was that government spending was too high, and the social safety net too big

In a deal you never read about, Finance cut spending and reduced social protection in its 1995 budget, and the Bank accepted to lower interest rates. Until then the Bank had been holding all Canadians to ransom with interest rates much higher than those prevailing in the U.S.

The Canadian central bankers were expecting the government to pull away first. You would have thought the reverse. Did the prime minister not appoint the Bank governor? And were money and banking not part of the constitutional responsibility of the federal parliament?

With the interest rate prop removed, the Canadian dollar fell. By 1997, lower interest rates, and a lower dollar spurred economic growth. That era did not last. A new Bank governor, David Dodge, began a game of footsie with his U.S. counterparts, and as Canadian rates slipped above U.S. rates, our money started to climb, and our economy to slow.

The big fall in interest rates created a boom in housing prices. Why? Because the cost of owning a house is related to the cost of borrowing. A mortgage of $100,000 at 12 per cent costs three times as much as the same mortgage at four per cent. So, for a house that cost $125,000, financed with a $100,000 mortgage at 12 per cent, the interest payments would cost roughly $1,000 a month or $12,000 a year. If you could mortgage it for four per cent, then the new monthly mortgage cost of the same $100,000 would be one-third less or $333.33 per month.

Housing prices moved up to reflect the lower monthly cost of owning a house. Funny thing, the cost of rental property did not go down. This is instructive.

Since the basic interest rate is an administered price — the Bank of Canada sets it — the interest rate structure should be administered as well, starting with charge cards, and the loan sharking operations of our banks and trust companies.

Sectors like rental housing, where business costs are greatly affected by interest rates, deserve to have administered prices as well. Yes, rent controls make sense.

Ironically, the power of the Bank of Canada is exaggerated by low rates. Rates of three per cent, when they are increased over a number of months by one percentage point to four per cent go up by one-third. Not many can absorb such an increase in interest costs. Rates of 12 per cent that increase by one percentage point to 13 per cent over some months go up by far less — eight per cent not 33.3 per cent.

The social costs of allowing a small group of influential insiders to determine what is really going on in our economy have yet to be estimated. A good guess is that they exceed the cost of bringing interest rate policy and the administered price structure of the banking sector under close public scrutiny.

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