Canada could face the spectre of deflation due to parallels with Japan’s experience. The early 1990s saw Japan’s asset-price bubble burst, leading to substantial losses within its banking system. Japanese banks had been instrumental in fueling this bubble, and its collapse left debtors unable to meet their loan obligations, prompting them to surrender collateral to the banks. However, the market value of these assets fell short of covering the outstanding loan amounts, resulting in significant capital losses for Japanese banks. This erosion of bank capital hindered their ability to provide fresh credit to the private sector, even in the face of meagre nominal interest rates offered by the Bank of Japan.

The pivotal role of banks as conduits between the central and private economies is crucial. When banks are either incapacitated or hesitant to channel the affordable credit extended by the central bank, economic growth can halt or decelerate considerably. A historical precedent exists in the United States during the early 1930s.

Turning our attention to Canada, its banking landscape has seen a notable accumulation of mortgage-related assets on its balance sheets. In the event of a substantial downturn in the housing market, triggering a wave of mortgage defaults, the Canadian banking system could confront significant losses akin to Japan’s ordeal in the 1990s. Even if measures such as reducing interest rates to near-zero by the Bank of Canada were taken, the potential impact on stimulating economic activity or inflation is uncertain.

In the absence of a direct infusion of newly-created money into private sector accounts by the Bank of Canada, the looming threat of deflation becomes increasingly palpable. Once again, a weakened banking system could be the harbinger of deflation, a trend often catalyzed by the aftermath of bursting asset bubbles – a consequence of the sharp devaluation of collateral supporting bank loans.



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