It is surprising to note that even though there were increasing indications regarding an imminent and important fiscal tightening shortly after the collapse of the stock market in October 1929, the federal government hardly took any initiative to back the country's financial system. However, it is beyond doubt that the government only had a limited ambit as far as initiating policy action to prop up the economy as the Finance Act stipulated that the advance payments to the banks could only be made following requests from the chartered banks in this regard. In addition, it must be remembered that the absence of a currency market also left the federal government with little or no scope in this matter. Another fact that constrained the government from initiating a policy action to support the economy was that Canada was still theoretically observing the gold standard. However, once the government had laid down the Advance Rate at 4.5 per cent in September 1928, it decided not to amend it till October 1931. In fact, this led to people questioning the competence and perception of the members of the Treasury Board regarding the fiscal issues.
While the Canadian federal government remained inactive as far as initiating a policy decision regarding the maintenance of the fiscal system was concerned, the chartered banks continued to reimburse their loans from the government as per the stipulations in the Finance Act. As a result, the fiscal constriction or contraction only worsened the economic slump further. As the financial situation became worse, the Canadian banks became gradually more vigilant regarding their respective lending pursuits. In fact, during this period, the banks were repaying the money they borrowed from the government under the Finance Act, as they came under sharp criticism for taking extensive loans before the stock market collapsed in October 1929.
There is little doubt that the above discussed economic factors have only added in intensifying the level of the economic recession in Canada, while the economic tightening aided in reinforcing the Canadian dollar that was evaluated at US$0.90 during the spring of 1932.
At last, the Canadian government lowered the Advance Rate from 4.5 per cent to three per cent in October 1931 and further to 2.5 per cent two years later in May 1933 as the banks reduced their borrowings from the government under the Finance Act. In between, in the autumn of 1932, the government also resorted to moral suasion or tactical pressure to compel the banks to take advance payments according to the provisions in the Finance Act and once again increase the amount of money and credit in circulation (reflate the financial system). Introduction of such moderation in the fiscal policy resulted to a passing drop in the value of the Canadian dollar, which was evaluated at US$0.80 for a short while. The infirmity of the Canadian dollar was only a temporary affair as it started gaining vigor again when the United States decided to ban gold export in April 1933 and undertook efforts like the Canadian federal government to reflate its fiscal system.
In 1934, the Canadian government made a decision to enhance the quantity of the Dominion paper currency in circulation through lowering their gold security to 25 per cent. This move by the federal government, however, did not have any significant bearing on the Canadian dollar. Considering the financial situation prevailing in those times as well as the parallel changes taking place in the neighboring United States, the decision of the Canadian government in this regard was seen as a suitable, but an uninteresting drawn out modest market reaction. And by 1934, the Canadian dollar somewhat restored equivalence with the U.S. dollar and was even exchanged at a small extra price from time to time. The Canadian dollar bounced back to its previous equivalence with the sterling, as the United States dollar decreased in value vis-à-vis gold and the pound sterling.
It was very natural that as the 1930s progressed and there was no indication of the economic slump (Depression) ending, the Canadian federal government was once again confronted with demands that it initiated necessary actions to prop up the economy. The public now began to grow skeptical regarding the sufficiency of the Finance Act. At the same time, there was an extensive public mistrust regarding the country's banking system primarily owing to the high charges/ interest rates and poor accessibility of loans. While everyone in the country was varyingly affected by the Depression, the peasants of western Canada were the worst hit. These farmers were not only hit by poor crop yield, but also falling prices for their commodities. They were especially disapproving of the banks and, at the same time, backed the establishment of a central bank in the country. These farmers sincerely believed that the setting up of a central bank would enable them to avail fixed credits at inexpensive rates.
On the other hand, owing to the rapidly waning prices of consumer items, the prevailing interest rates on bank loans were very high. Although the minimal interest rates on credits obtained from bank stood at seven per cent, the actual interest rates were around 17 per cent all through 1931 and 1932. In any case, the interest rates were soaring for all and sundry owing to the high Advance Rate paid by the banks for advance payments obtained by the banks from the government under the Finance Act. There was also a huge disparity between the interest rates on bank deposits and credits. While the usual interest rate on major loans taken for business purpose was six per cent, the average interest paid on deposits was a mere three per cent. The deposit rate was further reduced to 2.5 per cent following permission from the federal government in 1933.
The Canadian federal government established a committee in July 1933 and authorized it to examine the performance of the Finance Act as well as to give a cautious thought on the prudence of setting up a central banking establishment in Canada. The Canadian federal government Prime Minister Bennett nominated Lord Macmillan, a prominent British jurist as well as a well-known enthusiast of setting up a central bank in Canada, as the head of the commission. The other members of the high profile panel included Sir William T. White, a banker and a former Canadian Finance Minister who served during the war, Sir Charles Addis, a past Bank of England director, John Brownlee, the Prime Minister of Alberta, and Beaudry Leman, a banker from Montreal.
The commission chaired by Lord Macmillan started public hearings on August 8, 1933 and submitted its final report to the government within seven weeks on September 28 that year. Although the panel member were divided on the issue of establishing a central bank in Canada and narrowly voted in its favor, the decision of the committee was clear and left no one in any doubt. In fact, the two British members in the commission as well as John Brownlee exercised their franchise in favor of setting up a central bank in Canada, the two bankers from Canada voted against the motion. However, the final decision of the commission was endorsed by the Conservative government as well as the Opposition comprising the Liberal legislators.
As mentioned above, the Canadian bankers - Sir William T. White and Beaudry Leman - opposed the establishment of a central bank in the country. White disagreed with the majority decision on the pretext that it would be imprudent to set up a central bank in Canada considering the indecisive economic conditions. He argued that setting up a new and untested central bank was likely to create an obstacle for the government. White was of the view that Canada should return to the old gold standard and the major predicament of the country was disproportionate liabilities or money arrears. Similarly, banker Beaudry Leman too opined against the establishment of a central bank. He was of the view that setting up a central bank would lead to constitutional problems and the issue required to be thoroughly examined.
On the whole, the lobby of the Canadian chartered banks was in opposition to setting up a central bank for the country on several grounds. The points they argued in favor of their stand comprised worries regarding the availability of adequate proficiency for setting up a central bank in Canada, the non-existence of a currency market in Canada, the futility of the Federal Reserve in dealing with the prevailing economic slump or Depression as well as the enduring constancy of the banking system in Canada. Collectively, the Canadian banks were also worried regarding the lowering of their profits linked with their rights to issue paper currency for it was evident that the establishment of a central bank would certainly deprive them of this unique privilege.
On July 23, 1934, the imperial authorities granted their assent to the Bank of Canada Act following which the Central Bank of Canada begun its legal operations from March 1935. A former assistant general manager of the Royal Bank, Graham Towers was appointed the first Governor of the Central Bank of Canada. At the same time, J. A. C. Osborne, former secretary of the Bank of England, was appointed the Deputy Governor of the Central Bank of Canada with a view to offer his practical experience in central banking services.
With the Central Bank of Canada functioning officially, the federal government of Canada eventually revoked the Dominion Notes Act and the Finance Act on March 11, 1934. At the same time, the Dominion paper currency was promptly substituted by the new Bank of Canada paper currency to avoid any shortage of money in circulation. In 1934, the government also amended as well as implemented the Bank Act that regulated the functioning of the chartered banks in Canada. As a result of the amendment of the Bank Act, all private notes issued by the different banks in Canada were progressively eliminated from circulation making way for the Bank of Canada paper notes.
With the administration of Canada's fiscal policy being controlled by the Bank of Canada, which was seen as an enthusiastic financial institution, now there was more opportunity for a forward looking fiscal policy. Nevertheless, the Bank of Canada retained the Bank Rate, which was equal to the Advance Rate under the provisions of the previous Finance Act, at 2.5 per cent - the rate it had taken over from the stipulations in the Finance Act. Much later, the Bank of Canada reduced the Bank Rate during in the middle of the World War II in February 1943.
The federal government of Canada also enacted another legislation known as the Exchange Fund Act, which obtained the approval from the British imperial authorities on July 5, 1935. It is important to mention here that as per the Statutes of Canada 1935, the main objective of this legislation was to offer an endowment that may possibly be made use of in assisting in the regulation and safeguard of the value of the Canadian dollar in the external market. The wherewithal of the Exchange Fund was derived from the proceeds related to the reassessment or increasing the legal exchange value of the gold assets held by the Bank of Canada from the previous legal value of Can$20.67 for every ounce to the current international market price of US$35 for each ounce. It may be mentioned that though the Canadian legislature passed the Exchange Fund Act in 1935, the Section of the legislation that dealt with the use of the fund to safeguard the value of the Canadian dollar was not implemented till the time Canada made an entry into the World War II on September 15, 1939.
In any case, till the middle of the 1930s, there was basically no need of an Exchange Fund Account to make the Canadian dollar unwavering. The Bank of Canada did not have to get involved in stabilizing the Canadian dollar as it was being exchanged at a comparatively slender range somewhat in the region of equivalence with the U.S. dollar.
The value of the Canadian dollar began to fall with the worsening of the political atmosphere worldwide in the latter part of 1938. Compared to the U.S. dollar, the Canadian monetary unit dropped marginally at a marked down price of approximately one per cent. Although the drop in the value of the Canadian dollar was moderate when compared to the value of the pound sterling that declined by around six per cent during the later half of 1938. This occurrence was a sign of a significant movement of finances outside the United Kingdom.
The Canadian dollar experienced firmness for quite a few months before it once again came under a significant pressure all through the closing days of August 1939 owing to heightened tensions around the globe as well as the shifting of the finances to a safer haven in the United States. A fortnight before Canada declared war on Germany on September 10, 1939, the value of the Canadian dollar depreciated by around 6 per cent in comparison to the U.S. dollar. And by the time the Canadian federal government enforced regulations on the foreign exchange during the middle of September the same year, the value of the Canadian dollar dipped by another three per cent. It is interesting to note that the value of the pound sterling dropped all the more steeply. The value of the pound sterling weakened from the previous US$4.86 to US$4.06 prior to the enforcement of restrictions on the foreign exchange in the United Kingdom in the early part of September 1939. In effect, the downgrading in the value of the pound sterling during this time was around 14 per cent!