A big surprise? No, not really

It made the headlines of the National and every media outlet out there, the Bank of Canada reduced it's overnight lending rate by 0.75% to 1.5%, a 'deep cut' for some commentators. Will it have an effect? not really. Is it a sign of worse to come? I fear it may. But first here is why this cut does not come as a surprise and why, if the Bank is going to cut rates in the future, it may have only one bullet left in its charger.

The latest big economic news was released last Friday: Canada lost 71 000 jobs and the US about half a million. Proportional to the size of our economies, Canada's numbers are much worse than what happened down South. The recession could no longer be denied and with Parliament out the Bank was left alone to provide any stimulus to the economy.

Overnight lending concerns only a fraction day to day costs banks handle. With our banks already in a weak position from other investments not doing so well, even if our banking system were competitive you would not see the full reduction passed on to consumers (to a certain extent it would irresponsible for banks to do so). My more fundamental concern, and this is why I fear there is worse to come, is that the problem we face is not the cost of credit but rather its nonexistence. Banks simply are not lending (ask any business owner, they'll tell you). In that situation, the traditional tool of lowering rates to nudge up investment isn't going to get us anywhere. The Bank of Canada is in a difficult position, the interest rate is so low there remains very little room for anything but one, final, drastic cut to the overnight rate (if your going to end up at 0%, might as well go out with a bang). After that we face to possibility of being in a liquidity trap.

The solution? Helicopter money. I'm not joking. Milton Friedman's idea, not mine. And it's a sensible one. If banks aren't lending, then the central bank should drop huge wads of cash from helicopters into the hands of businesses and consumers to get them to spend again. Now, implementing an actual helicopter drop is out of the question but it does tell us what policies we should want our government to pursue: spend, spend, spend, bypassing the banking system.

Most of the pain at the moment is concentrated in Southern Ontario, Canada's manufacturing belt, but expect the end of winter and early spring to lead with piles of canceled tar sands, refinery and related projects in Alberta and Saskatchewan. World demand for oil will slump much further in 2009 (see this article in the Financial Times) and the days of even $40 barrels we be far behind us (another reason the environmental movement has got it's focus all wrong).