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Look What Would Happen To Canada’s Economy If We Had 1981 Interest Rates

Out-of-control inflation and high interest rates are truly the nightmare scenario for an indebted economy like Canada’s.

Pity the Turkish borrower. The country’s central bank on Thursday raised its key interest rate to a dizzying 17 per cent, from an already high 15 per cent, in an effort to entice global traders to buy the currency, which has been in free fall this year.

Turkey also suffers chronically high inflation ― around 14 per cent this year, compared to 1 per cent or less in the developed world ― and that makes high interest rates necessary, at least in the conventional view of central banks everywhere.

Its economy, in other words, is nothing like Canada’s. But if you think it couldn’t happen here, think again: It did, back in the early 1980s, when the Bank of Canada was fighting an epic battle with stubbornly high inflation. In mid-1981, the BoC’s key lending rate peaked at above 21 per cent.

In the next round of the inflation battle in the early 1990s, it peaked at around 14 per cent.

So yes, it can happen. And if it happened today ― if, for whatever reason, the Bank of Canada lost control of inflation like Turkey’s central bank has ― we would be, as the saying goes, royally boned.

Epic housing crash

It’s no secret that Canada has grown disproportionately dependent on the housing market for its economic health. You can expect that to disappear overnight if interest rates soar.

At the current going discount mortgage rate of around 1.6 per cent, a household in Canada earning $100,000 a year could afford a maximum price of around $660,000 on a first home.

If mortgage rates shot up to current Turkish levels ― or our early 1980s levels ― the maximum price for the same household would fall to $250,000. So we could expect house prices to fall by some 60 per cent.

Imagine the economic devastation if a majority of mortgage borrowers in Canada went underwater on their debt. Investors going insolvent, bank earnings in the red, stress levels through the roof.

The negative “wealth effect” from a housing collapse would prompt people to cut back on their spending, creating a domino effect that would impact every part of the economy.

A historic government debt crisis

The devastation in the housing market could actually take a backseat to the devastation in government finances.

Amid the COVID-19 pandemic, Canada has increased its public debt by more than any other developed country. At last count, the deficit for the current fiscal year sat at $381 billion, and the federal Liberals forecast another $121-billion deficit for next year.

Currently, Ottawa is paying around 0.7 per cent on its 10-year debt. At that rate, the $381 billion it borrowed this year will cost about $2.7 billion in interest payments per year. But if that borrowing cost rose to its 1981 peak, interest on that chunk of our federal debt ― and just that chunk ― would rise to more than $58 billion per year.

Watch: U.S. budget deficit hits $3.1 trillion. Story continues below.

That’s around $5 billion more than the feds spend in total on support for the elderly, including Old Age Security and the General Income Supplement. It’s 2.5 times what Ottawa spends on benefits to children and parents.

Needless to say, with a massive new expense like that, the government would be facing a debt crisis on a scale few living Canadians have ever seen. It would likely be worse than the debt crisis of the 1990s, when Canada’s credit rating was downgraded from AAA to AA+.

Without a doubt, Canadians would face serious reductions in government benefits, major tax hikes, or both. The economic devastation from government cuts and tax hikes would rival that of the housing crash.

You get the picture

We could go on ― about the damage to people who make car payments, to students with loans, overleveraged businesses and so on ― but you get the picture.

Simply put, Canada can’t afford higher interest rates, and the Bank of Canada ― which sets the trend-setting interest rate in the financial system, and controls interest rates in other ways such as purchases of debt ― knows this perfectly well.

That’s why in October it declared that it will not budge on its record-low 0.25-per-cent key rate for years, or, as the Bank put it, “until (the) inflation objective is achieved.”

The BoC has one job, officially, which is to keep inflation in check. These days it’s been running around 1 per cent, or half the 2 per cent the bank is targeting as the inflation rate in a healthy economy.

Since no one expects inflation to shoot past 2 per cent anytime soon, the BoC will have no reason to raise rates. But even if inflation did hit that target, recent financial history shows the Bank will likely find excuses to keep rates low anyway. That’s what central banks did for years as the economy recovered from the financial crisis of 2008.

Looking at the scenario above, it’s not hard to understand why. We have become a supremely indebted society, all the more so after all the emergency COVID-19 spending, and the only thing holding us together is those low, low interest rates.

Anything else literally would be a disaster.

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