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...nettles that can choke growth elsewhere in the economy, and policymakers must grasp them firmly and soon.
The Canadian financial system's stability is largely looked after by inflation targeting supported by flexible exchange rate (a desirable arrangement in today's fragmented international economy), but this stability comes at a cost. Canadian markets lose international transparency when linked to the rest of the world through a foreign exchange market and when local macro-policy decisions must be monitored by foreigners wanting to assess their riskiness. This unavoidable cost makes it all the more important to deal with other sources of inefficiency in the system.
Between them, Canada's commercial banking sector and its securities markets account for some 85 percent of financial system activity, and both need regulatory reform. A politicized approval process effectively prohibits mergers between big banks, limits their ability to exploit available efficiency gains, and narrows their ability to respond to new competitive challenges emanating from the world marketplace. At the same time, ownership rules and restrictions on the activities of foreign banks in Canada buffer domestic banks against competition at home. Some of the latter regulations perhaps help ensure that the large institutions, through which stabilizing monetary policy is conducted, especially in time of crisis, remain under Canadian control. Nevertheless, the case for allowing more freedom of manoeuvre to actual incumbents and more freedom of entry to potential competitors in commercial banking is overwhelming. As to Canada's securities markets, these are currently regulated by 13 agencies, one for each province and territory, with predictable effects on their transparency and the costs of doing business in them. A single national regulator is surely called for, as is a separate and effective enforcement agency.
The economic aspects of both sets of issues are well understood, yet the longstanding unpopularity of the large banks among the public at large makes it difficult for politicians to address their problems. Meanwhile, securities market reform is hampered by fears among other provinces and territories about the intentions and power of the Ontario and federal governments. These obstacles are preventing regulatory changes that would increase the financial system's efficiency and help to ensure the Canadian economy's continued competitiveness. The political will to overcome them is urgently needed.
In Canada's national accounts, financial services are treated as a sector of the economy, on a par with, for example, manufacturing or education. From the national income accountant s viewpoint this is reasonable: the firms, institutions and other agents that make up the sector sell services to their customers and distribute the proceeds of their sales to their employees and owners. From a policymaker's point of view, the classification also makes a certain amount of sense, because this sector presents challenges similar to those arising elsewhere: how to encourage its domestic and international competitiveness, to promote its productivity, and enhance its capacity to respond to a rapidly changing technological and economic environment.
Special Characteristics of the Financial Sector
And yet, if we look beyond accounting definitions to the particular role that the financial sector plays in economic life, it is quickly apparent that it also raises unique public policy issues. As the Introduction to the 1997 Final Report of Australia's Financial System Inquiry (Commonwealth of Australia, 1997) put it, "The stability, integrity and efficiency of the financial system are critical to the performance of the entire economy. The financial system is an essential component of the infrastructure of commerce." As such, this sector of the economy is a natural object for the attention of government, and one where it is essential to design policies with their economy-wide effects kept firmly in view.
A long history of trial and error--a great deal of the latter--has ensured that the most fundamental policy problems facing Canada's financial system are dealt with reasonably well, so much so that their very existence is sometimes overlooked as new concerns emerge and are addressed. These problems have not been finally settled, however. Rather, they are being coped with, and they continue to influence the manner in which new challenges within the system present themselves. Current ways of coping with these issues, furthermore, are not themselves immutable, and they interact with the means available to deal with others. (1)
This Commentary's Purpose
Any discussion of current policies towards Canada's financial services sector runs the risk of being inadequate and even error-prone if it ignores these facts. Policymakers need to be self-conscious about the overall environment in which policies are to be applied if the right choices are to be made; and, because those policies must be implemented through political processes, it is important that they also have the support of a well-informed public.
These problems have well-understood economic aspects, but they present serious political difficulties. And yet, it is important that these political nettles be grasped, because our failure to do so threatens the efficiency and adaptability of the financial sector and will ultimately impair the Canadian economy's overall competitiveness.
This Commentary aims at bridging some of the gaps in understanding about the role of the financial system that seem to separate policymakers from the public at large, in the hope of creating a greater sense of urgency than now exists about certain pressing problems that beset the system. After giving a brief overview of the system's role in Canada's economic life, this study discusses the political and regulatory impasse that exists with regard to merger activities involving chartered banks, and the difficulties that the absence of a single national regulator and of a separate and effective enforcement agency currently create for the country's securities markets. It concludes by regretting that, though the recent Federal White Paper on Financial Services (Department of Finance 2006) pays attention to the second of these issues, which is mainly a matter for provincial and territorial governments, it entirely ignores the first, which falls entirely under federal jurisdiction.
Coordinating Economic Activity in a Market Economy
As the commonly used phrase has it, ours is a market economy, whose most fundamental characteristic is the generation and distribution of wealth, not just by the production of goods and services, but crucially by their voluntary exchange. Almost as fundamental, but so obvious as often to go unremarked, is the fact that, overwhelmingly, the voluntary exchange in question is indirect and mediated through a monetary and financial system.
The Role of the Financial System
Autoworkers do not barter work for SUVs and hybrids, which they then drive to the mall to swap for food and clothing with the supermarket, and to offer as mortgage payments or retirement savings plan (RSP) contributions to the trust company. Though this surreal scenario does, on some fundamental level, characterize the ultimate nature of some of the exchanges that take place in a market economy, the transactions by which these are realized are very different. To continue with our example, autoworkers are paid wages in money, which their employers obtain by selling cars (or by borrowing in anticipation of such sales). At the mall, the autoworkers buy goods and services with that money (or perhaps on credit which they will later pay off by a transfer of money to the lender), and make money payments that reduce their mortgage debt and/or increase their RSP balances.
The economist's "market" is, in effect, a metaphor for a monetary and financial system whose unique social function is to facilitate the multilateral and indirect exchanges upon which economic life depends. The system's most primitive task, of which the elementary textbooks still make much, is to provide a common means of exchange that also serves as a unit of account in which prices are stated, so that goods and services may be indirectly traded in spot markets. But of far more significance in any modern economy is the system's role in transactions that involve the passage of time. In those same textbooks, the former task is assigned to the system's "monetary," and the latter to its "financial" component, but this pedagogically useful division is artificial, and therefore less helpful for the practical analysis of policy issues. (2)
In today's advanced economy, it is the transfer of deposit liabilities of financial institutions that typically consummates spot transactions--currency is merely small change--so there is no sharp distinction between the means of exchange used for current transactions and financial claims on the future. More fundamentally, when a family saves, it is, on some abstract level, trading with itself over time, exchanging current against future consumption. The transactions through which this trade is realized typically involve the transfer of money, which could have been used to buy consumption goods in the immediate present, to some other agent, such as a bank or publicly traded company, in exchange for a claim on money at some time in the future. Current and planned future transactions are thus inextricably linked when saving decisions are executed, as they are on the other side of the same transactions as other agents use the borrowed money to invest in resources that are to be used to produce goods for sale in the future.
Time and Uncertainty
Enabling agents to cope with the passage of time and uncertainty about the future are central functions of the financial system. All economic decision making is, to a greater or lesser extent, forward looking, and it is therefore inherently risky. Different agents have different attitudes towards risk, different capacities for assessing it and for valuing it. Because it is the financial system that coordinates those agents' activities, it is through its workings that they seek to overcome what John Maynard Keynes called "the dark forces of time and ignorance" in whatever ways they deem best for themselves. That is why modern systems provide myriad possibilities for linking consumers with producers, savers with investors, and for coordinating their plans, why these different possibilities enable these agents to share in the risks involved in any decision in different ways, and it is also why the financial system is continuously evolving new means of dealing with these matters.
It is well understood that, if market mechanisms are to work like Adam Smith's "invisible hand" to ensure that the actions of self-interested individuals lead to desirable social outcomes, the information and incentives facing those individuals must reflect the genuine social costs and benefits of their actions. The information and incentives in question are transmitted through the financial system. Such communication through prices stated in terms of money has often and aptly been compared to the use of a common language to communicate ideas. Just as ambiguity and deception in the use of language are sources of trouble, so too are misleading messages about the present, and false promises about the future, delivered by money prices.
Government and the Financial System
The financial system is a set of social arrangements whose performance has a profound influence on our economic well-being. Even those libertarians who do not accept that this fact makes the system a proper object for the...
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