Free vs Regulated Banking: Canada's Free Banking Era - Why Was the Bank of Canada Established?

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5 MIN READ - Cautious Rockers who’ve even glanced at the Cautious Economics Correspondent for Economic Affairs and Other Egghead Stuff’s articles on Canadian free banking would be justified in asking a logical question: 

“Given how well free banking worked for a century and even withstood the Great Depression without a single bank failure, why on earth did the Canadian government feel it necessary to authorize a central bank in 1935?”

The answer lies in 1930's politics. Curious Rockers feel free to read on to learn more.

Bank of Canada building, circa 1938

As we’ve covered in multiple past entries, Canada’s banking system was the industrialized world’s second least regulated from 1817 to 1844, and least regulated from 1845 to 1935. 

All throughout its entire 118-year “free banking” era the Canadian banking system was crisis-free in contrast to the heavily regulated United States which bore fifteen crises before 1935.

However the free banking era is universally considered as having abruptly ended in 1935 when Canada’s first central bank, the Bank of Canada, opened for business by order of the 1934 Bank of Canada Act.

Why then, if Canada’s free banking system was performing so well, did Canadian Parliament elect to establish a central bank?

As one might expect the answer is rooted in politics.

STEMMING RADICAL PARTIES

There were two primary political catalysts for Ottawa’s embrace of a new central bank.

The greatest, by far, was domestic Great Depression politics. 

In the depths of Canada’s economic hardship an eccentric upstart party named the Social Credit Party (interesting name given China’s modern Social Credit System) won a large bloc of parliamentary seats, mostly in Alberta where the party won 46% of the popular vote.

The Social Credit Party’s platform, based in the theory of social credit, was considered radical in its day.

Social Credit called for redistribution of wealth and mass printing of government “prosperity certificates” which would be doled out to the public plus any business that sold below cost to consumers. Furthermore the party platform was presented in agrarian Christian populist packaging, marketed with slogans hailing the national construction of “A Utopia of Our Own.”

Compounding problems was the surging “Cooperative Commonwealth Federation” (CCF), a socialist party founded in 1932 on a platform that included nationalization of financial institutions. Capitalizing on widespread public discontent with the depression, the CCF rose in just two years to official opposition status within the provincial governments of Ontario and Saskatchewan.

The rapid ascent of these fringe movements so alarmed the establishment Liberal and Conservative parties that they sought some form of political compromise to curb the most extreme elements of the Social Credit and CCF platforms.

A linchpin of that compromise was the Bank of Canada.

Although the Canadian banking sector held up extremely well during the Great Depression and weathered the slump without a crisis, the public nevertheless largely blamed banks—a historically unpopular and easy target—for the depression itself. 

Hence the Liberal and Conservative parties believed the creation of a central bank to conduct monetary policy would appease all disgruntled parties: not only the Social Credit Party and Cooperative Commonwealth Federation but restless Canadian voters as well.

GLOBAL PRESTIGE

A secondary impetus for the decision to establish a central bank was national prestige.

By the mid 1930’s most developed countries were attending regular international monetary conferences, and the post-1933 period saw a particularly rapid flurry of meetings where governments regularly sought to quell competitive “beggar thy neighbor” monetary policies—effectively a cycle of national currency devaluations to boost exports and dig their way out of their problems at the expensive of other trading partners.

However only countries with central banks were invited.

Canadian officials felt they were being left off the world stage, so the two major political parties supported the Bank of Canada Act in order to bring Canada the worldly prestige they thought it was due.

According to Bordo and Redish (1986)…

“The World Monetary and Economic Conference in 1933 had stated that all developed countries without a central bank should create them to facilitate monetary cooperation and recovery. In an article analyzing the need for a central bank, Queen's University economists had stressed the need for a central bank to send representatives to world monetary conferences; ‘There are few countries… …more vitally interested in international cooperation in the monetary and economic fields than Canada and yet we lack any institution which would permit effective participation in such cooperation.”

Shortly after a government commission headed by pro-central bank parliamentarian Hugh MacMillan handed down its central bank endorsement, Prime Minister R. B. Bennett…

“…announced that he would introduce a Bill to establish a central bank, ‘to regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment.’”

Canada’s banking sector had navigated the challenging depression economy just fine without a central bank, but Parliament created one anyway to satisfy politicians of all stripes: populist, socialist, international, and establishment.

RAPID GOVERNMENT SUPERVISION

Once opened the Bank of Canada rapidly took control of monetary functions previously performed by private competitive banks and the historic 118-year era of very light regulation abruptly ended.

-In 1935 the Bank of Canada became the official arbiter of banking system reserves and official lender of last resort.

-By 1936 the Bank of Canada was government-majority owned.

-In 1938 the Bank of Canada was completely nationalized by the federal government.

-By World War II private banknote issuance was effectively monopolized by the Bank of Canada, the last-ever private banknote issued in 1943 by the Royal Bank of Canada.

After World War II Canadian Parliament itself took a more active role in bank regulation. 

Federal deposit insurance was introduced in 1967.

Canada went off gold completely after Richard Nixon effectively ended the Bretton-Woods international gold-exchange standard.

Today Canadian regulators dictate capital ratio requirements to banks, monitor market shares for antitrust violations, and restrict Canadian banks from investing in risky assets.

And just like the Bank of England, Federal Reserve System, and every other modern day central bank, the Bank of Canada has embarked on a campaign of deliberate long-term monetary inflation to serve the central government's fiscal interests. Since 1935 prices in Canada have risen nearly 2,100% or an annualized inflation rate of 3.57%.

Put another way, the Loonie has lost 95.4% of its value, much as the US dollar has lost 95.6% of its value in the same period.

However even with such a dramatic departure from free banking since the Great Depression, Canada’s banking sector has still managed to avoid any systemic crises – unlike the United States which has still braved crises in 1990 and 2008.

What has Canada done differently even in the modern era to outperform the United States? We’ll discuss that subject in our final two chapters.