Tumultuous Times: Central Banking in an Era of Crisis 9780300263008

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The Yale Program on Financial Stability Series

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TUMULTUOUS TIMES CENTRAL BANKING IN AN ERA OF CRISIS |||||||||||||||||||||||||

MASAAKI SHIRAKAWA |||||||||||||||||||||||||

NEW HAVEN AND LONDON

 Published with assistance from the Yale Program on Financial Stability. Copyright © 2021 by Masaaki Shirakawa. Originally published as Chūō ginkō: Sentoraru bankā no keiken shita 39 nen (The Central Bank: My 39  Years as a Central Banker), Tokyo: Toyo Keizai, copyright © 2018 by ­Masaaki Shirakawa. All rights reserved. This book may not be reproduced, in w ­ hole or in part, including illustrations, in any form (beyond that copying permitted by Sections 107 and 108 of the U.S. Copyright Law and except by reviewers for the public press), without written permission from the publishers. Yale University Press books may be purchased in quantity for educational, business, or promotional use. For information, please email sales​.­press@yale​.­edu (U.S. office) or sales@yaleup​.­co​.­u k (U.K. office). Designed by Sonia L. Shannon. Set in Minion Pro and Gotham Display by Westchester Publishing Ser­v ices. Printed in the United States of Amer­i­ca. Library of Congress Control Number: 2021934646 ISBN 978-0-300-25897-4 (hardcover: alk. paper) A cata­logue rec­ord for this book is available from the British Library. This paper meets the requirements of ANSI/NISO Z39.48-1992 (Permanence of Paper). 10 9 8 7 6 5 4 3 2 1

| CONTENTS |



Prologue | 1

PAR T 1

Career Building at the Bank of Japan

C H AP TER  1

Starting My ­Career | 15

C H AP TER  2

The Japa­nese ­Bubble Economy | 27

C H AP TER  3

The Bursting of the ­Bubble and the Financial Crisis | 48

C H AP TER  4

The New Bank of Japan Act | 74

C H AP TER  5

The Zero Interest Rate Policy and Quantitative Easing | 88

C H AP TER  6

The Illusion of the ­Great Moderation | 115

PAR T 2

The Days as Governor

C H AP TER  7

My Appointment as Governor of the Bank of Japan | 133

C H AP TER  8

The Collapse of Lehman ­Brothers | 146

C H AP TER  9

The Increasing Clamor for Beating Deflation | 175

C H AP TER  1 0 C H AP TER  1 1

Demographic Challenges and Raising Productivity | 203

The Eu­ro­pean Debt Crisis | 220

C H AP TER  1 2

The Comprehensive Monetary Easing Policy | 234

C H AP TER  1 3

The ­Great East Japan Earthquake | 255

C H AP TER  1 4

Sixfold Suffering and the Currency War | 272

C H AP TER  1 5

The Sustainability of Government Finances | 293

C H AP TER  1 6

Enhancing the Stability of the Financial System | 314

C H AP TER  1 7

The Joint Statement by the Japa­nese Government and the Bank of Japan | 334

PAR T 3 CHAPTER 18

The Roles of the Central Bank The ­Great Monetary Experiment and the Spread of Japanification | 363

C H AP TER  1 9

Lessons from the Experiences of the Japa­nese Economy | 373

C H AP TER  2 0 C H AP TER  2 1

The Global Cooperation of Central Banks | 406

C H AP TER  2 2

C H AP TER  2 3



What Should We Expect of the Central Bank? | 390

The In­de­pen­dence and Accountability of the Central Bank | 422 The Central Bank as an Organ­ization | 436 Epilogue | 453 NOTES |

455

REFERENCES |

471

ACKNOWL­E DGMENTS | INDEX |

489

495

vi | Contents

Prologue THE DAY ­A FTER Thursday, March 21, 2013, was a sunny day. The cherry blossoms came out early that year, and I wanted to see them. The Koishikawa Botanical Garden, a miraculous expanse of greenery in the ­m iddle of Tokyo, is close to our apartment and my favorite place to take a walk. My wife joined me, and a­ fter we enjoyed the cherry blossoms, just then beginning to flower, we ­stopped at a kiosk and asked for two ice creams, 250 yen each. When I took a 500-­yen coin from my pocket to pay, the ­woman ­behind the ­counter, who was prob­ably of my generation, refused to accept it. “Governor Shirakawa, I presume,” she said. “I thank you so much for your five years of ser­v ice. ­Today I cannot take your money.” She also offered us cups of warm coffee to go with the ice creams. During my tenure as governor of the Bank of Japan I made it a rule not to accept even the smallest gifts so as to avoid any appearance of impropriety. That day I tried to do the same, but I was so moved by the w ­ oman’s sincere kindness that I broke my rule and accepted her gift. The previous day, my last as governor of the bank, had been a whirlwind. I had appeared before the Financial Affairs Committee of the House of Representatives of the National Diet, gone around to the many offices in the bank to say goodbye to my colleagues and staff, and held my final press conference. The next day, t­ here I was sitting on a park bench with my wife, relishing the sense of fulfillment that comes when you have finished a challenging job. My five years as governor had been filled with turbulence. Each day I felt as if I was ­running as fast as I could into a strong headwind. When I fi­nally crossed the finish line, I was so grateful for that act of kindness from the ice cream vendor in the Koishikawa Botanical Garden.

1

AN ACCIDENTAL GOVERNOR Winding back the clock a ­little more than five years, to 9:00 a.m. on March 11, 2008, I was in the National Diet Building to deliver my statement of intent before the Rules and Administration Committees of both the House of Representatives (the lower h ­ ouse) and the House of Councilors (the upper ­house). The cabinet of Prime Minister Yasuo Fukuda had nominated me to be deputy governor of the Bank of Japan, and both ­houses of the Diet needed to hear from me before giving their consent to my appointment. In the committee rooms, I spoke a­ fter Toshiro Muto, the current deputy governor of the Bank of Japan, who had been nominated to be governor.1 ­A fter reading my prepared statement, I concluded, “If I am given the honor of serving at the Bank of Japan, at a time when Japan is being subjected to significant changes both eco­nom­ically and financially, I ­w ill sincerely devote my heart and soul to discharging my duties.” ­A fter we had answered the committees’ questions, the outcome of their deliberations was most unusual. While the lower ­house of the Diet was ­under the control of the prime minister’s Liberal Demo­cratic Party (LDP), the upper ­house was ­under opposition control of Demo­cratic Party of Japan (DPJ), and this, being unusual in Japan, created a convoluted and awkward po­liti­cal climate. While the lower h ­ ouse gave its consent to the promotion of Muto to the position of governor, and also to the appointment of another deputy governor, the upper ­house declined to give its consent. As a result, only my appointment was approved by the Diet. Even before the votes ­were counted, press reports had speculated that the promotion of Muto would be blocked, that the office of governor would remain vacant, and that one of the deputy governors would have to become the acting governor. Postwar Japan had never seen such a situation, and I found it hard to imagine that this could happen. On March 18, just one business day before the term of governor Toshihiko Fukui was to expire, the cabinet nominated a former Ministry of Finance official as governor and nominated Kiyohiko Nishimura, a Policy Board member of the Bank of Japan and a former professor at the University of Tokyo, to be deputy governor. Again, consent for the nomination for governor was not forthcoming from the upper h ­ ouse, just as in the case of Muto, even as Nishimura’s nomination was given consent. Only days before I was to be formally appointed on March 21 as deputy governor, it dawned upon me that I would in fact become the acting governor when I became deputy governor. 2 | Prologue

Before my appointment I received precious advice from two former governors. One was an inspirational telephone call from Yasushi Mieno, the twenty-­sixth governor, who told me to be “­humble but bold.” The other was from out­going governor Fukui, when we had the handover of the governor’s functions. His advice was also impor­tant but more practical: “­Don’t ever catch a cold.” On March 21, I went to the Diet Building, where Prime Minister Fukuda presented me with my letter of appointment as deputy governor. Following a series of brief courtesy visits with key members of the ruling and opposition parties, I fi­nally entered the bank. While I had worked at the bank for thirty-­ four years, retiring in 2006 as an executive director, I had never anticipated becoming governor or even acting governor ­under such extraordinary circumstances. It was not to be business as usual for the accidental governor. ­After two hectic weeks, on the eve­ning of April 2, Finance Minister Fukushiro Nukaga called me at home to ask me, informally, if I would be willing to accept appointment as governor. While I do not know what was discussed within the government that led to my nomination as governor, in addition to the byzantine po­liti­cal situation in Japan at the time, the decision was also likely influenced by the fragile international financial environment. Just a few weeks ­earlier, on March 16, the Federal Reserve Bank of New York had provided emergency funding to JPMorgan Chase to support its purchase of troubled Bear Stearns. While financial markets seemed to be in a lull, anx­i­eties had not been dispelled. With a meeting of the G7 finance ministers and central bank governors in Washington, DC, scheduled for mid-­April, many influential commentators argued that, given the unsettled markets, it would be inappropriate for Japan to participate in the G7 meeting without a governor of the Bank of Japan. ­After receiving a formal request from Prime Minister Fukuda that I be nominated to serve as governor, I found myself back before the same committees to deliver my statement of intent as governor on April 8. On April 9, both h ­ ouses of the Diet consented to my promotion to governor but denied their consent to another candidate for deputy governor. On April 9, still as acting governor, I chaired my first Monetary Policy Meeting (MPM) of the Bank’s Policy Board. When the meeting was over, and I had completed the press conference to explain the decisions we had taken, I was off to the Prime Minister’s Office to receive my letter of appointment to serve as the thirtieth governor—­and one of the youn­gest ever postwar governors—of the Bank of Japan.2 My inaugural press conference as governor, and my second of Prologue | 3

the day, was over by 7:00 p.m.. The next morning I boarded a plane at Tokyo’s Narita International Airport to travel to Washington. The G7 meeting that spring was chaired by the US Trea­sury secretary, Hank Paulson Jr., and the focus was on responses to the early stages of what still seemed to be an American and British financial crisis. Of the central bank governors who attended the meeting, I was already acquainted with Ben Bernanke of the Federal Reserve, Mervyn King of the Bank of ­England, and Jean-­Claude Trichet of the Eu­ro­pean Central Bank. But this was my first encounter with Mark Carney of the Bank of Canada, Christian Noyer of the Bank of France, and Axel Weber of the Deutsche Bundesbank. It was the beginning of a long, fruitful relationship with fellow central bank governors.

FIVE YEARS OF TURBULENCE At my final press conference as governor, I was asked what I thought of my tenure. I remember answering “five years of turbulence,” which was exactly what I felt. The financial crisis in the United States, which first surfaced as prob­ lems in the subprime mortgage market in August 2007, eight months before my appointment as acting governor, spiraled out of control into the global financial crisis (GFC) with the collapse of Lehman B ­ rothers in September 2008. While that crisis began to gradually subside in the spring of 2009, 2010 saw the intensification of debt prob­lems in the euro area. Beginning as a crisis for Greece, it soon engulfed Ireland and Portugal, eventually spreading to Spain and Italy. Then on March 11, 2011, the G ­ reat East Japan Earthquake struck. In addition to the shocks of the earthquake, the tsunami and the meltdown of nuclear reactors at the Fukushima Daiichi Nuclear Power Plant violently shook Japa­nese society and its economy. On a dif­fer­ent level in terms of speed, but no less impor­tant, demographic change was visibly accelerating in Japan during ­those years. Japan’s total population peaked in 2010. Its working-­age population, which had already peaked in 1995, declined more rapidly as postwar baby boomers, myself included, reached retirement age. The decline of the working-­age population during my five years as governor was 3.2 million p ­ eople—­that is, 0.7 million p ­ eople, or 0.8  ­percent of the population, per year; that was undoubtedly a huge headwind for the economy. Japa­nese politics was also tumultuous. The LDP, which had almost continually been in power since its founding in 1955, suffered a historic defeat in the general election of August 30, 2009, and power passed to the DPJ. Three years 4 | Prologue

l­ater, in the general election of December 16, 2012, it was the turn of the DPJ to suffer humiliating defeat, and power returned to the LDP. Reflecting the seesawing fortunes of the po­liti­cal parties, prime ministers and finance ministers changed frequently during my tenure as governor of the bank. I frequently had to attend international meetings such as the G20 with a dif­fer­ent finance minister than at the previous meeting, and had to introduce a freshly appointed minister to my fellow central bank governors. My fellow governors ­were prob­ably surprised when, each time we met, I began my greetings with, “This is our new finance minister.” In t­ hese same years, less developed economies experienced an extended period of rapid growth. In par­tic­u­lar, the growth of China was exceptional. In terms of gross domestic product mea­sured by market exchange rates, China was only one-­fourth the size of Japan in the year 2000. From t­ here China overtook Japan in 2010, and then had almost doubled the size of its economy by 2015. The rapid growth of emerging economies, with their high rates of consumption of primary products, fed a corresponding rise in commodities prices. How much did I recognize the magnitude and the implications of ­t hese events at the time of my appointment as governor? As for the effects of the GFC, I knew ­t here would be severe consequences in light of my experiences ­ ubble, but even so, the following the bursting of the Japa­nese economic b ­ ere beyond my imagination. I had discussed extent and breadth of the crisis w the sustainability of the euro area in the abstract, but I was completely blindsided by the severity of the Eu­ro­pean debt crisis. Contingency planning for earthquakes in the sphere of central bank ser­v ices was clearly my responsibility, but the magnitude of the tsunami and nuclear accident following the earthquake also took me by surprise. While I saw rapid aging and decline of the population as impor­tant issues, I was not as alarmed by them as I would be in subsequent years. They w ­ ere turbulent years indeed. Nevertheless, when t­ hings are actually happening, one has to weigh the options, formulate the best response, and implement it, even if the confusion and uncertainty appear overwhelming. Public bodies, such as governments and the central banks, are no dif­fer­ent from private individuals and firms. From the perspective of the private-­sector agents, given that public policy is a pillar of the environment in which they operate, the governments and central banks that determine policy carry heavy responsibilities. At the same time, policies devised by governments and central banks cannot be separated from their contemporaneous social context and are sometimes swayed by the environment. Prologue | 5

CHALLENGES TO SETTING GOOD POLICY Selecting the best policy option as central bank governor is truly a task that carries heavy responsibility. One is obliged to make many tough decisions almost spontaneously. First, monetary policy is sometimes likened to driving a car with an opaque windshield, broken speedometer, and dubiously functioning gas and brake pedals, and it can surely feel that way. Thus, the decisions central banks make are difficult ­because of the extreme uncertainty that surrounds developments in the economy and the imprecision with which the central bank’s tools can influence ­those developments. Furthermore, the consequences of policy decisions may not become evident for a long time: it might take five or ten years, or even longer, to see their full consequences, as was the case with the Japa­ nese b ­ ubble economy in the latter half of the 1980s. Second, the toughness of decisions reflects the intricate relationship between the central bank on the one hand and politics and broader society on the other. In recent years, financial markets have extended their coverage, globalization has deepened, information and communication technologies have made significant advances, and social cohesion is in danger of breaking down. Th ­ ese ­factors have fed into the debates on the conduct of policy on the part of the central bank and also drastically changed t­ hose debates. Most notable are challenges to the notion of central bank in­de­pen­dence. In most advanced economies, the central bank enjoys operational in­de­pen­ dence, but that does not mean that it is f­ ree to do as it wishes. Policy decisions by the central bank ­w ill never be supported by the ­whole electorate, and the bank should not expect this. But the central bank cannot endure as  an institution in a demo­cratic society without some minimal level of trust and support from the public at large. The public needs to be convinced that the central bank, though it may look obstinate, is pursuing economic stability in the long term and, though it may look like it is implementing quite unconventional mea­sures, is carefully weighing the risks ­t hose mea­ sures entail. Fi­nally, decisions are tough and difficult ­because of the collective nature of central banks’ decision making. Like most central banks, the Bank of Japan adopts policy at a deliberative body called the Policy Board, and the governor has just one vote out of nine. This obviously does not mean that the governor’s share of influence is only one-­ninth. The governor is expected to provide leadership but is not and should not be a dictator. The governor is expected to elicit 6 | Prologue

the wisdom of other board members as the chair of the board and to help the ­whole membership make the best pos­si­ble decisions.

FOLLOWING MY INNER VOICE Decisions faced by the governor are thus difficult, and from March 21, 2008, onward I was in the thick of this responsibility. ­Every morning I was caught by a feeling that was hard to describe as I opened the door of the governor’s office. Of course, during my c­ areer at the bank, I had entered the office many times. ­After being promoted to division chief in 1990, I had more and more opportunities to visit the office, and I was a very frequent caller when I was a director general at the Monetary Affairs Department and the executive director responsible for monetary policy. The governor’s office then was where I would answer questions or offer options in response to requests from then governors Masaru Hayami and Toshihiko Fukui or where I would ask for their views on vari­ous issues. I was in the office, but I was not the person b ­ ehind the massive desk. This time around, my name was on the door. Even if the ­future was uncertain, the central bank had to make decisions and explain them. The buck would stop at my desk. A central bank governor has to lead the institution following his or her inner voice. When confronted with choices u ­ nder uncertainty, the ultimate yardstick for making decisions is one’s understanding of the economy, which is ­shaped by one’s experiences in the broadest sense. The portfolio of such experiences includes not only economic and monetary incidents that one has actually lived through but also more indirect influences as well. In my case, a large part of my experience included what had happened in the Japa­nese and global economies ­after I joined the Bank of Japan. My observations regarding public and po­liti­cal reactions to past policy decisions by the bank formed another impor­tant part. But just as significant was my training in economics. Particularly valuable was the feel, developed through the years, for the power, limitations, and the appropriate reach of economic theories as I observed how the fortunes of ­these theories ebbed and flowed in the economics profession. Help also came from my on-­the-­job training at the bank, where I learned how to break down seemingly intractable prob­lems into sets of answerable questions. Inspirations from contacts I had at the bank with ­people working at financial and nonfinancial businesses, as well as my reading of history, w ­ ere no less valuable than my encounters with economists and economic theory. In short, my previous thirty-­ four years at the bank had trained me to make decisions as governor. Prologue | 7

THE ORIGINS OF THIS BOOK ­ fter my tenure as governor was over, several friends, including politicians, A academics, and colleagues at the Bank of Japan and overseas central banks suggested that I should leave a rec­ord of my days in office. Several examples by overseas officeholders come to my mind. The book by former US Trea­sury secretary Hank Paulson Jr. is full of unique insights reflecting his long c­ areer at Goldman Sachs. Another valuable contribution by the former president of the Federal Reserve Bank of New York and by former US Trea­sury secretary Timothy Geithner illustrates, in a candid and practical manner, the impor­tant but unpop­u­lar issue of resolving failed financial institutions. One is also impressed by the clear prose, backed by academic work on the G ­ reat Depression of the 1930s, of Ben Bernanke, who was the chair of the Federal Reserve, describing how he steered central bank policies during the challenging periods in its history. While his is not a memoir, Mervyn King, the former governor of the Bank of ­England, has written a profound analy­sis of inherent weakness of the financial system that contributed to the GFC while paying meticulous attention to monetary history and the writings of the g­ iants of economic thought.3 From the perspective of a central bank governor of an emerging market economy, Duvvuri Subbarao, who led the Reserve Bank of India, offers a thoughtful, candid and persuasive account.4 This list is by no means exhaustive, and many other colleagues who worked alongside me at central banks and supervisory agencies have written memoirs and delivered speeches on the GFC and other ­matters that are full of insightful reflection. While ­there was some attraction to the idea of penning a rec­ord of my days as governor, it was not easy to overcome my initial reluctance. ­There ­were many good reasons for not writing it. I was especially concerned that a chronicle could give the wrong impression that I was engaged in self-­justification or in assigning blame. In fact, unlike in the United States, t­ here are not many cases where a governor of the Bank of Japan has written about his days in office.5 This is perhaps ­because of the long-­held virtue in Japa­nese society that it is better to say too l­ ittle than too much. Having said that, I was at the same time often frustrated with the state of popu­lar discourse regarding central banking and monetary policy. In my view, discussions often failed to take into account the real-­world issues that confronted the central bank. By reflecting on and describing the situation and addressing the issues that I think ­were most impor­tant, I thought that I could do what I have always endeavored to do: both draw upon and contribute to 8 | Prologue

the wisdom of the society at large to focus on the right policy prescriptions. Given that the conduct of monetary policy is still quite critical, I thought that all the relevant issues for policy decisions during my governorship should be made available in the public domain. Accordingly, I came to believe that I might be able to contribute something if I could rec­ord what I had been thinking during t­ hose five years of turbulence.

WHAT THIS BOOK IS ABOUT The original edition of this book was published in Japa­nese in October 2018, more than five years ­after I left the Bank of Japan. That distance in time reflects, in part, my desire to have the book read in an environment where it would not been seen as adding more fuel to a raging policy debate. The time that had elapsed also allowed me to think more deeply about issues while working on the book. The passage of time has also allowed data to accumulate, enabling a more definite evaluation of policies. Furthermore, as more research was conducted by central banks and academics, I was able to benefit from reading books and speeches by my former central banking colleagues and papers by economists at central banks and in academic circles. ­There are already many books written by academics and central bankers on monetary policy and central banking. If my book is to be worth more than the paper it is printed on, I felt I should focus on what was unique about my experiences. But this book is not a blow-­by-­blow personal memoir. If it w ­ ere, I would have included more personal accounts of events during my tenure as governor. One of the reasons I did not was that stringent constraints imposed by Japa­nese laws on confidentiality make it practically impossible to replicate the efforts of my former US colleagues. This book is not a theoretical book about macroeconomics or monetary economics, ­either. I have tried to explain vari­ous economic phenomenon based on my understanding of economic theory, but I have also spent considerable pages on explaining aspects of the “po­l iti­c al economy.” I would say this book is my personal reflections on what I learned about central banking and monetary policy during my five years as the governor of the Bank of Japan. I have approached this task from four dif­fer­ent perspectives. First, I have attempted to discuss, as much as pos­si­ble, a­ ctual developments in the Japa­nese economy and Japa­nese monetary policy in the global context. The discourse on central banks and monetary policy are heavi­ly influenced—­ perhaps dominated—by what is discussed in US academic circles. In fact, economic theory is in most cases built on the foundation of the US economic Prologue | 9

and social structure. ­Needless to say, the Unites States is not the only country in the world. Some of Japan’s experience over the past four decades—­such as its ­bubble economy in the late 1980s and the subsequent bursting of the ­bubble and the resulting financial crisis in the 1990s, the mild but per­sis­tent fall in prices since the late 1990s, and the rapid aging and decline of the population—­have actually offered a foretaste of what other countries would l­ater experience. What ­were once considered uniquely Japa­nese experiences are now observed around the world. That is why the term Japanification is increasingly used. I also have a feeling that the lessons drawn by foreign academics from the Japa­nese experience w ­ ere not readily applicable to monetary policies in other countries. Lessons wrongly drawn about Japan w ­ ere partially responsible, in my view, for the massive ­bubble that preceded the GFC and, for that ­matter, the GFC itself. Second, I have aimed to cover the activities of the central bank as they ­were—­namely, well beyond the conduct of monetary policy alone—­while drawing on my work experience at a central bank. The role of the central bank is not confined to monetary policy. It has many other impor­tant responsibilities, such as operating the payment system and regulating and supervising financial institutions. Fortunately, during my years at the Bank of Japan, I was able to have hands-on working experience in many fields in central banking. I wanted to make a contribution to rectifying the somewhat one-­dimensional views about central banking by adopting a balanced and holistic viewpoint. Third, I have offered the views of a leader of an organ­ization, as I saw ­things from my perspective as the Bank of Japan’s governor. Obviously, an organ­ ization is made up of many ­people. Consequently, an organ­ization’s decision ­will inevitably be influenced by internal dynamics, including the motivation of its members, relations between internal “silos,” and the prevalent orga­ nizational culture. A ­ fter becoming governor I became more conscious of issues such as the relation of the governor with other board members, staff morale, and sustaining good orga­nizational culture. I was also made aware of issues that I had not noticed before in the bank’s relations with the government and politics, with the press, with academia, and with other central banks. This book covers t­ hese topics as well. Fi­nally, I have also tried to convey the temporal context. Even if the world is full of uncertainties, decisions must be made in real time. The prevalent mood of the time, the dominant narrative, often heavi­ly influences policy debates. Unfortunately, such a mood is difficult to recall precisely ex post facto. ­People easily forget the fact that certain preconceptions and narratives may have overwhelmingly influenced decisions at the time. Certainly, decisions 10 | Prologue

cannot be reconstructed from macroeconomic data alone. That is why I have quoted from newspapers and books to help readers relive history and gain a more tangible understanding of how the central bank had to make decisions at vari­ous points in its history.

WHAT I WAS CONSCIOUS OF WHEN WRITING THE EN­G LISH EDITION This book is a somewhat shorter version of the Japa­nese edition, but it has been adapted considerably, and this turned out to be a much greater effort than what I had originally in my mind. The adaptation was strongly motivated by my conviction that we have to seriously reconsider the role of central banks and the conduct of monetary policy. This conviction was further strengthened a­ fter my finishing the manuscripts of the Japa­nese edition, and especially by developments such as growing macroeconomic similarity between Japan and other developed countries and the outbreak of COVID-19. Bearing this in my mind, I have, when writing the En­glish edition, made deliberate efforts at making non-­Japanese readers better understand the Japa­ nese economy and the Bank of Japan’s policy actions. I have added explanations regarding issues that non-­Japanese readers might have difficulty in understanding and left out some explanations that ­were too specific to Japan. Readers naturally might want to know my views on the Japa­nese economy and the Bank of Japan’s monetary policy a­ fter I left, especially in light of the extraordinary monetary experiment that was implemented. But I have deliberately refrained from ­doing this, with the exception of spending one chapter on explaining briefly what happened and how foreign economists interpreted the subsequent developments. My decision is not only ­because writing recent events would make my book more lengthy; more impor­tant, it would subtly change the tone of my book. My contribution is to stick with writing about my days as governor of the bank. That is what I see as the book’s real value, and what I hope is for the book to be read, to the greatest extent pos­si­ble, without prejudice.

THE STRUCTURE OF THE BOOK This book is composed of three parts and twenty-­three chapters. Each chapter is self-­contained, and readers can start reading any chapter alone depending on their interests. Prologue | 11

Part 1, “­Career Building at the Bank of Japan,” describes events since I joined the bank in 1972 up to my appointment as governor in 2008. The most notable events during this period ­were the ­bubble economy, the bursting of the ­bubble and the financial crisis that followed it, the adoption of the new Bank of Japan Act, the zero interest rate policy and quantitative easing, and the state of the global economy between 2003 and 2007. Part 2, “The Days as Governor,” attempts to explain what happened in the economy and finance ­after I became governor and how the bank responded. Anyone holding a public office is obliged to rec­ord the decisions during his or her tenure and the reasoning ­behind ­those decisions. Success or failure ­will not become evident ­until ­after a sufficient passage of time, but ­those who make the decisions ­will have to take the blame, or enjoy the credit, themselves. Part 3, “The Roles of the Central Bank,” takes up several themes that are relevant for many central banks. This part has been considerably adapted compared with the Japa­nese edition. In so ­doing, Japa­nese experiences w ­ ere put in global perspective and not treated as isolated or as outliers. Since the monetary and financial system is a complex system adapting to a changing environment, we cannot hope to find an optimal “fixed” system. I hope that this part ­will provide some food for thought about the ­future of central banking.

12 | Prologue

| CHAPTER ONE |

Starting My ­Career I joined the Bank of Japan in 1972, and I spent the next thirty-­nine years learning from many gifted and thoughtful colleagues. Early in one’s c­ areer it is impor­tant to learn how to do one’s job. I tried to give due regard to economic theory, to learn from o ­ thers in the field, to focus on accomplishing the bank’s mission through its operations, and to appreciate the global context and re­ spect our relations with other central banks. Each of ­these lessons influenced me when I ­later became the bank’s governor.

MY ENCOUNTER WITH ECONOMICS In March 1972, I received a bachelor’s degree in economics from the University of Tokyo, and I joined the Bank of Japan on April 1 as one of thirty university gradu­ates hired that year. When I was considering where I would work ­after finishing my degree, a general aspiration to perform some public ser­vice with my economics training led me to the bank. My focus on economics had, however, happened completely by chance. When I was admitted to the university in April 1968, I enrolled in a course for prospective law students. It was a time of student unrest, and for eight months, ­ ere no classes. With nothing ­else from June 1968 ­until February 1969, ­there w to do, a classmate invited me to join a study group reading Paul Samuelson’s Economics.1 Samuelson, who would receive the Nobel Prize in Economic Sciences in 1970, was one of the leading economic scholars of the ­century, and Economics was the standard textbook across the globe for many de­cades. The freshmen study group was extremely fortunate in having a wonderful tutor, Yasusuke Murakami, who was then an associate professor. As I began to study economics while attending the group’s meetings, my interest in the subject grew stronger. Studying law no longer seemed attractive to me. Shortly before I had to decide on what to study for the last half of my undergraduate education, I whipped up my courage and visited Murakami’s office for advice. He 15

suggested that I read the book Value and Capital by John Hicks,2 and that if I thought it intellectually inspiring, I should switch from law to economics. Hicks’s book was by no means an easy read for an economics novice, and I was unable to make it through to the end. Nonetheless, I was fascinated, and I de­cided to study economics. ­ ere At the Faculty of Economics of the University of Tokyo, group tutorials w an impor­tant part of student life. I became a member of a group that formed around Ryutaro Komiya, a professor who had a profound and lasting influence on me long into my c­ areer at the Bank of Japan. In ­those days Marxian economics was dominant at many Japa­nese universities, while courses presenting the Western style of economics w ­ ere rather l­imited. Armed with a rigorous analytical framework, Komiya was delivering sharp analy­sis of the ­actual economic issues facing Japan at the time and actively advocating policy ­prescriptions. He was often called “the demolisher of conventional wisdom.” Komiya’s analy­sis was always lucid and grounded in both economic theory and a detailed factual analy­sis of a­ ctual economic developments. Reading his work during my student years, I was captivated by the incisive power of economic reasoning. Policy debates in Japan at the time centered on the desirability of an upward revaluation of the exchange rate, which was then fixed at 360 yen to the US dollar, against the background of the widening trade surplus. I especially remember a series of papers written by Komiya on international finance, just prior to the collapse of the Bretton Woods system of fixed currency exchange rates, when so much attention around the world was focused on how best to or­ga­nize exchange rates. I learned a lot from Komiya. In par­tic­u­lar, he insisted that we think logically, employing economic princi­ples; that we be meticulous with the facts; and that we write as clearly as pos­si­ble.

JOINING THE BANK My decision to work at the Bank of Japan was deeply influenced by the first interviewer I met, who was such a wonderful person. Had I been interviewed by a dif­fer­ent staff member, I might have found work elsewhere and my life could have taken a completely dif­fer­ent course. My first assignment at the bank was in what is t­ oday the International Department. I was part of a small team following developments in, and focused on reform of, the international monetary system—in par­tic­u­lar, we paid attention to discussions at the Executive Board of the International Monetary Fund. While ultimate responsibility for the reform of the international finan16 | ­Career Building at the Bank of Japa

cial system in Japan rested with the Ministry of Finance, the bank followed the debates closely ­because of their significance in its role as the central bank. In August 1971 the international financial community was severely shaken by the so-­called Nixon Shock, which triggered the eventual collapse of the Bretton Woods system; major currencies, including the yen, ­were temporarily floated. December 1971 saw a multilateral adjustment of exchange rates known as the Smithsonian Agreement, where the yen’s parity to the US dollar was changed from 360 yen to 308 yen, an appreciation of 16.9 ­percent. Only a few months ­after ­these impor­tant events I took my first baby steps at the Bank of Japan. Roles assigned to freshmen staff ­were only supporting ones. I recall struggling to understand the Eu­ro­pean Economic Community’s attempt to launch the “snake in the tunnel” to limit the exchange rate fluctuations among six major Eu­ro­pean economies, including Germany, France and Italy. Having just studied international economics at a university, it seemed to me rather rash to launch a fixed exchange rate regime between economies that themselves had such dif­fer­ent rates of inflation. The “snake” was a failure, and subsequent similar efforts repeatedly broke down. But in 1972 I could not have anticipated the winding path that exchange rates and the international monetary system would take over the next fifty years. ­After six months I received a new assignment, still within the International Department; I was now assigned to h ­ andle the paperwork for the management of foreign exchange reserves. Japan’s exchange reserves ­were growing rapidly, having increased from US$5.5 billion at the end of March 1971 to US$16.7 billion by the end of March 1972, though that seems quite small compared with the present-­day level, above US$1 trillion. At the beginning of the 1970s the international monetary and financial system had not yet fully ­adopted the fiat money system. ­Under the Bretton Woods regime, currencies ­were fixed to the US dollar, which was convertible to gold, and the fixed exchange rate was to be adjusted only if the regime intended to correct an economy’s fundamental disequilibrium. Looking back ­today, we can see that the developed economies ­were just beginning to manage the fiat money system, heading down a road that would lead to many new ideas and practices, including money supply targeting, inflation targeting, and beyond. I stayed in the bank’s International Department for almost a year, ­until I was posted to the Okayama Branch in May 1973. It was wonderful training, to work as a central banker, even though t­ here was not much that I could accomplish by myself. I was extremely fortunate to get a glimpse of the international financial system and markets at such an early stage in my c­ areer. Starting My C ­ areer | 17

BEING A CENTRAL BANKER For the next thirty-­four years I worked at the Bank of Japan, thirty years as a member of the staff, and then four years as an executive director. My longest ser­vice, of nine years, was spent at what is now called the Monetary Affairs Department, which supports the Policy Board’s decisions on monetary policy. My other assignments included the Financial Markets Department (seven years), the Financial and Payment System Department (three years), the Institute for Monetary and Economic Studies (two and a half years), and the Research and Statistics Department (one and a half years). My appointment as an executive director was in July 2002, and I looked a­ fter issues related to the Monetary Affairs and Financial Markets Departments. ­After completing my term as executive director in July  2006 and retiring from the bank, I joined the newly established Kyoto University School of Government to teach central banking and monetary policy. Subsequently, in March 2008, I was appointed deputy governor of the Bank of Japan, and then governor only three weeks ­later. I held that office for five years before fi­ nally leaving the bank for good in March 2013. Looking back, I have spent almost my entire working life at the Bank of ­Japan. For better or worse, this extended work experience influenced my decision making while I was governor. I see similar ­career paths for heads and deputies of central banks in other countries. My numerous on-­the-­job experiences formed my central banker’s DNA. By this I mean two t­ hings. First, they influenced how I think about the role a central bank should play in the economic and financial system. My thinking evolved as I lived through ­actual economic and financial events and saw the consequences of the Bank of Japan’s actions; I was greatly influenced by the experience of living through the Japa­nese “­bubble economy” in the late 1980s, ­ ubble and the financial crisis that followed, and our then the bursting of that b subsequent experience with quantitative easing. Second, t­ hese experiences ­shaped how I think about day-­to-­day operations and the practical setting in which the central bank conducts its business. What one learns about work style early in one’s c­ areer has a lasting influence. I was fortunate to have so many wonderful colleagues and mentors to show me the way. What I learned can be summarized in four parts: (1) the importance of letting economic theory drive one’s thinking; (2) the value of collecting views and insights from o ­ thers, w ­ hether experts in the field or t­ hose with direct experience with the issues at hand; (3) recognition that central banking operations 18 | ­Career Building at the Bank of Japa

themselves can add real value to the economy; and (4) the importance of international exchanges with central bankers from other countries.

ECONOMIC THEORY AS A DRIVER OF THINKING Three years ­a fter joining the bank I was given the opportunity to enter the gradu­ate program in economics at the University of Chicago. In retrospect, I recognize that my time t­ here came during the golden age of the university’s economics program. ­Future Nobel Prize laureates then teaching in the gradu­ ate economics program or at its Gradu­ate School of Business included Milton Friedman, Theodore Schulz, George Stigler, Ronald Coarse, Gary Becker, ­Robert Lucas Jr., and James Heckman. It was a magnificent faculty. Microeconomic and macroeconomic theory, then respectively called “price theory” and “money” at Chicago, ­were offered in two parallel courses—­the expectation being that students would take one for credit but still attend the other course. For credit I took Gary Becker’s course on price theory, and I audited Milton Friedman’s course on price theory. Of all the professors, I was most influenced by Becker. His analy­sis of ­human capital, which was one of his most significant contributions to economics, showed the incisiveness of price theory, and I was fascinated by the rich implications that flowed from such seemingly ­simple ideas. Becker ranged well beyond the scope of traditional economics, into ­matters such as marriage and reproduction and crime and punishment. While such analyses ­were intellectually stimulating, I did not then grasp their real-­life significance. Several de­cades on, now looking at the prob­lems faced by the Japa­nese economy arising from low fertility rates, I am struck by the foresight of Becker and the  importance of identifying issues that could be pursued rigorously and analytically. ­There are three lessons I learned at the University of Chicago. The first lesson was that one needs to look for logical explanations of be­hav­ior based on ­people’s incentives. Incentives may or may not be pecuniary. The key is to explain p ­ eople’s be­hav­ior using the most basic framework of economics, which is optimization ­under vari­ous constraints such as bud­get, resources, time and information. Once I became familiar with this approach, I felt increasingly uncomfortable with imprecise arguments that emphasized cultural differences or structural f­ actors, and lacked any examination of incentives. The second lesson was the importance of empiricism. I particularly remember the macroeconomics course offered by Lucas, who was then revolutionizing Starting My C ­ areer | 19

the field with his theory of rational expectations. Based on his writings, I expected the course to be heavy on mathe­matics. But for the first few classes Lucas asked us to see for ourselves by drawing our own graphs of the fluctuations of production, inventory, and other components of the business cycle based on the famous research of Wesley Mitchell and ­others at the National Bureau of Economic Research. This experience hammered home the necessity of thoroughly reviewing the facts when exploring economic prob­lems. The third lesson was the usefulness of explaining ­things intuitively. A memorable episode took place in Milton Friedman’s classroom. Friedman would often read a passage from an article in the Wall Street Journal and then ask students to respond off the cuff. One day, one of the most gifted students began answering one of ­these questions in mathematical language. Friedman interrupted the student and said, “­Don’t speak about mathe­matics. Speak intuitively.” In the same spirit, we faced exam questions that simply asked, “True, false, or uncertain—­and why?” Th ­ ese questions w ­ ere intended to teach students how to pre­sent clear reasoning. The gradu­ate school at the University of Chicago, unlike ­those at Harvard University or the Mas­sa­chu­setts Institute of Technology, admitted a relatively large number of students. That large group of students was then culled through rigorous examinations, with the first hurdle being the interim qualifying examination in the PhD program, the “core.” Fortunately, I passed ­these exams, but the time allowed by the Bank of Japan for my studies was only two years, which was not enough time for me to finish a dissertation. I sounded out the ­human resources office for an extension but was turned down. I was already married, and my wife and I had a two-­year-­old d ­ aughter, which made it impractical to continue my studies without the bank’s financial support. Faced with the choice of returning to the bank on schedule or quitting my job to continue with my studies, I de­cided to return to Japan ­after earning a master of arts degree in June 1977. As I had qualified as a PhD candidate, I was hoping to finish writing my dissertation in Tokyo. But this turned out to be unrealistic given my workload when I returned to the bank. Although I was not able to obtain a doctoral degree, I was more than fortunate to have spent two years at the University of Chicago. When I reflect on what has changed in my worldview since my time ­there, and what has remained constant, the relationship between policy implementation and the use of theoretical models stands out. As I ­will explain further in ­later chapters, we need to recognize that theoretical models do not mimic the real world and are only simplifications of the real world’s complexities. Even with their flaws and 20 | ­Career Building at the Bank of Japa

simplifications, models are essential tools used to shed light on core issues. But when one is advocating a policy based on a model, one must also be aware of the many f­ actors in this complex world that our models do not account for. One should not let the use of a model framework cloud one’s view and prevent one from seeing what is actually happening in the world. One has to learn to be selective in the use of models, to look carefully at what is happening in the economy and the society at large, before being able to select the right models. Yet this is more easily said than done; I came to realize this gradually while performing my duties at the Bank of Japan.

GARNERING KNOWLEDGE FROM ­P EOPLE IN THE FIELD In my second year at the bank, when I was posted to the Okayama Branch, I learned the value of gaining insight by listening to p ­ eople in the field with direct experience and knowledge. In ­those days, as t­oday, all new hires out of the university ­were posted to the bank’s regional branches. ­After six months at the branch, I was assigned to a team looking at the local economy, and this compelled me to visit local firms to gather intelligence on their business. Except for a few large factories of major companies producing steel and petrochemicals, my visits w ­ ere concentrated on local establishments, which ­were mostly small-­and medium-­size enterprises. At first I was completely in the dark, without the faintest idea about what I should be asking. I tried to ask questions that I had prepared beforehand, but I was unable to engage in meaningful conversations on the spot. One of the companies I visited was a manufacturer of firebricks, a leading industry in Okayama. As monetary conditions had been tightened in response to the inflation that followed the first oil crisis of the 1970s, the business climate was extremely weak and the production of firebricks had dropped considerably. I also often visited the local agricultural cooperatives. Due to power­ful restraints on lending by the Bank of Japan, large corporations ­were looking to borrow from financial institutions that ­were not subject to its “win­dow guidance” policy.3 The agricultural cooperatives w ­ ere one source of credit that was beyond the reach of the bank. It was my job to send reports about such developments to the head office in Tokyo. While I do not think that my reports had any influence on policies at that time, it was an impor­tant experience for me to see what was actually happening on the ground. It was also helpful to realize that I could obtain valuable insights, and a feel for business and financial conditions, by talking with p ­ eople in the field. Starting My C ­ areer | 21

Of course, one cannot completely grasp what is happening in the entire economy just by listening to what prac­ti­tion­ers say. While it is often said that facts on the front lines of the microeconomy are impor­tant, not paying attention to anything e­ lse would result in a failure to see the bigger picture. Even so, one is able to obtain significant insights by learning what p ­ eople at ­those front lines are thinking. My sympathy with such an approach was reinforced throughout my ­career at the bank. In my tenth year of employment t­ here, I was the head of a section in the Financial Markets Department that had regular contacts with large businesses based in Tokyo, such as ­those in the steel and auto industries, as well as the trading h ­ ouses. I found the views of the firms’ management quite in­ter­est­ing. When I led another team in that department,4 we regularly ­gathered the views of midlevel man­ag­ers in the commercial banks’ funding and corporate strategy sections. Once I learned the value of contacts with ­people in the field, it became second nature to do the same in my subsequent assignments.

CENTRAL BANKING OPERATIONS ARE OF REAL VALUE TO THE ECONOMY As every­one knows, the devil is in the details, and the longer I worked at the Bank of Japan the more I appreciated the importance of the daily operations of a central bank. From textbooks on commercial law I learned about checks and promissory notes, but I first saw them when I was posted to the Okayama Branch. When the bank discounts promissory notes, someone has to assess the creditworthiness of the par­tic­u­lar issuer. And to do that one has to know how to read the balance sheet, and the profit and loss statement, of the issuing com­pany. The first time I got a vivid sense of the flow of funds through the economy was when I was assigned to the branch’s Government Trea­sury Operations Section. All payments to and from the national government, such as taxes, public works outlays, and pensions, pass through the government’s account at the Bank of Japan; this is why the bank is referred to as “the government’s bank.” At the government trea­sury operations section, one of my jobs was bookkeeping, which compelled me to see all of the paperwork that came from local private financial institutions into the branch. This is how I came to know firsthand the ebbs and flows of trea­sury funds as they reflect what is happening in the economy. For example, corporate income taxes w ­ ere due at the end 22 | ­Career Building at the Bank of Japa

of each month, and personal withholding taxes ­were due on the tenth of ­every month. Corporate income tax receipts peaked at the end of May, reflecting the March end to the fiscal year, the common accounting period in Japan. Personal withholding tax payments ­were received in relatively small lots, recorded on numerous slips of paper. The funds we received ­were then transferred to the government’s current account two business days ­after their due dates. Thus, from my work as a bookkeeper, I came to experience how the flow of funds fluctuated within seasons, months, and even during the day. Reflecting on my experience, I realize how uncomfortable I have become with the explanation of monetary policy in macroeconomic textbooks, which usually start with changes in the money supply. While this approach is, perhaps, changing, textbooks often still focus on the money multiplier and describe how the central bank controls the amount of central bank money (the “monetary base” or “high-­powered money”) and how a multiple of this becomes the money supply. The notion of a “money multiplier” suggests that commercial banks and other financial institutions ­will act mechanically, like robots, in response to central bank actions. But in the real world, beyond textbooks, the amounts of cash and deposits held by ­house­holds and firms reflect their individual choices. Financial institutions’ decisions to lend ­will only occur if they see profit opportunities. For example, when the central bank cuts interest rates, it ­will tend to increase lending by commercial banks through the pro­cess of maturity transformation. Looking at the balance sheets of commercial banks, their liabilities consist mainly of deposits and interbank borrowing, both of which exist mostly in the short term. Their assets consist of loans and securities investments whose maturities are longer than their liabilities. Consequently, when the central bank cuts short-­term interest rates, the spread between liabilities and assets w ­ ill widen, which in turn w ­ ill prompt commercial banks to increase lending and securities purchases, thus increasing maturity transformation. In the eyes of the central banker, the control of the money supply begins with the control of the overnight interest rate in the interbank funding market, which in Japan is the call money market. The interbank funding market is where financial institutions, including banks and securities brokers and dealers, borrow from and lend to each other large amounts of money without collateral, and in that market the largest volume is accounted for by overnight transactions, which come due and are repaid the next day. The central bank is able to control the interest rate charged to overnight transactions by influencing the conditions of supply and demand of its current account balances Starting My C ­ areer | 23

through its actions to provide and withdraw its own money. Such actions of the central bank are called market operations. Monetary policy is the pro­cess by which the central bank sets interest rate targets so as to achieve policy objectives, such as price stability. Meanwhile, market operations are a series of actions by the central bank to realize the desired levels of interest rates that are set by monetary policy decisions. The Bank of Japan has followed the practices of other central banks around the world but, unfortunately, its operations have been incorrectly derided by some academics, as if the bank was claiming a uniquely Japa­nese approach to monetary policy. Public and academic misconceptions about central bank operations are not unique to Japan. At international meetings following the global financial crisis of 2007–9, I often heard central bankers from other countries complain about public misunderstanding of their market operations. Of course, I did not know anything about such operations when I first joined the Bank of Japan. In school I was taught the standard view on monetary policy: that the central bank could control the money supply on its own. An understanding of the payment system, and its importance, is another ­thing I learned from direct experience with central bank operations. The textbooks on monetary economics usually begin by outlining the three functions of money as a medium of exchange, a unit of account, and a store of value. Many more pages are usually devoted to the latter two functions, with the unit of account often receiving the most attention. Yet when one works at a central bank, one naturally comes to realize that one of the bank’s core ser­vices is that of payments, or of providing a medium of exchange. In 1987, I first became involved in the issue of payments system policy. In January of that year, a del­e­ga­tion of se­nior officers of the Federal Reserve Bank of New York, or New York Fed, headed by its then president Gerald Corrigan, visited the Bank of Japan. In his visit to the Bank of Japan, Corrigan emphasized two issues. One was the importance of reaching an agreement in substance among Japan, the United Kingdom, and the United States on the introduction of minimum capital requirements for banks. The other was reducing foreign exchange settlement risk. At that time, Japa­nese banks ­were settling the dollar legs of their foreign exchange transactions through their dollar current accounts at the Tokyo branch of the Chase Manhattan Bank. Corrigan and the New York Fed ­were concerned about the timing gaps between the settlement of each currency that ­these arrangements entailed, and they recommended changes. Regular meetings on payment and settlement issues be24 | ­Career Building at the Bank of Japa

gan to be held among three central banks—­the Bank of ­England, the Bank of Japan, and the New York Fed—­and I attended the first of ­these meetings at the New York Fed as a ju­nior member. It was still then a novel idea, even outside Japan, to examine issues related to payment and settlement systems as a policy ­matter, but in the United States ­there was an increasing awareness of the need to reduce risks related to payment and settlement. As ­there was no specific section within the Bank of Japan to deal with ­these issues, I was instructed to cover them while posted at a section responsible for monetary policy. Many issues emerged that led to changes in payment and settlement practices, including the shortening of the time between trading and settling Japa­nese government securities, the introduction of a book-­entry system for commercial paper, and the establishment of delivery against payment for Japa­nese government bonds. Japa­nese financial institutions ­were generally not very enthusiastic about t­ hese issues. But continuous attention on improving payment and settlement practices within the financial system is another tangible way that central bankers can and do produce value for society. In essence, I learned the importance of financial “plumbing” issues.

INTERNATIONAL EXCHANGES WITH OVERSEAS CENTRAL BANKS The central bank does not have an equivalent institution within its national borders. It is only in other countries that ­there exist similar institutions. Consequently, in conversations with representatives of overseas central banks, I often found that we face the same issues and concerns, notwithstanding where we live or what language we speak. The first time I attended a meeting among central banks was that of the payment and settlement discussions with the Bank of ­England and the New York Fed, but the frequency of my attending such meetings as ­these increased significantly in the latter half of the 1990s. Participating in meetings at the Bank for International Settlements (BIS) was especially impor­tant for me, personally, in forming my background as a central banker. One of the most impor­tant roles of the BIS is to provide forums for central banks; the most well-­k nown of ­these are the bimonthly central bank governors meetings, held in Basel, Switzerland. But Basel is not a meeting place for governors only. Many se­nior and midlevel central bank staff, from many dif­fer­ ent disciplines, meet t­here. Notable committees include the Basel Committee Starting My C ­ areer | 25

on Banking Supervision; the Committee on the Global Financial System (CGFS); and the Committee on Payments and Market Infrastructure. At the Bank of Japan, and at other Japa­nese public institutions, it was the usual practice to entrust meetings with overseas institutions only to the staff and veteran officers specifically responsible for international relations or negotiations. As a consequence, public and government institutions tended to be populated by two types of staff, the domestically oriented and the internationally oriented, and—if I may exaggerate a l­ittle—­policy was generally determined by the domestically oriented staff, while the job of the internationally oriented staff was to explain ­those policies to the outside world. While much of my ­career at the Bank of Japan was spent in the Monetary Affairs Department, which was deemed domestically oriented, I was fortunate to attend international meetings frequently. Participation in international meetings gave me an opportunity to network with overseas colleagues. In the early days of my international banking c­ areer, I was most heavi­ly involved in the CGFS.5 Due to the fact that Toshihiko Fukui, the se­nior deputy governor of the Bank of Japan, became the chair of this committee in 1997 and was soon succeeded as se­nior deputy governor by Yutaka Yamaguchi in 1998 (who continued in that position ­until 2003), I was constantly in contact with the secretariat of this committee. The secretariat was then headed by Claudio Borio, who went on to become the leading figure of BIS research, and the exchanges with Borio had a g­ reat influence on my thinking. Th ­ ere w ­ ere many other overseas colleagues, too many to list individually, that I came to know through activities at the BIS. ­After I became the governor of the Bank of Japan, I had the plea­sure of working with them in their capacity as the heads and deputies of their respective institutions.

26 | ­Career Building at the Bank of Japa

| CHAPTER TWO |

The Japa­nese ­Bubble Economy In e­ very economy ­there is an event that casts a long shadow over the national consciousness. For the United States it is the ­Great Depression of the 1930s. For Germany it is the hyperinflation following World War I. Such historical events are firmly imprinted in the collective memory of the nation and greatly influence subsequent economic policy making. In the case of Japan, ­after World War II, it is certainly the “­bubble economy” of the late 1980s, its subsequent bursting, and the financial crisis of the late 1990s. While t­here is not yet a consensus on the lessons to be learned, the b ­ ubble and its aftermath s­ haped the mind-­set and be­hav­ior of ­t hose who lived through the period, myself ­included.

AN UNPRE­C E­D ENTED ­B UBBLE From September 1985 to November 1988, I was a midlevel man­ag­er at the Bank of Japan’s Monetary Affairs Department, which was responsible for formulating monetary policy. This was followed by a stint, u ­ ntil May 1990, as a midlevel man­ag­er at the Research and Statistics Department, which was responsible for the economic forecasts supporting monetary policy decisions. Thus, I spent most of the ­bubble years working directly in the area of monetary policy. No other experience could have so profoundly influenced my thinking about the economy and monetary policy. Before proceeding, it is impor­tant to explain what I mean by the term ­bubble. A popu­lar definition of a ­bubble is a situation in which asset prices considerably diverge from economic fundamentals or under­lying cash flows. I do not use this definition alone, however; I define ­bubble as a situation in which (1) asset prices considerably diverge from economic fundamentals or under­lying cash flows and (2) debt increases beyond capacity to pay (i.e., “too much debt”). As I ­will explain in subsequent chapters, this added condition of too much debt is critical. If I am pressured to suggest an alternative term to avoid any confusion, 27

it would be financial imbalance; this term is more comprehensive, encompassing many forms of unsustainability, including maturity mismatch of borrowing and lending and currency mismatch, though that may sound too abstract and scholarly. I ­will, throughout this book, use the terms ­bubble and financial imbalance interchangeably. From the perspective of global economic history, b ­ ubbles come and go. The Japa­nese b ­ ubble economy of the late 1980s, however, was one of the largest the world has ever witnessed and was unpre­ce­dented in modern history. The average annual growth rate from 1986 to 1990 of the Japa­nese economy was 5 ­percent, peaking in 1988 at 6.4 ­percent. The output gap—­the difference between ­actual and potential output or economic activity—­reached around an astonishing 6 ­percent by the end of 1980s.1 The Business Conditions Diffusion Index, from the Bank of Japan’s widely followed Tankan survey, climbed from a low of −17 between December 1986 and March 1987 to crest at 41 in June 1989. This was the first and last time the index showed an improvement of almost 60 points in just u ­ nder three years.2 The growth of bank lending, which was just above 10 ­percent per annum even before the b ­ ubble economy, accelerated from the mid-1980s to hit 14 ­percent in 1987. Though its growth then moderated somewhat, it picked up its pace ­toward 1990 to again reach 14 ­percent.3 The stock market was also soaring. The Nikkei Index, which closed at 12,660 yen on September 20, 1985, the day before the Plaza Accord on exchange rates among G5 countries, broke through 20,000 yen at the beginning of February 1987 and reached 26,000 yen by the end of August that year. Whereas the market experienced a brief setback in the global sell-­off following Black Monday (October  19, 1987), it bottomed at the beginning of 1988 but subsequently reached 30,000 yen by year’s end to peak at an all-­time high of 38,915 yen on the last trading day of 1989. Looking at the ranking of global businesses by market capitalization, ­there ­were seven Japa­nese firms among the top ten and fourteen among the top twenty firms.4 The largest was Nippon Telegraph and Telephone, followed by the Industrial Bank of Japan, the Sumitomo Bank, and the Fuji Bank, with the Dai-­Ichi Kangyo Bank rounding out the top five. All in all, stocks r­ ose more than threefold in slightly more than four years. Fi­nally, real estate prices, which began to rise in central Tokyo in 1983, markedly ­rose beginning in 1987. The price increase did not run its course ­until the beginning of 1991, spreading from the greater Tokyo area to regions around Osaka and Nagoya (see fig. 2.1). Given the difficulty of comparing real estate prices across borders, to put the Japa­nese b ­ ubble economy into a global context one can look at the stock mar28 | ­Career Building at the Bank of Japa

(Year-on-year, %) 80 Central Tokyo commercial 70 Tokyo commercial Tokyo residential 60 50 40 30 20 10 0 –10

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991

(Year-on-year, %) 80 Osaka commercial 70 Nagoya commercial Region residential 60 50 40 30 20 10 0 –10

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991

Figure 2.1 ​The change in land prices. Note: Central Tokyo comprises Chiyoda-ku, Chuo-ku, and Minato-ku. Source: Japa­nese Ministry of Land, Infrastructure and Transport.

ket, utilizing the price-­to-­earnings ratio (P/E ratio). Using an adjusted mea­sure that reflects both the business cycle and inflation, following the methodology developed by the economist Robert Schiller, the P/E ratio hovered around 90 in Japan. While it is true that corporate cross-­holding of stocks boosted the Japa­nese P/E ratio in an accounting sense, even if we adjust for this impact, the level of the P/E ratio was comparable to that reached during the US dot-­ com ­bubble.5 In fact, looking at the aggregate capital gains in the Japa­nese equity and real estate markets for the period between 1986 and 1990, its gains relative to annual gross domestic product (GDP) reached a stunning 460 ­percent, which handsomely exceeds the 300 ­percent figure for US capital gains between 2003 and 2007.6 Capital losses following the bursting of the ­bubble w ­ ere also massive, with losses for the period between 1991 and 2000 reaching 230 ­percent of GDP. At the level of individual firms, many Japa­nese businesses dabbled in financial transactions dubbed zaitech (financial engineering), which accounted for many of the scandals of hiding losses a­ fter the ­ ubble economy. bursting of the b

THE D­ RIVERS OF THE ­B UBBLE ECONOMY Why did such an extreme b ­ ubble develop? I coauthored an extensive working paper on this question with two Bank of Japan colleagues, Kunio Okina and Shigenori Shiratsuka, that was first published in May 2000 and then a year ­later as a book.7 Now, nearly twenty years ­later, my views remain broadly intact. When we try to analyze and explain the Japa­nese ­bubble economy ­today, ­there are two key concepts. The first is to put the b ­ ubble in a global perspective. At the time of our initial writing, Japan and the Nordic economies (and Sweden in par­tic­u­lar) w ­ ere the only developed economies to have experienced significant ­bubbles in recent de­cades. As the Nordic economies ­were perceived to have been able to extricate themselves from their financial crises relatively quickly, Japan’s ­bubble economy was often thought of as a phenomenon unique to Japan. ­Because we have, since then, experienced an increasing number of such b ­ ubbles globally, the approach should be more universal, and an effort ­toward extracting commonality becomes all the more impor­tant. The second key concept is to explain why the b ­ ubble happened and how we—­especially policy makers—­should deal with it by trying to replicate the economic, po­liti­ cal, and social situation at the time and to facilitate p ­ eople without the experience of direct responsibility of policy implementation or memory of ­t he bubble to imagine the difficulties with which central banks w ­ ere faced. 30 | ­Career Building at the Bank of Japa

When looking for ­drivers of ­bubbles, we naturally want to identify a single, all-­encompassing cause. But the search for a single, seemingly mechanical, cause is bound to fail ­because the pro­cess of ­bubble formation is more akin to that of a complex chemical reaction. I say this not to avoid a systematic analy­ sis of ­bubbles. In the paper my colleagues and I coauthored, we looked at the events that induced and inflated the b ­ ubble economy from two perspectives: initial conditions that gave birth to the b ­ ubble and f­ actors that accelerated its expansion. Initial conditions consisted of two related f­ actors: exceptionally bullish expectations and an extremely rapid expansion of credit. Once the ­bubble was formed, its expansion was aided and abetted by three ­factors: an extended period of accommodative monetary conditions, procyclical interactions between finance and the real economy, and a tax regime prone to accelerating increases in real estate prices. Fi­nally, ­these analyses are not complete without discussing the weakness of governance with regard to preventing runaway ­bubbles.

EXCEPTIONALLY BULLISH EXPECTATIONS From ­today’s perspective it may be hard to believe that in the second half of the 1980s what one could portray as exceptionally bullish expectations ­were evident everywhere in Japan. This stemmed in part from the stellar per­for­ mance of the Japa­nese economy, compared to the economies of global peers. In terms of expansion, Japan grew 3.8 ­percent per annum during the 1980s, while inflation reached only 1.0 ­percent in the latter half of that de­c ade.8 ­Japan’s economy was indeed the best performer globally, and one could then employ the term ­great moderation, which was ­later used to describe advanced economies more generally. Milton Friedman explic­itly praised the per­for­mance of the Japa­nese economy and the Bank of Japan’s monetary policy, writing in a 1982 paper, “Among the advanced countries of the world, the outstanding example is Japan,” referring to the successful containment of inflation.9 In the corporate and industrial spheres, t­ here w ­ ere many developments that enhanced the self-­confidence of the Japa­nese public. Some export industries—­ and ­those of semiconductors and automobiles, in particular—­became highly competitive, with production levels overtaking ­those of the United States by the late 1970s and early 1980s. Confidence in the Japa­nese management system became stronger in the c-­suites of corporate Japan. As US academics began to study the strength of Japa­nese corporations, praise was increasingly showered on the Japa­nese management system. One typical example was the The Japanese Bubble Economy | 31

1989 book Made in Amer­i­ca, which was coauthored by researchers at the Mas­ sa­chu­setts Institute of Technology, including Nobel Prize laureate Robert Solow, and focuses on what went wrong with American industrial productivity. Whereas the tone of the book may seem rather surprising to readers t­ oday who know about the subsequent rejuvenation of US industry, it points out that Japa­nese manufacturers ­were more efficient in their management and production than ­were their US peers. In the meantime, enhanced competitiveness exacerbated trade frictions with the United States, which led to protectionist sentiments in the US Congress. The Japa­nese current account surplus reached 4.1 ­percent of GDP in 1986, and Japan’s net external investment position became the largest in the world. The flip side of Japan’s current account surplus was a massive capital outflow. Th ­ ere ­were two symbolic overseas investments by Japa­nese firms that invoked nationalist sentiment among Americans: Mitsubishi Estate’s purchase of Rocke­fel­ler Center in Manhattan in 1989 and Sony’s purchase of Columbia Pictures in the same year. Turning to international financial markets, Japa­nese banks ­were aggressively increasing their lending, and in parallel with trade frictions the “excessive presence of Japa­nese banks” was also a source of tensions with overseas economies.10 Looking at statistics on international banking assets, as much as 90 ­percent of the overall increase in 1988 was attributed to Japa­nese banks, which resulted in their having the largest share of assets outstanding, at 38 ­percent of any nation’s banks (the corresponding number for US banks was 15 ­percent).11 Economic relations between Japan and the United States at that time ­were rather similar to t­ hose between China and the United States ­today. Superior macroeconomic per­for­mance, enhanced industrial competitiveness, a widening current account surplus, and the apparent strength of the big Japa­nese banks all contributed to supercharging the self-­confidence of Japan’s ­people and corporations.

EXTREMELY RAPID EXPANSION OF CREDIT The other initial cause of the ­bubble economy was the extremely rapid expansion of credit, reflecting the increasingly aggressive be­hav­ior of financial institutions. This was not just a reflection of improving economic conditions; ­there was also a sense of impatience in the changing environment surrounding financial institutions. The profitability of financial institutions, though strong by t­ oday’s standards, was then actually trending lower and expected to weaken further. As regards their assets, banks ­were hard-­pressed to find 32 | ­Career Building at the Bank of Japa

profitable lending opportunities, partly as a result of the gradual decline in Japan’s potential growth rate, from the high growth years of the 1960s and ­ ere also challenged by 1970s to the “stable growth” era of the 1980s. Banks w financial liberalization, which enabled large corporates to tap capital markets directly for credit, bypassing the banks. On the liability side, banks w ­ ere worried that the ongoing liberalization of deposit rates would increase their funding costs, thus squeezing profit margins. In trying to meet ­these challenges, banks ­were aggressively lending to small-­ and medium-­size enterprises and providing mortgages to h ­ ouse­holds. The quick fix that many banks chose to pursue was large-­lot property lending centered on three sectors: real estate, construction, and nonbank financial institutions. From March 1985 to March 1989, domestic banks’ real estate financing jumped from 20.1 trillion yen to 48.8 trillion, an annual rate of increase of 25 ­percent (reaching a high of 33 ­percent during the 1987 fiscal year). Unfortunately, the banks’ credit assessment capabilities ­were not up to the task.

ACCELERATING F­ ACTORS OF THE B­ UBBLE ECONOMY The ­bubble, which had its origins in the exceptionally bullish expectations and the extremely rapid expansion of credit, ballooned further for several other reasons. First, an extended period of very accommodative monetary conditions played an impor­tant role. The official discount rate, which functioned as the policy rate ­until 1997, was first lowered to 4.5 ­percent in January 1986, and ­after five successive cuts reached a historical low for the time of 2.5 ­percent in February 1987; it stayed ­there ­until May 1989. In such an environment many expected that the period of low interest rates would persist for some time, reflecting low inflation and policy rhe­toric emphasizing international policy coordination, as further explained below. Second, procyclical interactions between finance and the real economy had a strong impact. One feature of finance is that when real estate prices rise as a result of increased financing, profitability improves not only for real-­estate-­ related lending but also for all other lending, resulting in a further ease in financing conditions. The incentive of financial institutions to lend is further strengthened by improvements in the capital position of borrowers and enhanced collateral value. Ironically, such be­hav­ior was further encouraged by the capital requirements introduced for internationally active banks, which had the effects of rewarding gains on owned equities from the strong equity market. The Japanese Bubble Economy | 33

The requirements, which ­were newly introduced partly in response to the perception of the international community of an excessive presence of Japa­ nese banks, permitted banks to count as capital 45 ­percent of latent profits from their equity investment portfolios. The capital accord only stipulated a minimum level of capital, but as Japa­nese banks came to regard this as the economic capital needed for their business, without considering a­ ctual risk, it was bound to have adverse consequences. In retrospect, the rule allowing 45 ­percent of latent profits to be counted as capital, introduced at the request of Japa­nese authorities, had the effect of further promoting banks’ aggressive credit creation. Fi­nally, Japa­nese tax policy also encouraged increases in real estate prices. Real estate holdings w ­ ere then taxed lightly while realized capital gains w ­ ere taxed relatively heavi­ly. Furthermore, the tax rate on capital gains decreased with the length of the holding period. Consequently, when ­people expected real estate prices to rise, they would delay any real estate sales as long as pos­si­ble to defer capital gains taxes and take advantage of the f­ uture increase in prices. Such speculation was inexpensive ­because the tax cost of holding real estate was so low. Thus, elevated real estate prices in Japan also reflected the pre­sent value of tax advantages that would arise from expected ­future economic growth. Unfortunately, ­these expectations ­were overly optimistic.

WEAKNESSES IN THE MECHANISMS TO CHECK THE B­ UBBLE ECONOMY An understanding of the origin and swelling of a ­bubble would not be complete without a review of why the system failed to check its expansion. When a ­bubble is expanding, all economic agents—­firms, h ­ ouse­holds, and financial institutions—­should have at least contemplated the less optimistic outcomes resulting from a downturn in asset prices, even if the ­future looked rosy at the time. The ­bubble economy was allowed to swell ­because mechanisms that could have put a brake on excesses, most notably robust corporate governance, w ­ ere wanting. During the high-­growth era in Japan, the governance of Japa­nese firms relied heavi­ly on monitoring by the main bank. This, however, was no longer effective as it became more common in the 1980s for large firms to fund themselves in the capital markets. The new providers of funds, the investors in corporate stocks and bonds, w ­ ere not in a position to enforce robust corporate governance. In par­tic­u­lar, shareholders tended to be largely ­silent ­until firms 34 | ­Career Building at the Bank of Japa

­ ere on the brink of collapse, reflecting the extensive network of cross-­ w shareholdings among firms and financial institutions. Even if an investor wished to examine the risks of a firm, published financial statements ­were inadequate. Furthermore, directors w ­ ere mostly corporate insiders. Having said that, in the case of nonfinancial corporate entities, bankruptcies w ­ ere real threats, and this had a certain restraining effect on excesses. But since ­t here had been no failures in the postwar years, such self-­control was hard to come by in financial institutions. What about the authorities that regulated and supervised financial institutions but did not effectively rein in the excesses? In the case of Japan at that time, the responsibility of regulating and supervising banks rested with the Banking Bureau of the Ministry of Finance, and I have no idea what crossed the minds of the bureau’s staff. The Bank of Japan shared a supervisory function with the Ministry of Finance in the sense that the bank does on-­site examination for ­those financial institutions holding accounts with the bank. In addition, I was also privy to information on financial institutions collected daily by the Banking Department of the bank. This information, called off-­ site information, was treated differently in the bank from on-­site examination. At the time, many Banking Department staff ­were disturbed by the excesses at financial institutions. The same is more or less true for staff at the Ministry of Finance. Nonetheless, remedial actions ­were not taken, aside from some cosmetic ones. Simply voicing concern was dif­fer­ent from taking effective remedial action; for the latter, conviction and courage ­were needed, and it seemed that both w ­ ere lacking. Yet blaming politics for a lack of courage is not a correct assessment. Courage is a function not only of the strength of po­liti­cal pressure but also of conviction in the need for taking remedial actions, and the latter must be supported by good analy­sis. What was essentially lacking was deep insight into what would happen if actions w ­ ere not taken.

AUTHORING A REPORT ON REAL ESTATE PRICES Against this backdrop the Bank of Japan de­cided to publish a report laying out the considerable risks to the Japa­nese economy of letting the ­bubble economy run wild. Following the practices of the time, the report’s authorship was not indicated, but I was the lead author, with valuable input from colleagues. Titled “Recent Increases in Japa­nese Real Estate Prices and Their Consequences,” the report was published in the April 1990 issue of the Bank of Japan Research Bulletin.12 In retrospect, while stock prices had already peaked, The Japanese Bubble Economy | 35

real estate prices continued rising for another year and a half. As we noted in the executive summary, Observing the be­hav­ior of economic agents, a myth that real estate prices ­will continue rising, or at least ­will not fall, seems to be implicitly accepted. Having said that, if one is to reflect on recent overseas experiences, t­ here are instances, notably in the US and the UK, where the fall in real estate prices triggered prob­lems at financial institutions. Picking up the common threads of ­these experiences, three lessons can be garnered: (1) when real estate prices rise quickly, a reversal may be observed; (2) in such an environment, prob­lems might not be contained in individual institutions and could destabilize the ­whole financial system; and (3) nonperforming real estate loans are most often observed at smaller financial institutions and nonbanks. . . . In terms of price stability, a rapid increase in real estate prices is not unrelated to general inflation trends. In addition, from the perspective of maintaining financial stability, and bearing in mind the experiences outside Japan described above, it is impor­tant to steer the financial system away from difficulties induced by volatile real estate prices. Fi­nally, it is essential that financial institutions should, in their real estate related lending, perform comprehensive due diligence and manage risks robustly. Obviously the importance of risk management is pertinent to e­ very activity of financial institutions, and is not confined to real estate lending, but if an institution holds a disproportionate portfolio of real estate related exposures, it is bound to be more severely impacted by fluctuations in real estate prices. The Bank of Japan is emphasizing such risk management through its daily contacts with financial institutions and occasional on-­site examinations. At the time it was a minority view to argue that the bank should immediately pull its policy levers of bank supervision or monetary policy to rein in the rapid increases in real estate and stock prices or the frenzied increases in bank lending. But many of us could see the excesses in the financial system and the economy, and most p ­ eople had a nagging feeling that something was amiss. In par­tic­u­lar, t­ here was an ongoing debate on distributional fairness as ­people w ­ ere priced out of the housing market in the greater Tokyo area. It was not difficult to voice such feelings of concern or unease in general terms, but my recollection is that it was much more difficult to articulate how 36 | ­Career Building at the Bank of Japa

to implement an effective policy response, be it monetary policy, strengthening regulation, and supervision of financial institutions or amending l­egal or tax treatment. I was not then se­nior enough to be directly engaged in making policy decisions, but I sensed that the bank’s leadership faced im­mense obstacles. With regard to monetary policy at that time, an overwhelming majority of academics and private-­sector economists ­were against making changes to monetary easing. It was no dif­fer­ent with international organ­izations, and in the annual meetings associated with the Article IV Consultations of the International Monetary Fund, such views of concern did not earn any sympathy.

THE NEED TO REVISE MONETARY EASING The strongest argument to tighten monetary policy is to suggest that inflation ­will accelerate if nothing is done. This line of argument, however, does not ­attract many followers when a­ ctual inflation is subdued. The year-­on-­year ­increases in the Consumer Price Index excluding fresh food—­regarded as a  better gauge of ­future developments than is total inflation—­was only 0.8 ­percent in 1986, 0.3 ­percent in 1987, and 0.4 ­percent in 1988, reflecting the substantial appreciation of the yen exchange rate following the Plaza Accord and the precipitous fall in crude oil prices (so-­called reverse oil shock). In the context of inflation targeting, which became the established wisdom among developed countries in the 1990s, such numbers might have signaled too low a rate of inflation. I particularly recall a paper titled “Monetary Policy and Asset Price Volatility,” coauthored by Ben Bernanke (who was then still a university professor), that argued that the Bank of Japan’s monetary easing had accelerated the rise in stock prices during the period between 1987 and 1989, based on a simulation increasing the policy rate to around 10 ­percent ­under a policy function with the output gap and expected inflation rate as inputs.13 When the paper was presented at the annual Jackson Hole Economic Symposium in 1999, then deputy governor of the Bank of Japan, Yutaka Yamaguchi, who was aware of the graph illustrating the result of the simulation, commented, “I ­don’t see how a central bank can increase the interest rate from 8 ­percent to 10 ­percent when we d ­ on’t have inflation at all.”14 I agreed with Yamaguchi on this point. Another line of argument for amending monetary easing was to express concerns over the high growth of the money supply, which was ­r unning at more than 10 ­percent annually. Such an argument was also not persuasive ­because ­those emphasizing the importance of the money supply also tended The Japanese Bubble Economy | 37

(Year-on-year, %) 14 M2 Consumer Price Index (excluding fresh food)

12 10 8 6 4 2 0 –2 1980

1982

1984

1986

1988

1990

1992

1994

1996

Figure 2.2 ​The money stock and consumer price inflation. Sources: Bank of Japan; Japa­nese Ministry of Internal Affairs and Communications.

to focus on the centrality of containing inflation, yet ­actual inflation was quite subdued. Anyone expressing concerns over the rapid growth of the money supply was in effect derided as crying wolf (see figure 2.2). ­There ­were also many who argued that a feeling of in­equality was becoming more prevalent as asset prices r­ ose. In­equality between t­ hose who owned real estate and ­those who did not was widening, and ­house owner­ship was declining among the younger generation.15 Against this backdrop, discontent among the population was increasing, and it drew the attention of the National Diet. But issues of equality and social justice seemed inadequate as reasons to argue for firmer monetary policy. With the benefit of hindsight, Japan faced both excessively high debt levels and excessive risk taking. The debate over the high growth of the money supply at the time and the related views of monetarists focused on deposits—­that is, the liability side of banks’ balance sheets. Their concern was if and when ­t hose deposits or money would begin chasing goods and ser­v ices, thereby ­causing inflation. Yet a completely dif­fer­ent picture would emerge when one looked at the asset side of banks’ balance sheets. A significant proportion of banks’ assets is lending, and such lending involves private borrowing. While firms may use money borrowed from banks to purchase goods and ser­vices, 38 | ­Career Building at the Bank of Japa

they may also purchase existing assets such as real estate and stocks. As the purchase of ­these assets increases, their prices ­will rise, and, through the resulting improvements in capital positions and collateral value, the conditions of both lenders and borrowers ­will tend to improve, thus encouraging further lending and borrowing. All seems well ­until the ­bubble bursts and asset prices fall, shrinking the asset side of banks’ balance sheets though the amount of debt does not shrink. From the perspective of the central bank and bank regulators and supervisors, the crucial issue was the eventual destabilization of the financial system following huge increases in debt (or credit), which in turn endangered sustainable economic growth. On the surface ­there seems to be ­little difference between the concern over sharp increases of the money supply and that over excessive growth of debt or credit. Nevertheless, the two reflect sharply dif­fer­ent views on developments in economy and finance. Traditionally the transmission channel of monetary policy focused on the “deposit channel.” The importance of the “credit channel” was not appreciated, with the depressive effects of nonperforming loans on the economy and finance being outside the models. I was guilty of this oversight, arguing that excessive capital expenditures would lead to large adjustments in the capital stock and that such a large fluctuation in economic activities should be avoided. I was initially not sufficiently conscious of the key fact that excessive debt would negatively impact the real economy through the financial system. My thinking changed a­ fter I was assigned to the Bank of Japan’s Research and Statistics Department in November 1988. The head of the department, Akira Nambara, was ever skeptical of the argument that inflationary pressures ­were mounting. Instead he always expressed apprehension over excesses in bank be­hav­ior at internal meetings. In retrospect, his intuition was spot on. I came to realize the importance of examining the issues raised by the increases in real estate prices and bank lending from the perspective of bank be­hav­ior and the financial system. The main thrust of our report on real estate prices was to inform the public that the rise reflected a ­bubble and the bursting of the ­bubble could have significant implications on the real economy through the financial system. Whereas this was a crucial point, it was unusual at that time for a central bank to go public with such a message. Accordingly, painstaking preparations went into the publication of the report. A complementary report by the overseas research section of the department, “The Secondary Banking Crisis in the United Kingdom in the Early 1970s,” was published in the January 1990 issue of the Bank of Japan Research Bulletin.16 Our report on real estate prices followed in April. The published version of the April report The Japanese Bubble Economy | 39

was slightly softened regarding implications for the financial system than the version for the bank’s internal circulation, but I believe that it was nonetheless a very strong message coming from a central bank.

WHY DID INTEREST RATES REMAIN LOW? Our understanding of the relationship between b ­ ubbles and monetary policy is still evolving and not settled even ­after the collective experience of the global financial crisis of 2007–9. An intricate web of ­factors created and sustained the Japa­nese b ­ ubble economy of the late 1980s, and I do not believe that monetary easing was the only cause. But I am confident that prolonged easing was at least an aggravating f­ actor. Such a view on the relationship between b ­ ubbles and monetary policy is quite dif­fer­ent from that of mainstream macroeconomists and policy makers in the United States, who see a more ­limited role for monetary policy.17 I ­will come back ­later to this issue in chapter 16. ­ ubble economy is often The Bank of Japan’s monetary policy during the b criticized on two fronts. One theory is that monetary tightening was overdue, and another is that it was overdone. I follow the first theory. I do not believe that the five rate cuts themselves during the easing cycle w ­ ere the fundamental ­ ubble. At least as far as the first three rate cuts are concerned, cause of the b the act of lowering interest rates itself was a natu­ral and appropriate course of action in the context of worsening economic conditions as the yen appreciated ­after the Plaza Accord. The prob­lem was not the rate cuts per se but the fact that the rates stayed too low for too long. Why did monetary easing continue for so long? Long before the first ­actual rate increase in May 1989, the Bank of Japan was exploring the possibility of raising the policy interest rate. Senior deputy governor Yasushi Mieno had repeatedly hinted at the necessity of making adjustments to monetary easing in his background briefings to reporters by noting that “we are sitting on a pile of dry tinder.”18 Beginning in August 1987, the bank began to gradually induce market rates to go higher in the short-­term money market so as to eventually tie the official discount rate to the higher market rates. Such efforts, however, w ­ ere interrupted as Black Monday struck in October 1987. The following day the Nikkei Index fell by 3,836 yen, or 14.9 ­percent; it did not, however, hit bottom ­until January 4, 1988, at 17.6 ­percent below what it had been on October 18, 1987, the day before Black Monday. The yen appreciated as

40 | ­Career Building at the Bank of Japa

well. The yen-­to-­dollar exchange rate—­which had been relatively stable at around 140 yen—­quickly appreciated, reaching 121 at the beginning of 1988. Volatility in the international financial markets following Black Monday was an issue only ­until early 1988. As the markets gradually regained an even keel, the United States and West Germany began to raise their policy rates, starting in the spring of that year. The Bank of Japan could not follow suit given that the long-­standing practice was that the official discount rate was changed only ­a fter mutual agreement between the Ministry of Finance and the bank. Government, business leaders, economists, the press, and international financial institutions ­were all overwhelmingly in f­avor of continuing with monetary easing. The routine reason given was the risk of upsetting the stabilization in international financial markets, but the real motive was the fear among the government and the business community that rate increases would bring about further appreciation of the yen. Consequently, the change in the course of monetary policy was delayed in Japan. About this period, Mieno would write in 2000, “Success or failure of policies is judged by the results. In that sense, regrettably, the prolonged period of easy money cannot escape criticism.”19 With re­spect to the actions or inactions of the Bank of Japan, ­t here ­were pressures from the government and the po­liti­cal establishment, and the bank had l­ittle l­egal in­de­pen­dence. But I do not believe that this is an adequate explanation. Inflation was quite subdued, and that posed a huge obstacle to raising interest rates. Actually, the Consumer Price Index r­ ose by only 0.2 ­percent year-­on-­year in the summer of 1988, and by 1.1 ­percent even in March 1989. In addition, the appreciation of the yen was dreaded by corporate Japan, resulting in an obsession with the risk of reigniting the upward motion of the currency. T ­ here was also a view emphasizing the dawn of a “new economy,” stressing the possibility of higher growth potential for the Japa­nese economy. The discourse was remarkably similar to what was heard in the years 2003–7, prior to the global financial crisis, u ­ nder the ­ reat Moderation in the United States.20 On top of heading of the so-­called G all this, ­t here was also a strong desire of the government not to ruffle feathers before the planned consumption tax was successfully introduced in Japan in April 1989. Against this background the government argued that the bank should avoid ­doing anything that would make it difficult to introduce the consumption tax, which had failed in the past but had gained the status of a national proj­ect.

The Japanese Bubble Economy | 41

I do not know if ­there ­were po­liti­cal pressures on the Bank of Japan or to what extent such pressures influenced a­ ctual decisions. Con­temporary accounts seem to indicate that t­ here w ­ ere.21 I certainly felt powerless as a central banker when the bank unexpectedly cut interest rates in October 1986 and again in February 1987. I felt even more helpless when a joint statement was released by US president Ronald Reagan and Japa­nese prime minister Noboru Takeshita in January 1988 stating, “To achieve sustained growth as well as to foster exchange rate stability, the Bank of Japan agrees, ­under the pre­sent stable price conditions, to continue to pursue the current policy stance and to make efforts to accommodate declining short-­term interest rates.”22 It was highly unusual for an official document released a­ fter a meeting between two national leaders to make reference to contemporaneous market operations by a central bank. But it also seems to go too far to say that the long period of easy money was solely caused by overt po­liti­cal pressures. We should not understate the significance of the prevailing mood of the times, the po­liti­cal and economic zeitgeist, or, to be more precise, the conventional wisdom of the day regarding optimal policy. In my view, the initial monetary easing in the late 1980s in Japan took account of three intertwining rationales: international policy coordination, preventing the appreciation of the yen, and reducing the current account surplus through expanding domestic demand. Each of ­these ­later made it difficult for the Bank of Japan to move ­toward tightening.

THE UNDER­P INNINGS OF MONETARY EASING With regard to international policy coordination, the first policy rationale, the Plaza Accord among the G5 economies, came into being on September 22, 1985. The accord recognized that it was necessary to correct the US current account deficit and German and Japa­nese current account surpluses, and for that purpose, it was agreed to embark on collective exchange rate adjustments. In the accord Japan committed itself to expanding domestic demand as an economy with a current account surplus. It was notable that only Japan used the word commit. At the same time, Japan also indicated that its monetary policy would be conducted flexibly, taking exchange rate developments into account—an ­unthinkable undertaking in view of ­today’s mainstream macroeconomics thinking, which assigns monetary policy to price stability. West Germany also had a current account surplus but t­ here was no similar reference to its mone-

42 | ­Career Building at the Bank of Japa

tary policy. When one reviews published rec­ords by the architects of the accord, including the Japa­nese finance minister Noboru Takeshita, Japan was not dragged kicking and screaming into the accord; instead the Japa­nese ­were “the most willing participants.”23 US participants at that time seemed to have strongly emphasized the risks of rising protectionism in US Congress. James Baker, the US Trea­sury secretary, wrote on the thirtieth anniversary of the ­ idn’t act first, the protectionaccord, “Our leverage with them was that if we d ists in Congress would throw up trade barriers.”24 The US dollar had already peaked in February 1985, and the correction of the strong dollar was actually underway at the time of the Plaza Accord. Having said that, the accord did indeed accelerate the correction. The dollar-­to-­ yen exchange rate, which was at 242 yen just before the accord, broke through 200 yen t­ oward the end of January 1986. By July 1986 the rate was hovering in around 150, and by the end of March 1987 it reached the 140 yen level. While the correction of the strong dollar was initially welcomed, it was not long before grave concerns ­were raised in Japan that the appreciating yen would lead to a recession. As a result, the overriding policy objective in Japan quickly changed to halting the appreciation of the yen, and when the Louvre Accord was drawn up in February 1987, Japan concentrated its efforts to acknowledge that the leading economies would not tolerate a further appreciation of the yen. In order to have the United States endorse this accord, the Japa­nese government agreed to “follow monetary and fiscal policies which w ­ ill help to expand domestic demand and thereby contribute to reducing the external surplus.”25 In addition, a rate cut by the Bank of Japan, announced two days before the meeting at the Louvre, was used as a catalyst for the accord. From the perspective of stressing the importance of the Louvre Accord, through which Japan secured a commitment not to accept a further appreciation of the yen, rate increases in Japan w ­ ere opposed as something that would endanger international coordination. Fi­nally, the third policy rationale—­the idea that the Japa­nese current account surplus should be reduced through boosting domestic demand—­was the most harmful. Conceptually, current account surpluses ­will shrink when imports increase as domestic economic conditions improve. Nevertheless, it is equally plausible that some current account surplus could remain even when the economy reaches full employment. The surplus that remains ­after taking account of the business cycle is called the under­lying surplus. Given that the current account surplus is the difference between savings and investment, as

The Japanese Bubble Economy | 43

well as that between the imports and exports of goods and ser­vices, the under­ lying current account surplus can be ascertained by looking at the under­lying or long-­term be­hav­ior of savers and investors. Given the globalized economy and markets, the level of real interest rates is determined globally. When real interest rates are set in such a manner, some economies w ­ ill see a surplus of savings and o ­ thers w ­ ill see a shortage; capital w ­ ill move across borders accordingly. Consequently, the under­lying surplus or deficit of the current account depends on the availability of savings and opportunities for investments within an economy, which in turn is determined by real ­factors such as prevailing technologies and demographics. ­These real ­factors cannot be controlled by monetary policy. Japan at that time was just entering a period where the de­ pen­dency rate was at its lowest, which meant that savings would begin to increase to build up retirement nest eggs. Consequently, it was inevitable that Japan would rec­ord substantial current account surplus for some time. Attempting to compress the surplus through the expansion of domestic demand was in effect committing to continue monetary easing for a long time.26

THE PLAZA AND LOUVRE ACCORDS IN RETROSPECT In the United States, many who attended the conference marking the thirtieth anniversary of the Plaza Accord saw it as a success, for the reason that it diffused protectionist sentiment in the US Congress.27 For ­these attendees, the debates in Japan—­strong opposition to interest rate increases citing international coordination—­were none of their business and any harm done was self-­ inflicted. In Japan the two accords gave rise to the three policy rationales, explained above, which constrained the ability of the Bank of Japan to reverse monetary policy in a timely manner. The desire of the Japa­nese government to alleviate trade tensions with the United States is understandable as a po­liti­cal goal in itself considering Japan’s overall relations with the United States—­including ­matters of national security. My own view is that the implications for macroeconomic management ­were given short shrift, and the price Japan had to pay turned out to be quite high. More than twenty years a­ fter the Plaza Accord, I had a chance to sit next to Hans Tietmeyer, the former president of the German Bundesbank who was then the vice chair of the board of the Bank for International Settlements (BIS), at a lunch on the occasion of a bimonthly BIS governors meeting. He was ex-

44 | ­Career Building at the Bank of Japa

tensively involved in the international negotiations around the time of the Plaza Accord, as a state secretary at the German Federal Ministry of Finance, and he described his experiences to me. Perhaps as advice to a newly appointed governor, he passionately spoke about how the capitulation of Japan to the United States subsequently led to the b ­ ubble economy and, for that m ­ atter, the subsequent malaise that Japan suffered. It was a sobering experience to learn the heavy responsibilities of macroeconomic policy makers.

THE MAEKAWA REPORT During the b ­ ubble economy, a majority of experts in government, as well as academic and private-­sector economists, supported the idea of reducing the current account surplus through the expansion of domestic demand. Obviously, one reason for this was the strong pressure from the United States. Another popu­lar line of argument in Japan was exemplified by a report compiled by the Advisory Group on Economic Structural Adjustment for International Harmony, in April 1986, better known as the Maekawa Report, named for the chair of the advisory group, Haruo Maekawa, a former governor of the Bank of Japan. The report stated, “Setting as a medium-­term national policy goal, the government should announce its determination both domestically and internationally to attain the goal of steadily reducing the nation’s current account ­imbalance to one consistent with international harmony.” ­After explaining the importance of boosting domestic demand through structural reform, the report concluded, “In the implementation of ­these recommendations, fiscal and monetary policy has a significant part to play. . . . ​While ensuring currency stability, flexible management of monetary policy is necessary to realize an economy led by domestic demand.”28 The basic thinking ­behind this report—­that the economy should be led by domestic demand—is justifiable, and I perfectly agree with the statements in the report that deregulation was necessary to achieve that goal. The prob­lem, however, was that the report linked the expansion of domestic demand with shrinking the current account surplus. The under­lying current account balance is something that is determined by the under­lying savings and investment balance, which reflects prevailing technologies and demographics, among other ­things. Japan’s surplus was just such a surplus. At the same time, the current account deficit of the United States was also determined by its under­ lying savings and investment balance, which would not be affected by an

The Japanese Bubble Economy | 45

expansion of Japa­nese domestic demand. If Japan ­really committed to reducing its current account surplus through expanding domestic demand, the logical consequence was an extended period of excessive economic stimulus, and the price was dear. To my knowledge, the only academic who was able to pen a concurrent critique on this line of thinking was Ryutaro Komiya.29

LESSONS OF THE ­B UBBLE ECONOMY In the end, it took the Bank of Japan ­until May 30, 1989, to begin tightening monetary policy. This rate hike followed t­ hose of West Germany (June 1988) and of the United States (August 1988). The Japa­nese economy was already overheating. Even then, this belated adjustment of monetary policy was greeted with strong anxiety in the next day’s Nikkei editorials that the interest rate increase in Japan might impair international policy coordination.30 From ­these episodes during the Japa­nese b ­ ubble economy of the latter half of 1980s, I have learned several lessons. First, ­bubbles happen. And once they happen, the economic consequences can be dire. I did not recognize the b ­ ubble early on and I was hesitant, as late as 1987, to say that market prices did not reflect fundamentals. I was fi­nally able to recognize the b ­ ubble in the Japa­nese real estate market when we wrote our report on real estate prices. ­ ubbles, it has to Second, even if the central bank alone cannot prevent b do its best to restrain them. Many central banks are entrusted with financial regulation and supervision in addition to monetary policy. While the debate on the relationship between b ­ ubbles and monetary policy is not settled, t­ here is no claim that disputes the fallout of lax regulation and supervision. In Japan, although the Ministry of Finance had the formal powers over financial institutions, in the eyes of the public, which saw the Bank of Japan conducting examinations of financial institutions, the bank was also regarded as sharing some supervisory responsibility. The bank cannot escape criticism for not attempting to put a brake on the excesses of financial institutions. Monetary easing was not the sole cause of the ­bubble economy, but the ­bubble would not have swelled so much without the extended period of easy money, and I have to conclude that monetary policy should share the blame. Furthermore, I am struck by the fleeting nature of public opinion. The considerable opposition to monetary tightening during the ­bubble economy quickly gave way, a­ fter the b ­ ubble had burst, to fin­ger pointing at the bank for 46 | ­Career Building at the Bank of Japa

its failure to conduct monetary policy properly. Recalling the mood of the times, this may seem unfair. But as the responsibility for monetary policy is given to the bank by law, it should not be pos­si­ble to deflect criticism, and the bank should not complain. What is impor­tant is not to become captive of the prevailing mood of the times. I often think of how we can avoid such captivity. Just hoping for the central bank’s heroic action is neither realistic nor sustainable. I believe what is needed on the part of the central bank is encouraging deep analy­sis, warning against policy logic leading to economic and ­ultimately social disaster at an early stage, and feeling a strong sense of responsibility.

The Japanese Bubble Economy | 47

| CHAPTER THREE |

The Bursting of the ­Bubble and the Financial Crisis In the early 1990s, the Japa­nese b ­ ubble burst. While the magnitude of the event did not immediately become apparent, it gradually began to dawn on every­ body that the economy and society w ­ ere extremely vulnerable. By the late 1990s, prob­lems in the financial sector snowballed to crisis proportions, dragging down economic activity. Harsh criticism of the conduct of monetary policy by the Bank of Japan was leveled—in par­t ic­u ­lar from US academics. I was appointed as division chief of the bank’s newly or­ga­nized Financial System Department in May 1990 and for the next three years tackled the prob­lem of the nonperforming loans made during the ­bubble years.

THE B­ UBBLE DEFLATES Though it is not pos­si­ble to pinpoint the date, as Japan entered the 1990s it gradually came to realize that the b ­ ubble had burst. The peak of the Nikkei Index at 38,915 yen was observed on the very last trading day of 1989. From t­ here it fell precipitously. Six months l­ater it stood at 32,817 yen, and in another six months it was at 23,848 yen, fi­nally hitting 14,309 yen on October 18, 1992, a decline of more than 60 ­percent from what it had been at its peak. The timing of the stock market drama was so impressive that we tend to forget that the decline in real estate prices began much l­ ater (see fig. 3.1).1 According to the semiannual index of land prices compiled by the Japan Real Estate Institute, the crest came in September 1991; but land prices published annually by the Ministry of Construction point to January 1991.2 According to the latter, the price of land in the commercial district of Osaka, which showed the greatest increases during the ­bubble, collapsed to just 10 ­percent of its peak value by 2002. Although the paper I coauthored for the bank in 1990 pointed out the existence of a ­bubble in real estate prices, I had not ­imagined a fall of this magnitude.3 48

(Index, CY 1980 = 100) 1200 Tokyo residential Tokyo commercial Osaka residential Osaka commercial

1000

800

600

400

200

0 1980

1985

1990

1995

2000

2005

2010

2015

2020

Figure 3.1 ​The land prices. Source: Japa­nese Ministry of Land, Infrastructure and Transport.

The business cycle peaked in February 1991. Annual real gross domestic product growth fell from 5.1 ­percent in 1990 to 3.8 ­percent in 1991, 1.0 ­percent in 1992, and 0.3 ­percent in 1993. The likely cause for the ­bubble bursting is often identified as the aggregate lending restrictions on property-­related lending, which was implemented by the Banking Bureau of the Ministry of Finance. Having defined property-­related lending as lending to real estate, construction, and nonbank financial institutions, the ministry asked financial institutions to reduce the growth of property-­related lending to less than that of total lending (both property-­related and non-­related), and imposed reporting requirements. While it is true that t­hese lending restrictions prompted real estate prices to begin their descent, I do not think it is appropriate to lay all of the blame on such restrictions. Sooner or l­ ater, real estate prices ­were ­going to ­ ubble itself. fall; their eventual fall was an inescapable consequence of the b Another commonly cited cause for the bursting of the ­bubble economy was monetary tightening on the part of the Bank of Japan. Beginning with an increase of 0.75 ­percent in May 1989, the official discount rate was raised five times, for a total increase of 3.5 percentage points. But I also think it is unhelpful to view monetary tightening as the culprit. Had the Bank of Japan raised rates only in May 1989, or ­were it seen to be finished with tightening with just The Bursting of the Bubble | 49

one increase, the ­bubble would likely have kept expanding, inflicting even greater pain when it burst. The more impor­tant question is how policy makers in the f­ uture should respond if they see the economy veering off a sustainable path.

AN OVERLY OPTIMISTIC ECONOMIC OUTLOOK In the second half of the 1980s Japan experienced an unsustainable expansion ­ ubble had burst, broadly of credit and of the economy itself. Even a­ fter the b defined policy and academic community—­including the Japa­nese government, the Bank of Japan, private and academic economists, market participants, and international organ­izations—­were per­sis­tently too optimistic.4 Corporate Japan was no dif­fer­ent, which is clearly shown in the bank’s Tankan survey. The bank’s assessment of economic conditions, published in July  1991, was also upbeat; while recognizing a gradual slowdown, the assessment noted that “the Japa­nese economy was still expanding against the background of rising income for both firms and h ­ ouse­holds.”5 We w ­ ere all oblivious to the scale of nonperforming loans at banks. Many thought that the May 26, 1992 Financial Times report of 42–53 trillion yen in nonperforming loans at Japa­nese banks was overly sensational.6 But the final bill for the financial crisis exceeded 100 trillion yen. The failure of banks began with the smaller ones, and financial assistance from the Deposit Insurance Corporation of Japan was first utilized in April 1992. Prob­lems eventually spread to larger institutions, and between 1997 and 1998 Japan found itself in a financial crisis. In order to comprehend developments in the post-­bubble period, one has to look not only at economic ­factors but also at the interactions between the economy and politics and between the economy and the society at large. Furthermore, the relevant economic ­factors cannot be fully analyzed only via macroeconomic textbooks, which tend to concentrate on the relatively short term; one needs to carefully examine the Japa­nese economic and business ­ ubble perfectly coincided models of the postwar period.7 The bursting of the b with the advent of the information technology revolution and the global expansion of market economy due to the entry of the former planned or socialist economies.

THE FINANCIAL SYSTEM DEPARTMENT IS BORN In May 1990 the Bank of Japan undertook an extensive internal reor­ga­ni­za­ tion, and one of its features was the establishment of the Financial System 50 | ­Career Building at the Bank of Japa

Department. Headed by Tadayo Homma, the department was tasked with developing policies to promote the stability of the financial system and had two divisions: the Financial System Division and the Payment and Settlement System Division. The former division looked a­ fter regulatory and supervisory ­matters affecting financial institutions and, in ­today’s parlance, macroprudential policies; the latter division dealt with policies regarding payment and settlement systems. I became the chief of the Financial System Division and was in that position u ­ ntil May 1993. Looking back on ­these years a­ fter we experienced the height of the financial crisis in late 1990s, they are somewhat dwarfed. But they ­were actually far more turbulent than the preceding years. My experiences at the bank ­were just as impor­tant in shaping my thinking on the role of the central bank as my experiences during the b ­ ubble years in the last half of the 1980s. If I had not been the chief of the Financial System Division, my thinking might have continued to emulate the mainstream macroeconomists and continued to ignore the central role of credit. All central banks play an impor­tant role in maintaining financial stability, no ­matter what the formal ­legal arrangements are. The Bank Examination Department of the Bank of Japan conducted examinations of financial institutions that had accounts with the bank. Such examinations of account-holding financial institutions, which included both banks and securities firms, had its historical origins in a recommendation by the Financial System Research Council of the Ministry of Finance a­ fter the financial crisis following World War I. The bank also obtained information on financial markets and institutions through daily contacts between its Banking Department and major participants in the markets. Furthermore, the bank is the lender of last resort—providing liquidity to financial institutions when they might other­wise default on their obligations—in order to safeguard the financial system. Immediately a­ fter the Financial System Department was established, in June 1990, I was called to the governor’s office with Homma. Governor Yasuishi Mieno, promoted from senior deputy governor a half year previously, asked to develop a basic strategy for the Bank of Japan to deal with failure of financial institutions. Even though the Japa­nese stock market had already peaked, real estate prices w ­ ere still rising and the ­bubble economy still seemed to be expanding. The assignment showed remarkable foresight, considering that a financial crisis would manifest itself only a few years ­later. I had not the slightest clue of how to approach this task. Japan did experience a serious financial crisis following World War I, but no financial institution had The Bursting of the Bubble | 51

failed a­ fter World War II. I also had scant knowledge of the practicalities of ­ andling a troubled bank. Consequently, the first order of the day was to h study overseas experiences. For that purpose, Homma and I went on a trip to the United States and Eu­rope for two weeks, from the end of June to the beginning of July 1990, mostly visiting other central banks.8 In the United States we visited the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Bank in New York (aka the New York Fed); the Federal Reserve Board (FRB) in Washington DC; and the Resolution Trust Corporation, and we learned extensively from many of their experts. In Eu­ rope we saw se­nior officials at the Bank of E ­ ngland, the Bank of France, the Bank for International Settlements, and the Netherlands Bank. I still remember meetings with Ernest Patrikis at the New York Fed, Ed Ettin and Bill Taylor at the FRB, and Eddie George at the Bank of E ­ ngland. During the course of this trip we learned of the importance of maintaining financial stability by preventing system risk and the sequential failure of multiple firms. We also gained practical knowledge about how other countries dealt with failed financial institutions. In ­those days, many Japa­nese thought that a bank bankruptcy would result in a deposit payout, which meant that ­after protecting bank deposits up to the maximum amount of deposit insurance (10 million yen for a depositor at a bank at that time), a failing bank would be liquidated u ­ nder bankruptcy procedures that w ­ ere applied to firms in general. This, however, was not an accurate description of the procedures in the United States at that time. Only very small banks, equivalent in asset size to ­ ere handled this way. The branches of Japa­nese agricultural cooperatives, w prevalent US strategy for dealing with a failed bank was via purchase and assumption (P&A). In a P&A, one financial institution salvaging another failed institution assumes all of the liabilities and unimpaired assets of the failed institution, with the FDIC providing financial assistance. The management and the shareholders of the failed institution are both penalized: management loses its job, and the shareholders’ equity stake is extinguished. In that sense, a financial institution ­will fail, but the depositors w ­ ill be fully protected and the soundness of other institutions is much less likely to be questioned.

DRAWING UP POLICIES TO DEAL WITH FAILED BANKS ­ fter returning from our trip, we had extensive internal discussions on the opA tions for dealing with f­uture failures. Three bodies handled bank failure in Japan at that time. The main actor was the Banking Bureau of the Ministry of 52 | ­Career Building at the Bank of Japa

Finance, with the Bank of Japan and the Deposit Insurance Corporation of ­Japan playing supporting roles. By law, the se­nior deputy governor of the Bank of Japan was the ex officio governor of the Deposit Insurance Corporation. The corporation’s offices ­were in the bank’s Tokyo headquarters building, and it had a total staff of just more than ten, consisting mainly of the bank’s seconds and retired bank officers. From the summer of 1990 on, thanks to the foresight and leadership of the director general of the Banking Bureau, Masaaki Tsuchida, discussions among the bureau, the Financial System Department of the bank, and the corporation ­were initiated to identify how, in practice, we could actually utilize the corporation’s powers. In parallel, within the bank we further discussed a basic strategy to deal with failure of financial institutions. Fi­nally, in January 1991, a set of four princi­ples for the strategy was drawn up and approved by Mieno. The first princi­ple was that any financial institution that had “in effect” negative equity needed to be placed in resolution. “In effect” meant that even a financial institution whose financial statements ostensibly showed positive equity would be resolved as long as equity was expected to fall into negative territory ­after appropriate charges and write-­offs. Though this statement may not sound surprising ­today, it was a radical position at that time ­because it would force the Ministry of Finance and the Bank of Japan to make assessments of the quality of assets held by financial institutions and to close any institution whose assets the ministry and the bank judged to be impaired and inadequate. Given that delinquent loans come in many shades of gray, and only a part of them are likely to be seen as hopeless in the eyes of every­one, strong protests w ­ ere expected from the institutions’ management, shareholders, and depositors, as well as local politicians and residents, if the authorities w ­ ere g­ oing to shut down the institution based on the authorities’ judgment of solvency. The second princi­ple was that deposit payouts ­were to be the exception rather than the rule. In princi­ple, deposits would be protected. If an institution had “in effect” negative equity, it would not be able to pay its debt in full. In such a situation, the mainstream view among academics and the media in Japan was to protect depositors only up to the amount of deposit insurance—­that is, to pay off depositors and liquidate the failed financial institution like any other failed business. This was regarded as the right t­ hing to do, and any bailout was regarded as a source of moral h ­ azard. We did not follow such a liquidation strategy for two reasons: the first was that even in the United States, where ­there ­were relatively numerous failures of financial institutions, a typical resolution was carried out through P&A; the The Bursting of the Bubble | 53

second and more fundamental reason was that the Bank of Japan recognized that liquidation could plausibly bring down the ­whole financial system, considering the huge amount of nonperforming loans at Japa­nese financial institutions. Accordingly, the bank judged that the most desirable strategy was to compel financial institutions that had negative equity to draw up a restructuring plan and raise capital on that basis. If that could not solve the prob­lem, a buyer should be found conditional on financial assistance from the Deposit Insurance Corporation. The third princi­ple was that in order to minimize moral ­hazard, parties responsible for ­running a failed financial institution would be held accountable. Management would lose its job, and shareholders of the institutions would be penalized by dilution of their equity stakes. The fourth princi­ple was that the Bank of Japan would lend money if that was necessary in resolution. It may now seem that this is only stating the obvious, ­because the central bank is the lender of last resort, but in t­ hose days the involvement of the bank in resolution raised alarms about moral ­hazard. ­After the four princi­ples ­were approved as the bank’s preferred strategy internally, Homma and I went to the Banking Bureau of the Ministry of Finance to explain the bank’s thinking. The ministry was alarmed by the idea that financial institutions that had “in effect” negative equity would be so quickly resolved. But given that economic conditions w ­ ere not yet markedly worsening, and that the memories of the ­bubble economy ­were still fresh, the ministry’s reluctance is understandable in the po­liti­cal and social context of the day, even if we did not agree. The bank’s leadership chose to avoid a prolonged debate with the ministry and a­ dopted the pragmatic approach of trying to apply the spirit of our princi­ples, to the extent pos­si­ble, in individual resolution cases.

THE ­A CTUAL FAILURE OF BANKS Not long afterward, the condition of many financial institutions quickly deteriorated. If one conducts a search of articles in the four major Japa­nese newspapers using the terms “nonperforming loans” or “nonperforming assets” as keywords, the number of articles clearly increases from 1991 onward, though ­there are still not as many as in the late 1990s, when the financial crisis was raging. The Financial System Department took on the stressful task of resolv-

54 | ­Career Building at the Bank of Japa

ing individual financial institutions and, at the same time, the broader policy issues regarding resolution. During my time t­ here, the Financial System Department had not yet become the “field hospital” that it would be during the late 1990s. Even so, the peaceful era when no financial institutions failed was over, and cases began to trickle in. The first failure, in July 1991, came from an unexpected corner of the financial system. It was the Tokyo branch of the Bank of Credit and Commerce International, an arm of an internationally active bank with headquarters in Luxemburg. Since branches of overseas banks ­were not covered by Japa­nese deposit insurance, the branch was resolved without the use of deposit insurance funds. Then, in August 1991, fictitious deposit certificates for billions of yen bearing the name of the Toyo Shinkin Bank ­were exposed. The department was extremely busy that summer containing the fallout from ­these two institutions, coordinating its actions with the Ministry of Finance. The first involvement of the Deposit Insurance Corporation was with the failure of the Toho Sogo Bank in April 1992, when Iyo Bank acquired what remained of Toho Sogo with the corporation’s financial assistance. The second assisted resolution was the failure of the Toyo Shinkin Bank in October 1992, and the third was that of the Kamaishi Shinkin Bank in May 1993. Thus, when the b ­ ubble economy burst, the early casualties w ­ ere smaller financial institutions. But as economic conditions deteriorated and stock prices fell further, it became apparent that the health of the larger financial institutions was also in jeopardy. What emerged was utterly surprising. Larger banks, including city banks, long-­term credit banks, and trust banks, had substantially increased their lending during the ­bubble, especially to construction and real estate concerns and to nonbanks. Lending to nonbanks, which included both affiliated and nonaffiliated entities, represented economic exposure to the same sectors of construction and real estate. Of the lending, the most problematic was executed by jusen (housing finance companies), the first of which had been established in 1971. Jusen ­were nonbanks sponsored by banks for the purpose of providing residential mortgage lending, a business that banks themselves did not value much at the time. Yet as banks began to offer residential mortgage lending themselves, reflecting the diminishing lending opportunity to corporates, jusen turned from residential mortgage lending ­toward commercial real estate mortgage lending. When the b ­ ubble burst, a significant amount of the lending provided by jusen was impaired. As early as 1992, I still clearly

The Bursting of the Bubble | 55

remember being chided by a former executive director of the Bank of Japan, Takashi Tamaki, then the CEO of Chiba Bank, who explained, “Your job is not dealing with the small fry, you must resolve the big banks and nonbank financial institutions, especially the jusen.” We often hear how large financial institutions are “too big to fail.” To paraphrase, this suggests that it is impossible to take down a large financial institution ­because when it goes ­under, it ­will trigger a chain reaction harming other healthy institutions. The Japa­nese situation was far more serious. Most of the large financial institutions w ­ ere themselves directly hit by falling real estate prices and their own nonperforming loans. It was not a question of ­whether one bank might bring down ­others. E ­ very major bank suffered from a common serious disease.

THE LACK OF “ARMS AND MUNITIONS” The challenge that the Ministry of Finance and the Bank of Japan faced was formidable. We ­were not equipped with a resolution framework that was up to the task of stabilizing financial institutions burdened with nonperforming loans without unsettling the financial system. Both the l­egal framework and practical methodology, which might be likened to arms in ­battle, and the capital to absorb the losses, which might be likened to munitions, ­were lacking. I became increasingly frustrated. To be better equipped we had to cultivate public understanding of the need for reform, but this was an uphill task when the ­bubble economy had only just burst. The media, politicians, and academics all accepted the view that failing financial institutions should be liquidated as if it ­were one of the Ten Commandments. This meant that depositors would be protected by the Deposit Insurance Corporation up to 10 million yen, and anyone who had a larger claim would receive pro rata payouts from the bankruptcy estate. Liquidation, however, was not a realistic option. Given that the burden of prob­lem loans was so heavy and that so many financial institutions ­were sinking u ­ nder their weight, the liquidation of one financial institution would have pulled the rug out from ­under other institutions, most likely resulting in a systemic event. If this happened, vital economic functions would be destroyed. Strong opposition to taking action other than liquidation was prevalent and not uniquely Japa­nese. In his memoir of the global financial crisis (GFC) of 2007–9, Timothy Geithner, then the US Trea­sury secretary, candidly expresses

56 | ­Career Building at the Bank of Japa

his exasperation with what he calls the “Old Testament view” of the necessity of liquidation as punishment to prevent moral h ­ azard.9 The necessary “arms and munitions” consisted of a l­egal framework that made resolution as orderly as pos­si­ble, supported by money or public funding. The Bank of Japan performed the grunt work of formulating appropriate approaches. Par­tic­u­lar attention was paid to the financial resources available. The first line of defense was money paid into the Deposit Insurance Corporation, but that only amounted to some 700 billion yen at the end of March 1993. The question then became ­whether the Japa­nese financial system as a ­whole had sufficient capital. This could not be answered just by scrutinizing the balance sheets of individual financial institutions. In an environment in which so many financial institutions had been hit by the fall in asset prices, the economy as a ­whole was propped up by their efforts to avoid bankruptcy. Capital became not a static but a dynamic concept. To use a phrase that increasingly became popu­lar a­ fter the GFC, a macroprudential perspective was necessary, something that was desperately lacking at that time.

OPPOSING THE USE OF PUBLIC FUNDS Opposition to the use of public funds was not solely based on concerns over moral h ­ azard. Another argument voiced by mainstream academic economists was that the lack of lending by banks was not ­because of a lack of capital but ­because of a lack of demand for borrowing. This view was particularly voiced by banks and bank-­affiliated think tanks. This was described as a clash between theories of a “lending famine” versus a “borrowing famine.” In retrospect, the debate between the demand-­led and supply-­led natures of declining lending was not particularly productive, as they are two sides of the same coin. Lack of capital in the nonfinancial sector as a ­whole ­will ­either discourage investment decisions or the banks’ lending decisions w ­ ill reflect increased risk of default, leading to less lending ­either way. Even as the seriousness of the prob­lem in the financial sector gradually sank into the public consciousness, opinion on the necessity of using public funds did not shift as long as it was perceived that the issue solely concerned the viability of individual financial institutions. In the court of public opinion, institutions that danced during the ­bubble economy deserved to be punished by bankruptcy. Even many knowledgeable experts did not understand that nonperforming loans would come to haunt every­one in the macroeconomy.

The Bursting of the Bubble | 57

The first serious discussion on the use of public funds for resolution was in August 1992 when the Japa­nese prime minister, Kiichi Miyazawa, floated the idea of injecting public funds at a meeting of business leaders. This idea was immediately squelched, as both business leaders and the media expressed strong opposition on the grounds that it was against the grain of ­free market princi­ples to support firms with public money.

NONPERFORMING LOANS AND THE MACROECONOMY More fundamentally, gaining support for adequate “arms and munitions” confronted the lack of understanding of the huge overhang of nonperforming loans that, if left unresolved, would weigh on the economy’s growth for years to come. I was also not conscious of such a possibility in 1990, but my views gradually began to change, starting in the summer of 1991. I came to doubt my prior belief that nonperforming loans would not affect the macroeconomy and came to the realization that causality could run both ways. My change of heart reflected the recognition that a consistent understanding of economic developments—­such as the ever-­increasing pile of nonperforming loans, the dim outlook held by financial institutions, and the weakness of the macroeconomy—­would require that I confront the likelihood of this reverse causality. I hastily began to study Japa­nese and overseas historical examples, including the Japa­nese ­bubble and its aftermath t­oward the end of World War I, the US financial and economic distress following the Wall Street Crash of 1929, and the collapse of commercial real estate prices in New ­England in the latter half of the 1980s. I also asked the staff of the Financial System Department to run a series of simulations that incorporated the feedback mechanism to thus change assumptions on the ­future path of real estate prices, use ­actual data on the nonperforming loans and equity holdings of Japa­nese financial institutions, and assume that banks would have to maintain minimum capital adequacy ratios. The results suggested that even if one ­were optimistic about a recovery in real estate prices, financial institutions would not be able to increase their risk assets for many years and still meet their capital requirements. This led me to believe that it was necessary to emphasize the chain of causality from finance to the macroeconomy. The key was to share a basic outlook on the macroeconomy. Once t­ here was agreement on that, t­ here would have been no choice but to reach agreement that the prob­lems would not go away without the use of public funds, however po­liti­cally unpop­u­lar that might be. Unfortunately, ­there 58 | ­Career Building at the Bank of Japa

­ ere few p w ­ eople in Japan who understood this at the time. As the Bank of Japan was busy persuading the Ministry of Finance to consider the use of public funds, in April 1993 a report was published by a group of distinguished academics and private-­sector economists, sponsored by the Policy Research Institute of the ministry. The report’s executive summary presented a view very dif­fer­ent from that of the Bank of Japan: ­ actors that have supported the per­for­mance of the Japa­nese economy, F including the elevated standards of technical proficiency and education, industriousness of the ­labor force, and the high savings and investment rate, have not been negatively impacted in a significant degree as a result of recent developments. In the Japa­nese economy, business conditions have deteriorated since 1991, accompanied by a relatively rapid fall in asset prices. Nevertheless, this is basically in part a blowback of the buoyant latter half of the 1980s as well as normalization of asset prices following a period of rapid increases.10

A NECESSARY FRAMEWORK FOR RESOLVING FINANCIAL INSTITUTIONS The most reasonable strategy for resolution, while minimizing the risk of triggering a systemic event, was to pursue P&A of the weakest firms. But for this strategy to be ­viable, we needed both potential suitor institutions willing to assume the assets and liabilities of the failing institutions and we needed to be able provide financial incentives for the potential suitors to assume ­these assets and liabilities. In Japan at that time, however, it was difficult in the first place to find appropriate suitors; even more difficult ­were the prob­lems pertaining to the institutional setup. The Deposit Insurance Act stipulated that any disbursement from the insurance fund to facilitate P&A would be capped at the payout cost.11 The removal of this restriction was needed, but the insurance fund was then too small. Such a shortfall of funds could only be fixed by amending the Deposit Insurance Act to increase the insurance levy. But in an environment where all banks faced capital prob­lems, an increase in the levy on the banks was not the answer. The use of public funds was essential. H ­ ere, however, arose a dilemma. In The Bursting of the Bubble | 59

order to gain the understanding of politicians and the public, it was necessary to explain the dire straits of the Japa­nese financial system. But publicly explaining the prob­lems of the system, without the financial resources committed to managing resolutions, could itself trigger a systemic event and depress economic activity. No m ­ atter how hard one looked, t­ here was no good solution given the constraint on public funding. The lack of financial resources was a serious prob­lem, but the lack of a ­legal framework was also a crucial issue. At that time, the framework for resolving financial institutions was the same for that of nonfinancial businesses, which made it impractical to actually use it. As the Bank of Japan dealt with the failure of several smaller institutions, it faced many practical issues, and building on such experiences, bank staff began a study of ­legal frameworks covering failed financial institutions. Beginning in early 1992, with the participation of Junichi Matsushita, a l­egal scholar in bankruptcy law, and Kenichi Fujinawa, an attorney at a leading law firm in Tokyo, the bank examined the practical issues; it compiled an internal report by July of that year.

FAILED EFFORTS AT PERSUADING THE MINISTRY OF FINANCE In the spring of 1993, I handed my counterpart at the Ministry of Finance a detailed paper outlining the comprehensive package of reforms that we felt ­were needed, reflecting three basic princi­ples. First, self-­help of the highest degree would be required of private financial institutions, as they restructured and raised capital. Second, if an institution w ­ ere unable to regain an even keel on its own, the Deposit Insurance Corporation would provide financial assistance, and if that, too, was insufficient, the use of public funds would be considered. Third, in order to facilitate a P&A-­style resolution, and at the same time to manage and collect nonperforming loans, t­ here would be established a special financial institution that would assume the prob­lem assets and liabilities. We indicated that the Bank of Japan was ready and willing to provide capital to facilitate P&A transactions and to take direct equity stakes in a special “bridge bank.” While many of ­these ideas would eventually see the light of the day in the years to come—­particularly the bridge bank, first called the Tokyo Kyodo Bank and ­later the Resolution and Collection Corporation—­consent from the Ministry of Finance was not forthcoming in 1993. The Bank of Japan did attempt to persuade the ministry—­not only at my division chief level but also at the 60 | ­Career Building at the Bank of Japa

director general and executive director levels. Mieno lobbied Prime Minister Miyazawa, but the proposals did not bear fruit, at least not immediately. I had the opportunity to have a private meal with Homma in April 1998, just before his term as executive director of the Bank of Japan was set to expire. Reminiscing on our days at the Financial System Department, I asked what he thought was the defining moment leading up to the Japa­nese financial crisis of 1997–98. He immediately answered that it was our unsuccessful negotiations with the Ministry of Finance between the end of 1992 and the spring of 1993.

THE DEEPENING FINANCIAL CRISIS ­ fter I left the Financial System Department, the resolution of two credit A ­u nions mired in bad real estate loans—­A nzen and Tokyo Kyowa—­was announced in December 1994. For this purpose, the Tokyo Kyodo Bank was established in January 1995, its equity being provided by the Bank of Japan and private financial institutions. ­Later that year, in July and August, respectively, the Cosmo and Kizu credit ­unions received business improvement ­orders from the Ministry of Finance. August also saw the announcement of the resolution of the Hyogo Bank. Following that, in June 1996, a bill to enable the use of public funds amounting to 685 billion yen for the resolution of the jusen was approved by the National Diet. Jusen, stuck with a huge amount of nonperforming loans, became insolvent. The question was how to spread losses among the creditors of the jusen, which included both large banks and smaller financial institutions, such as agricultural cooperatives, as well as the par­tic­u­lar sponsoring banks with special management and shareholding ties to individual jusen. If the general princi­ple of bankruptcy law ­were to be followed, all creditors should be treated equally, allocating losses pro rata. The prob­lem was that if this approach, dubbed the lenders’ responsibility princi­ple, ­were ­adopted, the resulting loss would have ruined the agricultural cooperatives, whose capital positions ­were quite fragile. A view that was strongly voiced was that it was more appropriate to hold the sponsoring banks accountable for their role in introducing the jusen to the cooperatives, which was an approach dubbed the sponsors’ responsibility princi­ ­ ere emphasized, the larger financial ple. If the sponsors’ responsibility w institutions that had sponsored the jusen would bear a higher proportion of losses. But decisions to accept ­these losses could, in turn, have invited shareholder suits against the banks’ management. The use of public funds attracted The Bursting of the Bubble | 61

strong criticism from politicians and the media, and ­after tumultuous debates in the National Diet, with a sweetener of extra loss allocation to large banks thrown in, a law that authorized 685 billion yen in public funds was enacted. Although t­ hese funds essentially bailed out the agricultural cooperatives, the public did not seen it in this way, and opinion turned against the Ministry of Finance, the Bank of Japan, and the larger financial institutions. With the opposition parties’ criticisms of the government echoed by the media, the use of public funds to resolve larger financial institutions was postponed by more than two years. The height of the financial crisis was reached in late 1997, when the Japa­ nese financial system was looking into the abyss. The triggering event was the filing of a petition by Sanyo Securities to begin corporate reor­ga­ni­za­tion proceedings on November 3. The next day, Sanyo defaulted on its call money obligations in the interbank money market—­t he first time this had happened since World War II. This sent huge shockwaves through the financial markets and, in my opinion, was the most decisive moment in the Japa­nese financial crisis of the 1990s. Qualitatively, it was equivalent to the failure in the United States of Lehman ­Brothers during the GFC. In response to the default, interbank lending contracted, and this in turn brought about sharp outflows of deposits from troubled financial institutions. This immediately resulted in funding difficulties at the Hokkaido Takushoku Bank. On November 24, Yamaichi Securities announced its intent to wind down its business as it revealed the existence of huge off-­the-­book obligations. Just two days l­ ater, on November 26, the Tokuyo City Bank failed and the funding costs of all Japa­nese banks r­ ose sharply. The spread that Japa­nese banks had to pay in the US dollar funding market, the so-­called Japan premium, reached one hundred basis points before November was over.

ENHANCING THE FRAMEWORK FOR RESOLVING FINANCIAL INSTITUTIONS While the costs of the deepening financial crisis ­were enormous, it did create a broader understanding of the need to enhance the resolution framework for financial institutions. The first notable action was the December 1995 government announcement that for the next five years all deposits in Japa­nese banks would be protected—­that is, t­ here would be no deposit payout. This was followed by a revision of the Deposit Insurance Act, which made it pos­si­ble, from June 1996 onward, to provide financial assistance over and above the payout 62 | ­Career Building at the Bank of Japa

cost. A special deposit insurance levy was introduced beyond the existing ­ ere not large enough to fund general levy, and if the existing insurance fund w a resolution, the Deposit Insurance Corporation was authorized to borrow, with government guarantees, the amount of any shortfall. This framework was only available for resolving credit ­unions. Though banks ­were still excluded at this stage, se­nior officials at both the ministry and the bank repeatedly stated that they would make ­every effort at avoiding a situation in which Japan could trigger a global financial crisis. The next impor­tant step was in February 1998. The Deposit Insurance Act was further amended and the Act on Emergency Mea­sures for the Revitalization of Financial Functions (hereafter the Financial Revitalization Act) was passed. Combined, t­ hese laws made it pos­si­ble to use up to 30 trillion yen of public funds for resolution, and to provide financial assistance exceeding the payout costs to banks. With ­t hese additions to the tool kit, fresh capital totaling 1.8 trillion yen was injected into twenty-­one major banks in March 1998. But this was not decisive b ­ ecause banks, which w ­ ere concerned with reputational damage, made requests that ­were too small to adequately replenish their capital. As a result, capital shortfall at Japa­nese banks persisted, which eventually became evident as the Long-­Term Credit Bank of Japan began to falter. Consequently, in the autumn of 1998, the Diet again debated the framework for stabilizing the Japa­nese financial system and strengthened the resolution scheme again, including increasing the authorization for the use of public funds to 60 trillion yen. The third milestone was reached when the Diet passed the Act on Mea­sures for Rapidly Securing the Soundness of Financial Functions (hereafter the Securing Financial Soundness Act). Revisions to the Financial Revitalization Act allowed the appointment of trustees to oversee resolution, the establishment of bridge banks, and temporary nationalization of banks. The Securing Financial Soundness Act introduced a scheme to strengthen the capital base of financial institutions, including allowing the purchase of preferred stocks issued by financial institutions, and provided the basis for the injection of 7.5 trillion yen into fifteen major banks in March 1999.

RESPONSES FROM THE BANK OF JAPAN In parallel with the government’s efforts, the Bank of Japan used its own powers to prevent the meltdown of the Japa­nese financial system—­most significantly by providing funds as the lender of last resort. It should be noted that The Bursting of the Bubble | 63

the bank de­cided to lend money to many financial institutions even though they did not have sufficient qualified collateral. This was lawful provided that the bank received the approval of the Ministry of Finance. ­These special loans reached nearly 40 trillion yen by the end of 1998. The decisiveness of the Bank of Japan is best illustrated by the case of Yamaichi Securities, which failed on November 24, 1997. Yamaichi was the fourth largest securities ­house in Japan, with assets totaling 3.7 trillion yen. Although not engaged with the banking operation in Japan, it had a banking subsidiary in Eu­rope. Given the deteriorating confidence in Japa­nese banks, the failure of Yamaichi could have been Japan’s “Lehman moment” and dealt a devastating blow to the Japa­nese financial system. Th ­ ere ­were no laws then that would have enabled an orderly resolution of ­either banks or securities companies, ­there ­were no firms willing to step forward and buy Yamaichi, and it was not pos­si­ble to inject capital using public funds. If Yamaichi had negative equity and the Bank of Japan lent money to Yamaichi, the bank would incur losses, which meant that the Japa­nese public would have to foot the bill through reduced revenue distribution to the government from the bank. The use of central bank money funds was certain to meet heavy re­sis­tance from the public and the politicians. Even so, the bank de­cided to provide what was an unlimited amount of liquidity to Yamaichi u ­ nder Article 25 of the old Bank of Japan Act, which stated that “the Bank of Japan, subject to the approval of the minister in charge, may perform necessary operations with a view to maintaining and promoting the credit system.” Consequently, all liabilities of Yamaichi from market participants, including overseas participants, ­ were replaced with borrowing from the bank; this in turn enabled an orderly resolution, avoiding a systemic event.12 I did not take part in this momentous decision by the Bank of Japan. When Yamaichi’s bankruptcy estate was fi­nally resolved in January  2005, it was confirmed that it had negative equity, and the bank incurred a loss of 111.1 billion yen.13 That was, I believe, a small price to pay compared with the potentially destructive systemic events that would have been likely without the bank’s assistance. During the Japa­nese financial crisis of the 1990s, the Bank of Japan also provided equity capital to facilitate orderly resolutions. Th ­ ese included obtaining an equity stake in the Tokyo Kyodo Bank, providing subordinated loans to Midori Bank and providing funds for the jusen resolution fund.14 Although ­these actions ­were unusual for a central bank, the Bank of Japan needed to undertake ­these and other innovative mea­sures, within the bound­aries of 64 | ­Career Building at the Bank of Japa

the law, to prevent a breakdown of the financial system. It is regretful that so few Westerners appreciated the scope of the Japa­nese authorities’ actions to stabilize our financial system. Had ­there been a wider awareness of the creativity and courage of ­those who confronted the Japa­nese financial crisis of 1997–98, perhaps the global financial crisis that we all faced a de­cade ­later could have turned out differently.

THE END OF THE FINANCIAL CRISIS It is difficult to pinpoint just when the prob­lem of nonperforming loans peaked. Relevant dates would include 2001, when the nonperforming loans ratio and credit cost ratio both hit highs of 8.7 ­percent and 2.5 ­percent, respectively.15 The credit ratings of Japa­nese banks continued to deteriorate ­until 2003, and ­after 2004 ­there ­were more upgrades than downgrades. Bank stocks fell in the first half of 2003. All in all, it took more than ten years from the bursting of the b ­ ubble for the bad loan prob­lem to recede.16 Three principal ­factors can be identified that helped abate the crisis. The first was simply the passage of time. For the economy to return to a normal trajectory, we needed to unwind each of the “three excesses” of employment, physical capital, and debt. Of ­these, employment was regarded as more or less a fixed ­factor of production in Japan, where ­labor relations, especially at large corporates, still tended to follow the “Japa­nese employment model” of lifetime employment, promotions based on se­niority, and company-­specific ­labor u ­ nions. ­ ubble economy, it was not surprising Given the magnitude of the Japa­nese b that it took time for the three excesses to be dissolved. The second f­ actor was a period of global economic recovery and expansion in the period of 2002–7, which supported the Japa­nese economic recovery (see chapter 6). The third contributing ­factor was the use of public funds and the establishment of a workable resolution framework.

DID JAPAN KICK THE CAN DOWN THE ROAD? Japan’s approach to its financial crisis is often criticized as an exercise in “kicking the can down the road,” or of regulatory forbearance. I cannot provide a rejoinder from my own experience, ­because I was not involved in financial stability policy during the darkest years of the late 1990s, and I have mixed feelings about this assessment. My feeling at the time was that Japan should put forward mea­sures to resolve failed financial institutions in an orderly manner The Bursting of the Bubble | 65

and as quickly as pos­si­ble. In retrospect, I think the bank did all it could within its powers to come up with practical and workable solutions proposals. I am quietly proud of our efforts and believe that many of my bank colleagues share ­these feelings. I was and am still exasperated that the bank’s proposals went nowhere, and I still regret that so much time was spent frantically trying to devise and implement second-­or third-­best solutions when it was apparent that the first-­best solution could not carry the day. Why did Japan delay? I can identify four f­ actors. First, the accounting was too slow in recognizing the existence of nonperforming loans. Since prob­lem ­ ere booked as nonmarketassets at Japa­nese banks ­were mainly loans that w able assets, they w ­ ere not marked to market and thus loss recognition was delayed. This contrasts with what happened in Eu­rope and the United States in 2007–9, where many of the prob­lem assets ­were in the trading books and ­were obliged to be marked to market. In Japan, in order to recognize losses for tax purposes, banks had to obtain the blessing of bank examiners for write-­offs and provisioning. But the necessary consent was rarely forthcoming, reflecting the wishes of tax authorities affiliated with the Ministry of Finance. With an inadequate disclosure regime, it could be said that Japan lacked the informational infrastructure for dealing with nonperforming loans. Second, it was not widely understood that an overhang of nonperforming loans would lead to lower economic growth for the entire nation. Third, ­there was no catalytic event like the collapse of Lehman ­Brothers that dramatically changed the views of the public and the po­liti­cal establishment to encourage them to accept the use of public funds. ­Until such a time, public support would not be forthcoming. Perversely, that Japan succeeded in averting an acute financial panic may have delayed public recognition of the seriousness of the prob­lem and also delayed the availability of public funds to help resolve financial institutions in an orderly manner. In 2009 Kazuhito Ikeo, a prominent Japa­nese economics scholar, thoughtfully explained Japan’s delay in dealing with nonperforming loans: While it is easy to criticize t­ hose responsible for kicking the can down ­ itter fact the road, if ­there was no capacity to deal with a prob­lem, the b is that ­there is no choice other than kicking the can. . . . ​In the end, the best course of action is to avoid falling into a situation where the banking system as a w ­ hole f­ aces serious difficulties in the first place (i.e., conduct appropriate macroeconomic policies), but once trapped, it would be impossible, or eco­nom­ically desirable, to rule out “too-­many-­to-­fail,” 66 | ­Career Building at the Bank of Japa

however unpop­u­lar that course of action may be. . . . ​Furthermore, the ­ ere quite unpreregulatory and supervisory authorities of this country w pared. ­There was no structure (­legal framework), and ­there was only ­limited orga­nizational resources and expertise. . . . ​O ver the course of this pro­cess, one cannot deny that ­there ­were actions on the part of authorities that could be deemed passive or blame shifting. Nevertheless, even if it took the better part of a de­cade, a series of prudent actions ­under the existing constraints was, in general, able to establish a stable and functioning resolution regime.17

PO­L ITI­C AL LEADERSHIP AND THE ROLE OF EXPERTS Would it have been pos­si­ble to tackle the prob­lem, without delay, in the early 1990s? One sober reflection was offered by Prime Minister Miyazawa, one of the most intellectually power­ful politicians of the time and the one who first aired the possibility of using public funds. As he noted in an interview, “In l­ ater years, I am often asked if ­there was anything that might have been done differently, but the conditions ­were not ripe enough. While I had noticed and pointed out the prob­lem, unfortunately that did not lead to a consensus to move ahead.”18 His remarks sound somewhat aloof, as if the prob­lem was someone ­else’s rather than his own as prime minister. But that judgment is too harsh. When expert opinion is divided, perhaps we should hold the leader accountable for not choosing the better course, but in Japan at the time, the presumed experts on the staff at the Ministry of Finance ­were not divided but strongly opposed to the use of public funds. Leading scholars and academics ­were also opposed to the use of public funds. I vividly remember conversations with some of the top economics professors of my generation in 1992, who vigorously argued that the Deposit Insurance Corporation should alone execute the deposit payouts and that financial institutions should be liquidated. In my view, we should understand the delay in the use of public funds to be a consequence of both po­liti­cal indecision and of a failure of analy­sis by the experts both in government and academia.

MONETARY POLICY FOLLOWING THE BURSTING OF THE ­B UBBLE ­After the bursting of the economic b ­ ubble, the Bank of Japan began to ease monetary policy in July 1991. The policy interest rate—at that time, the official discount rate—­was cut from 6.0 ­percent to 5.5 ­percent. I was at the Financial The Bursting of the Bubble | 67

System Department at the time and was not part of the internal discussions ­ ehind that decision. But as the dust was still settling, I recall a significant number b of commentators worrying about too early a change in the course of policy. Reviewing newspaper editorials ­today, one finds comments noting “an appropriate decision,” but ­there ­were also many worries about the possibility of the ­bubble resurging and few concerns expressed about the slowdown of the economy. Following this initial cut, the policy rate was reduced further in November and December  1991, in April and July  1992, and in February  1993, when it reached 2.5 ­percent. It was three months a­ fter the seventh rate cut, in May 1993, that I moved to the Monetary Affairs Department to head the division in charge of the formulation of monetary policy. Shortly ­after I took up my responsibilities, I was called into the office of the department head, Yutaka Yamaguchi, and asked to give my views on the economy and the desirable course of monetary policy. With my thoughts on the economy heavi­ly colored by my experiences at the Financial System Department, I told Yamaguchi that the economy was weak reflecting the ongoing balance sheet adjustments and that it would be appropriate to immediately cut interest rates further. Yamaguchi had the same views and recommended a rate cut of 0.75 ­percent to Mieno. A ­ fter extensive deliberations, the governor agreed with the advice of the Monetary Affairs Department and the discount rate was lowered to 1.75 ­percent in September 1993. Following that the rate was cut to 0.75 ­percent in April 1995, and to 0.5 ­percent in September of the same year. Fi­nally, the zero interest rate policy was a­ dopted in February 1999 (see fig. 3.2). ­ ubble econAs I have noted, sluggish growth following the bursting of the b omy is often attributed to a delay in easing monetary policy. If one uses the Taylor rule—­which is a standard framework for the conduct of monetary ­policy—as a reference point, the monetary easing actually ­adopted by the Bank of Japan closely tracked the rates generated by the rule, and so was not particularly slow by this mea­sure.19 ­W hether a more forceful easing of monetary policy following the bursting of a ­bubble can effectively prevent a downturn of the real economy is impor­ tant, both in the specific case of Japan at that time, and more generally. Economists at the FRB conducted a detailed study of the Japa­nese economy in this period and reported the results to the Federal Open Market Committee. The paper, written by thirteen economists, was published in 2002. As the authors concluded, “Our sense is that much of the failure of monetary loosening to support asset prices and to boost the economy owed to offsetting shocks rather than to a genuine breakdown of the monetary transmission mechanism. The 68 | ­Career Building at the Bank of Japa

% 9 8 Official discount rate Call rate (overnight)

7 6 5 4 3 2 1 0 1985

1987

1989

1991

1993

1995

1997

1999

2001

Figure 3.2 ​The official discount rate and call rate. Source: Bank of Japan.

‘financial headwinds’ associated with the collapse of asset prices prob­ably did, to some extent, hinder the ability of monetary policy to boost activity. . . . ​Even so, t­ here is l­ittle evidence that the transmission channels of monetary policy ­were so diminished as to have obviated the benefits of faster and sharper monetary easing in the 1991–95 period.”20 With hindsight I can see that it might have been desirable to ease monetary policy more rapidly, though I do not think it would have changed the course of the economy materially. In any event, policy makers do not have the benefit of hindsight and instead face uncertainty about the course of the economy and about the consequences of their choices. My own sense is that their analy­sis underestimated the financial constraints that the volume of nonperforming loans imposed on the economy and thus overestimated the benefits of an ­earlier easing.

CRITICISMS FROM ABROAD ON THE MONETARY POLICY OF THE BANK OF JAPAN ­ fter the mid-1990s, the conduct of monetary policy on the part of the Bank of A Japan began to attract harsh criticisms from academics abroad, and especially The Bursting of the Bubble | 69

t­ hose in the United States.21 One of the harshest critics was Ben Bernanke, then a professor at Prince­ton University, who would ­later chair the FRB. In his memoir, he recalls the broadside he fired at the bank in 2000: “At a conference in Boston in January 2000, I had started by asking ­whether Japa­nese officials ­were suffering from ‘self-­induced paralysis,’ accused them of having ‘hidden ­behind minor institutional or technical difficulties in order to avoid taking actions,’ criticized them for ‘confused or inconsistent’ responses to helpful suggestions from academics such as myself, and concluded by blaming them for an unwillingness to experiment. ‘Perhaps it’s time for some Roo­se­veltian resolve in Japan,’ I pontificated.”22 Many Japa­nese economists jumped on this and similar commentary that began to call on the bank to conduct monetary policy much more aggressively and decisively. The tone of arguments about Japa­nese monetary policy has changed over the years, but only a ­little. As Bernanke noted, “Years ­later, having endured withering, motive-­impugning criticism from politicians, editorial pages, and even fellow economists, I found myself wishing I had dialed back my ­earlier rhe­toric. In 2011, in response to a question from a Japa­nese newspaper correspondent, I confessed, ‘I’m a ­little bit more sympathetic to central bankers now than I was ten years ago.’ ”23 But the damage to the Bank of Japan’s credibility, when it needed it most, could not be restored.

THE STAGNATION OF THE JAPA­N ESE ECONOMY FOLLOWING THE BURSTING OF THE ­B UBBLE The years a­ fter the bursting of the ­bubble economy are often described as the “lost de­cade” or even the “lost de­cades.” While growth was sluggish, ­there ­were ups and downs: the first cyclical peak was in February 1992, followed by a trough in October 1993; another peak came in May 1995, and another trough in January 1999. Each time the economy was coming out of a trough, optimism began to prevail, deterring the sense of urgency in efforts to revitalize the economy. It was not before 1997, when the financial crisis deepened, that adjustments in employment began in earnest. As many large firms in Japan saw the reduction in the head count of full-­time permanent workers as a last resort in any restructuring, ­these firms restrained their new hires and brought on temporary workers instead. It was called an ice age for new recruits, and the younger generation was severely affected. Consequently, t­ hose recently graduated from 70 | ­Career Building at the Bank of Japa

college who had to find a job could not improve their on-­the-­job skills at the start of their ­careers and had to put up with lower incomes. That in turn led to long-­lasting social issues, such as a decline in marriage and births. The long-­ term effects of a one-­time shock is what economists call hysteresis. Hysteresis ­ ubble economy was indeed large, which observed following the bursting of the b underscores the importance of avoiding financial crises. How should one make sense of the lower growth rate during the de­cade ­ ubble economy?24 First, t­ here w ­ ere the direct following the bursting of the b consequences of the ­bubble, typified by the correction of the “three excesses” of employment, physical capital, and debt that accumulated at that time. When t­ hese excesses w ­ ere being worked off, spending by firms and h ­ ouse­holds was depressed and growth suffered. Investments initiated during the b ­ ubble premised on extrapolated optimistic assumptions became low-­yielding assets and a drag on economic growth.25 Second, Japa­nese firms w ­ ere not in a position to adapt well to the fundamental changes that swept through the global economy in the 1990s. In November 1989 the Berlin Wall fell, and the former Communist Bloc economies came to be integrated into the global market economy in the early 1990s. This meant that a huge supply of ­labor entered the global economy through international trade and investment. The 1990s saw dramatic advances in information and communications technology. Against the backdrop of ­these torrents of globalization and revolutionary technological innovation, markets around the world became both more integrated and reflected a more elaborate global division of l­abor in production pro­cesses. Overseas firms took advantage of this to optimize their production capacity and sales channels to maximize their value while successfully outsourcing to cut costs. Th ­ ere ­were also value-­creating the advances in information and commuinnovations that took advantage of nications technology. Japa­nese firms had difficulty responding to this new ­environment. The traditional Japa­nese business model relied on pursuing efficiency enhancements within businesses’ own assembly lines of mass manufacture and thus ­were not oriented to exploit the changing global environment.26 Even when businesses wished to reform their models, it was not easy to flexibly redeploy l­abor resources u ­ nder the lifetime employment system. Furthermore, as the resilience of firms was considerably eroded with the bursting of the b ­ ubble, the priority was on their very survival, and they w ­ ere often financially unable to meet new challenges. I, among o ­ thers, was not able to foresee that the fall of the Berlin Wall and the onset of new technology would change the world as much as they did. The Bursting of the Bubble | 71

Fi­nally, policies ­adopted during the sluggish economy had the effect of impairing the efficiency of the economy. As a result of policies that “kicked the can down the road,” inefficient businesses w ­ ere allowed to continue operating. ­These firms w ­ ere often called zombie firms. Looking back, I think we have underestimated the importance of the second ­factor. The ability of firms to change has been and ­will always be an impor­ ­ ubble economy depressed tant basis of productivity. The bursting of the b economic growth through many channels. Declining-­trend economic growth over one or more de­cades can be understood by real economic ­factors, the private-­sector incentives that affect them, and overarching structural f­ actors.27 ­Every economy has its own model of economic management, reflecting its traditions, and all institutional setups are interrelated. In other words, t­ here is “strategic complementarity,” to borrow the term used by the late professor Masahiko Aoki of Stanford University. Aoki describes the years a­ fter the ­bubble as the “transitional three de­cades” rather than a “lost de­cade.”28 In this sense, I think that the Japa­nese economy missed this institutional transition pro­cess. When the b ­ ubble burst, I was somewhat aware of the slowness of institutional adaptation, but was ­later caught almost completely unaware of the effects of the declining working-­age population, which reflected rapid aging. The working-­age population in Japan peaked in 1995, and the changes in demographics began to cast a long shadow.

LESSONS OF THE BURSTING OF THE ­B UBBLE ECONOMY AND THE FINANCIAL CRISIS The first lesson for me is that when ­bubbles burst, the affected economy ­will have to endure an extended period of low growth. With the importance of this lesson deeply ingrained in my worldview, I had quite low expectations for global economy once the collapse of Lehman ­Brothers had subsided. The second lesson is of the importance of trying to prevent the collapse of the financial system in the first place. The years a­ fter the bursting of a b ­ ubble are likely to see substandard growth, but if the stability of the financial system is compromised, the economy ­will face even more disappointing growth with dire consequences for the society at large. Due to hysteresis, such effects ­will be long lasting. The third lesson is that the central bank must both recognize the fundamental issues facing the domestic economy and persuasively explain them to the government and the public. Looking back at the early 1990s, my deepest 72 | ­Career Building at the Bank of Japa

regret is that the Bank of Japan failed to convince the public of the implications of the banks’ nonperforming loans at a much e­ arlier stage. Management of an economy w ­ ill not be jeopardized by making m ­ istakes in short-­term economic forecasting. Instead, catastrophic errors result from making a wrong diagnosis on the fundamental issues facing the economy. Obviously, the central bank alone cannot easily change public perceptions. Having said that, the characteristics of the central bank—­for example, that it has a macro perspective, has easy access to intelligence from financial institutions and markets, and employs many good economists—­make it the most capable organ­ization for economic research. As such, the central bank should encourage good research. I would like to stress the importance of having in­de­pen­dent research institutions that are not overly influenced by the conventional wisdom of the day and are capable of conducting open and transparent policy debates.

The Bursting of the Bubble | 73

| CHAPTER FOUR |

The New Bank of Japan Act The original Bank of Japan Act was passed in February 1942, two months ­after the outbreak of the Pacific War, and it has strong overtones of state control. As such, the bank had long had a strong desire to revise the law. A perfect alignment of the stars in the late 1990s set in motion an effort for an overhaul, and in April 1998, as the Japa­nese financial crisis raged, a totally revised act came into force. ­Factors leading to the revision included the remorse over the b ­ ubble the late 1980s, a global trend t ­ oward strengthening central bank economy of in­de­pen­dence, and—­perhaps above all—­a revulsion against the concentration of policy-­making powers in the hands of the Ministry of Finance. The revision of the law was an impor­tant milestone in the conduct of monetary policy, but at the same time, the bank faced an uphill task ­because t­ here was no room to cut interest rates further and Japan was in the midst of a financial crisis.

A BRIEF HISTORY OF THE BANK OF JAPAN ACT The year 1998 was a turbulent one for Japan, which was in the midst of the financial crisis that had begun the previous year. It was turbulent for the Bank of Japan as well, in that the new Bank of Japan Act came into force in April, granting the bank ­legal in­de­pen­dence with regard to the conduct of monetary policy. ­There was another significant institutional change, in which financial regulation and supervision was carved out of the Ministry of Finance as part of the establishment of the Financial Supervisory Agency in June. That became the Financial Ser­vices Agency in July 2000 and came u ­ nder the minister for financial affairs in a general reor­ga­ni­za­tion of the executive branch in January 2001. Looking back on history, the Bank of Japan, which was founded in 1882, had experienced three major revisions to its ­legal framework. The first was in 1942, when government control over the bank was strengthened, shadowing the l­egal framework of the Nazi Reichsbankgesetz of 1939. The second revision 74

came in 1949, and it attempted to “de­moc­ra­tize” the bank u ­ nder the auspices of the Supreme Commander for the Allied Powers, who was occupying Japan and overseeing domestic affairs ­after World War II. While a policy board modeled ­after the Federal Reserve System was established and the sole authority to set the official discount rate was bestowed upon the board, most of the government’s broad powers over the Bank of Japan, including its supervision, ordering specific actions, approving its bud­get, and dismissing executive officers, remained intact. Following two abortive attempts to amend such a framework, in 1959 and 1964, the current Bank of Japan Act was fi­nally approved by the National Diet in June 1997 and became effective in April 1998. Article 1 of the previous Bank of Japan Act (hereafter the old act) displayed a strong inclination for government control, which said, “The objective of the Bank of Japan ­shall be to control money, to adjust finance and to nurture and develop the credit system according to government policies in order to effectively realize the full national economic potential.” In addition, it gave the government broad powers to order specific actions and dismiss executive officers. Given that such a framework was not compatible with the more liberal institutional setup following World War II, many of the old act’s provisions ­were used only sparingly, and moreover it was evident for some time that a review from the ground up was necessary. As Yasushi Mieno, who was a bank governor u ­ nder the old act, writes in his memoir, “The Bank of Japan Act before the revision, was . . . ​a flawed ­legal framework for a central bank and was made barely operational through creative maneuvers. As such, I had a very strong wish to have the old act changed in line with modern practices, and told my successor that it was a priority. . . . ​­There then appeared a perfect alignment of stars, stirring a debate for an overhaul.”1

­F ACTORS UNDER­LYING THE REVISION The old Bank of Japan Act was laced with provisions that could be described as humiliating for a modern central bank in a developed economy. Accordingly, I, too, had long shared with my colleagues at the bank the desire for its eventual revision. At the same time, as a dispassionate observer, I was also of the view that in the Japa­nese po­liti­cal climate of the time it would not be realized anytime soon. It was in such a situation that the debate to revise the act suddenly began. The news first reached me when I was the bank’s chief representative in New York in 1996. Surprised as I was in hearing that news, I was excited at the prospect. The New Bank of Japan Act | 75

Since I was not directly involved in the review pro­cess, I cannot speak with any authority regarding the ins and outs of the concurrent developments. I can in retrospect say, however, that the revision would not have taken place if it ­were attempted before or ­after 1997. The first ­factors supporting the granting of in­de­pen­dence to the Bank of Japan was widespread reflection on the historic b ­ ubble economy of the late 1980s and the role of monetary policy. The ­ ubble, but it was widely extended monetary easing was not the sole cause of the b regarded as one of the impor­tant contributing ­factors. It came, therefore, to be broadly recognized that it was necessary to rid the government of its influence over the conduct of monetary policy and give the bank operational in­de­ pen­dence in order to prevent another b ­ ubble. The second ­factor was the global trend ­toward strengthening central bank in­de­pen­dence. Accelerating inflation from the 1970s had jeopardized macroeconomic stability, and the experiences of that period, the shorthand for which was stagflation, gave rise to the belief that a better outcome could be achieved if an in­de­pen­dent central bank could be allowed to conduct monetary policy aimed at price stability by shielding it from short-­term po­liti­cal pressures.2 Such views first emerged in academia and gradually began to influence the po­liti­cal establishment. Consequently, around 1998, when the new Bank of Japan Act came into force, t­ here w ­ ere significant changes overseas regarding the institutional arrangements for central banks. The Eu­ro­pean Central Bank (ECB) was founded in 1998, according to the provisions of the Treaty of Maastricht, which was signed in 1992. In the United Kingdom, the L ­ abour Party government ­under Tony Blair gave operational in­de­pen­dence to the Bank of E ­ ngland shortly ­a fter coming to power in 1997, which was formalized in 1998 along with strengthened accountability. ­These two f­ actors w ­ ere impor­tant, but would not alone have been sufficient to bring about a revision of the Bank of Japan Act. Such a change to the fundamental ­legal framework relating to the cornerstone of the economy and the financial system does not come about without an outburst of significant po­ liti­cal energy. The reflection on the b ­ ubble economy and the subsequent financial crisis led to strong distrust and hostility ­toward the concentration of economic policy-­making powers in the hands of the Ministry of Finance. Change was further accelerated as wine-­and-­dine scandals at the ministry surfaced in the mid-1990s. This was the third ­factor. The pro­cess for the revision of the Bank of Japan Act began with the launch of a proj­ect team of ruling co­a li­tion party experts in February 1996. That team released its report in June, which recommended that “the government should 76 | ­Career Building at the Bank of Japa

establish a transparent and impartial forum to examine” the revision of the Bank of Japan Act.3 In response, Prime Minister Ryutaro Hashimoto launched the Central Bank Study Group, which was mainly composed of academics, along with an ex-­government official, in July. The group’s report was published in November. The ball was then picked up by the Financial System Research Council at the Ministry of Finance, which discussed issues in a subcommittee chaired by Ryuichiro Tachi, a respected scholar of financial economics, followed by a bill submitted to the National Diet, which became law in June 1997 and was entered into force in April 1998. ­There was a consensus in princi­ple on granting in­de­pen­dence to the Bank of Japan. Nevertheless, views ­were divided on the appropriate institutional setup to realize it. The devil was always in the details.

THE OBJECTIVES OF THE BANK OF JAPAN One of the most fundamental issues for central bank in­de­pen­dence is how to describe the objective of a central bank—­particularly as regards monetary policy. In the new Bank of Japan Act, the objectives of the bank are laid out in article 1: the first is issuing banknotes, the second is carry­ing out currency and monetary control, and the third is contributing to the maintenance of the stability of the financial system. Following this, article 2 sets out the objective of monetary policy as “achieving price stability, thereby contributing to the sound development of the national economy.” ­These two opening articles of the act ­were noteworthy for two reasons. First, the Bank of Japan is directed to conduct not only monetary policy but also to play a role in stabilizing the financial system. Whereas ­t here continues to be a global debate about ­whether central banks should be exclusively focused on monetary policy and price stability or to also take on responsibilities for financial stability, giving the bank responsibilities for both price stability and financial stability was contrary to the trend in other countries in the 1990s. Given my experiences dealing with the fallout of Japan’s ­bubble economy and how the instability of Japa­nese financial institutions complicated the conduct of monetary policy, I strongly supported giving the bank both responsibilities and still believe that this is the more enlightened approach. The second noteworthy feature was that the objective of monetary policy does not stop at “achieving price stability” but continues to require the Bank of Japan to “contribut[e] to the sound development of the national economy.” ­ ubble economy, even if prices are seemingly As it was during the Japa­nese b The New Bank of Japan Act | 77

stable or if inflation remains very low, when financial imbalances are deemed to be accumulating it may become necessary to adjust monetary policy. While article 2 may be read in dif­fer­ent ways, my view is that the Bank Act requires the conduct of monetary policy to maintain price stability in the context of the ultimate goal of sustainable growth.

ARTICLE 65 OF THE JAPA­N ESE CONSTITUTION The new Bank of Japan Act granted in­de­pen­dence to the bank with regard to the conduct of monetary policy. ­There had been extensive debates as to the most appropriate form and degree of in­de­pen­dence, and ­those debates centered on a legalistic question: What place does the central bank occupy in the Japa­nese executive branch? In other words, from what is the central bank in­de­pen­dent? Obviously, in a demo­cratic polity, the central bank cannot be a kingdom. This question is not new. Looking at the United States, a­ fter several “in­de­pen­dent agencies” w ­ ere set up during the 1930s, their constitutionality was extensively debated. As for the Federal Reserve Board (FRB), the meaning of its in­de­pen­dence has been the focus of much discussion since World War II, and it is now widely recognized that the FRB has “in­de­pen­ dence within government.” 4 According to an official publication of the FRB, the Board of Governors of the Federal Reserve System is described as an “in­ de­pen­dent agency” of the federal government that “reports to and is directly accountable to Congress.”5 In Japan what was unsettled at the time of the two previous abortive attempts to revise the Bank of Japan Act boiled down to consistency with article 65 of the Japa­nese Constitution, which stipulated, “Executive power s­ hall be vested in the Cabinet.” According to the government’s official view, formulated by the then mighty Cabinet Legislation Bureau, for any in­de­pen­dence arrangement for the Bank of Japan to be constitutional, the government had to retain the power over bud­get and personnel decisions. The government’s power over personnel was not controversial, but its power over the bud­get of the bank was debatable. Meanwhile, the prime minister’s Central Bank Study Group report of 1996 was s­ ilent on this point. The report of the Financial System Research Council, in turn, pointed to the existence of views that governmental control over the bank’s bud­get was not necessarily essential. Eventually, in revising the Bank of Japan Act, with re­spect to the control over personnel it was de­cided to let the cabinet appoint the governor, deputy governors and Policy Board members, subject to consent from both ­houses of the National Diet. 78 | ­Career Building at the Bank of Japa

As regards the bud­getary ­matters of the Bank of Japan, it was de­cided that they would require approval from the finance minister—­except for ­those items related to the conduct of monetary policy. Therefore, if the bank wished to make provisions for potential f­uture losses, ministerial approval would be ­required. This is dif­fer­ent from standard practice at central banks in other developed economies. Whereas the Bank of Japan can make in­de­pen­dent bud­getary decisions for items related to monetary policy only, overseas central banks had, without exception, complete bud­getary in­de­pen­dence. It could be said that the debates on in­de­pen­dence leading to the revision of the Bank Act in 1998 might have been overly focused on the superstructure of in­de­pen­ dence—­that is, the pro­cess of conducting monetary policy—­and have given short shrift to the substructure underpinning in­de­pen­dence, which was equally impor­tant.

THE CONDUCT OF MONETARY POLICY AND RELATIONS WITH THE GOVERNMENT Beyond l­egal formalities, what exactly does it mean to conduct monetary policy in­de­pen­dently? We would not say ­t here was in­de­pen­dence if the government has a vote in the decision-­making body for monetary policy, if the government must affirmatively approve policy decisions, or if the government can overturn decisions of the central bank. ­Under the new Bank of Japan Act, monetary policy decisions are taken by the bank’s nine-­person Policy Board, comprising the governor, two deputy governors, and other six board members. Comparing the arrangement to the old act, which bestowed the government extensive powers to instruct the bank and the power to sack the governor, it could be said that the bank became more in­de­pen­dent ­under the new act. Furthermore, as article 3 of the new act stipulates, “The Bank of Japan’s autonomy regarding currency and monetary control s­ hall be respected.” One issue related to in­de­pen­dence attracted much attention, and that was the relation between monetary policy and the general economic policies of the government. It was manifested in article 4 of the Bank of Japan Act, which reads, “The Bank of Japan ­shall, taking into account the fact that currency and monetary control is a component of overall economic policy, always maintain close contact with the government and exchange views sufficiently, so that its currency and monetary control and the basic stance of the government’s economic policy ­shall be mutually compatible.” The New Bank of Japan Act | 79

Nobody can deny that the Bank of Japan must “always maintain close contact with the government and exchange views sufficiently.” At the same time, given that the bank must “achiev[e] price stability, thereby contributing to the sound development of the national economy” in its conduct of monetary policy, any policy decision failing to achieve this objective would be illegal. At the end of the day, it should be obvious that this article was requiring nothing more than sufficient exchanges of views. Not every­one agreed, however. As a m ­ atter of fact, some politicians both in and outside the government often referred to this article when they insisted on monetary easing from the bank. The Bank Act empowered the government to attend policy meetings, to introduce proposals to such meetings, and to request the postponement of decisions by the bank. As a ­matter of comparison, ­there is no provision with re­spect to the ECB or the FRB that allows the government to introduce proposals to such meetings or to request postponing decisions. In the case of the FRB, nobody from the executive branch attends the Federal Open Market Committee (FOMC). In the case of the ECB and the Bank of E ­ ngland, while government representatives attend the policy meetings, their remarks are said to be confined to items that directly relate to macroeconomic conditions such as fiscal policy. In contrast, in Japan, government representatives not only attend but also make remarks on monetary policy at e­ very meeting. I remember once being quizzed by a very se­nior staff member at the FRB, when I visited the FRB to study the ways in which the FOMC operated in the early 2000s, as to ­whether it was “­really pos­si­ble to candidly discuss the direction of monetary policy when ­there are government representatives in the room.”

HAS THE BANK BECOME MORE IN­D E­P EN­D ENT? It is challenging to objectively make an international comparison of the degree of in­de­pen­dence of central banks. One may attempt to compile a “central bank in­de­pen­dence index” based on ­legal features that could affect in­de­pen­ dence, and such studies suggest that Bank of Japan in­de­pen­dence is not very high compared to other advanced economy central banks, even ­after the overhaul of the Bank of Japan Act.6 Having said that, even if the law provides for strong in­de­pen­dence, ­there could be instances in which such laws are actually not respected. On the other hand, even if in­de­pen­dence is weak in a l­ egal sense, established practices may re­spect in­de­pen­dence to some degree. While the bank was not very legally in­de­pen­dent before the revision of the Bank Act, the inflation rate was among the lowest in the developed economies, and one could 80 | ­Career Building at the Bank of Japa

have argued that the bank was enjoying a reasonable degree of de facto in­de­ pen­dence (see chapter 2). My observations regarding the conduct of monetary policy before the revision of the Bank Act are from the perspective of a ju­nior staff member and therefore may not be representative of how policy was r­ eally determined in ­those days. With that caveat, my hypothesis is that it was an arrangement with both the bank and the Ministry of Finance having vetoes. That means that the bank could not decide to tighten policy on its own, and the ministry could not decide to ease policy on its own ­either. Nevertheless, if the bank was strongly inclined to tighten policy, the government could not have been able to resist forever. In that sense, while it might have taken time, the views of the bank would ultimately have had an impact. The bank may not have been formally very in­de­pen­dent, but in practice, it was a ­little more power­ful than the letters of the law suggested. The prob­lem with such an informal arrangement was that it could not function well if ­there ­were completely novel circumstances or ­there ­were extremely colorful politicians in the office of the prime minister or finance minister. In such cases, monetary tightening would be delayed, with consequences such as the “runaway inflation” of 1973–74, or the ­bubble economy of the last half of the 1980s. All in all, l­egal weaknesses regarding in­de­pen­dence could be compensated by good institutional practice and consultation, but they would be potentially fragile. Without a doubt, l­egal in­de­pen­dence does m ­ atter.

THE ACCOUNTABILITY OF THE CENTRAL BANK The central bank must be ­under some form of demo­cratic control and accountability to po­liti­cal institutions. Without such control the central bank might become self-­righteous and a source of prob­lems. The governance of the central bank is a question of how society’s ­w ill for achieving long-­r un stability should be reflected in the decisions of the bank. In the case of politicians, they ultimately submit to the ­will of the ­people in elections. In the case of CEOs of listed corporations, their success or failure ­will be judged by profits or stock prices. If their per­for­mance is lackluster, they ­w ill be forced to resign or be driven out. Compared with ­t hese examples, the design of central bank governance mechanisms is not s­ imple. The most impor­tant complication is that it is not straightforward to judge per­for­mance. Even with regard to the most severe upheavals of the economy, such as the b ­ ubble economy or its subsequent burst, The New Bank of Japan Act | 81

the debates on the culpability of the Bank of Japan and its monetary policy are not yet settled. Given that the effects of central bank policies do not become fully evident u ­ ntil sufficient time has passed, views on the success or failure veer between the short term and the medium to longer term. Furthermore, the per­for­mance of an economy depends on many real-­world f­ actors outside the control of the central bank. Consequently, in many economies, central bank governance focuses on the accountability of the in­de­pen­dent institution. It is understood that in order to be accountable, the central bank needs to provide sufficient explanations on the substance and rationale of its decisions to the general public. In view of this, the Bank of Japan is required to explain its actions to the National Diet. The bank submits its Semiannual Report on Currency and Monetary Control to the Diet, on which a special hearing is held. Furthermore, the bank must also explain its actions to the broader public through press conferences, speeches, and the publication of papers. The key to ensuring accountability is transparency— in par­tic­u­lar, providing information on the pro­cess leading up to policy decisions. Accordingly, the Bank of Japan Act has provisions mandating the publication of minutes and full transcripts of the Monetary Policy Meetings of the Policy Board. When I was governor of the bank, the former was published with a lag of about one month and the latter with a lag of ten years.

MONETARY POLICY AND THE BANK OF JAPAN ACT The provisions on monetary policy in central bank legislation around the world are quite diverse, reflecting the historical context in which each law is ­adopted. For example, older central bank laws list many objectives of the central bank, whereas legislation that was a­ dopted ­after the 1990s tends to focus on price stability, as evident in the cases of the ECB and the Bank of ­England. The Bank of Japan Act follows this trend, but does not stop t­ here. The act requires the bank to ultimately aim for the sound development of the national economy through achieving price stability. The way it is written reflects the experiences of the last half of the 1980s, where the economy eventually suffered a large fluctuation as a result of soaring asset prices and the wild expansion of credit, even as prices remained stable. This definition of the objective of monetary policy in the new Bank Act is quite sensible. With regard to the objective of monetary policy, t­ here is also a debate regarding the appropriateness of referring to the stability of economic activity or employment in addition to price stability. This is often framed as a choice 82 | ­Career Building at the Bank of Japa

between single and dual mandates. As I have noted above, the ECB and the Bank of ­England are examples of central banks that have a single mandate, where price stability is the sole objective. On the other hand, the FRB, which is required to pursue price stability and maximization of employment, is an example of a central bank that has a dual mandate. By comparison, when I was governor of the Bank of Japan, ­there ­were strong calls for a revision of the Bank Act in order to incorporate maximum employment as an additional objective of monetary policy. I believe that differences between central banks with single and dual mandates are not very apparent in the ­actual conduct of monetary policy. As I see it, no central bank w ­ ill pursue price stability with complete disregard for economic conditions. I tend to agree with the view that any small differences between central banks in their conduct of monetary policy reflect less the provisions of respective founding legislations and more the national psyche reflecting recent historical experience. For example, the United States is relatively more sensitive to stable employment ­because of the ­Great Depression of the 1930s, and Germany is relatively more sensitive to price stability b ­ ecause of the post–­World War I hyperinflation that gave rise to Nazism. In addition to the objectives of monetary policy, provisions covering the ­actual operations of the central bank are just as impor­tant, ­because monetary policy is implemented through lending or asset purchases. The list in the Bank of Japan Act regarding assets that the bank can purchase is rather extensive, covering a wider range than that dictated by the FRB. As I ­will explain in ­later chapters, the purchases of asset-­backed commercial paper in 2003 and of commercial paper and corporate bonds in 2009 ­were within the mandates of the act. Furthermore, even if an asset is not listed in the act, if the bank deems it necessary it can purchase that asset ­after receiving an authorization from the finance minister. This flexibility came in handy when the bank began to purchase shares of real estate investment trusts and exchange-­traded funds in 2010.

THE ROLE OF THE BANK OF JAPAN IN THE STABILITY OF THE FINANCIAL SYSTEM As has been noted, provisions clearly outlining the role of the Bank of Japan with regard to financial stability ­were introduced in the new Bank of Japan Act. This was a significant advance from the old act. More specifically, first, the new provisions unambiguously stated that the bank should contribute to the maintenance of the stability of the financial system through ensuring the stability The New Bank of Japan Act | 83

of the payment and settlement system. Second, the bank was granted powers to conclude agreements with financial institutions that have accounts with it regarding on-­site examinations of ­those institutions. Fi­nally, the ­legal framework for the bank to provide liquidity as the “lender of last resort” was clarified. U ­ nder the new arrangements, actions u ­ nder this function w ­ ill require the decisions of both the government and the bank. That is, the government may request the bank to conduct any business necessary when the government finds that it is especially necessary for the maintenance of stability of the financial system; the bank’s Policy Board ­will then decide ­whether it is appropriate to take action. Meanwhile, on-­site examinations by the bank are regarded as a necessary function to underwrite the lender of last resort function. Even before its founding act was revised, the Bank of Japan had conducted contractual on-­site examinations of financial institutions, but ­there ­were some complaints that they w ­ ere burdensome to t­hose institutions, which w ­ ere also subject to legally mandated examinations conducted by the Banking Bureau of the Ministry of Finance. Furthermore, another power­ful argument at the time was that the central bank should concentrate on conducting monetary policy aimed at price stability and stay away from bank regulation and supervision in order to avoid conflicts of interest. In fact, around the time that the new Bank Act came into force, the Bank of ­England was granted operational in­de­pen­dence for conducting monetary policy while relinquishing its long-­standing bank supervision function to the newly established Financial Ser­vices Authority. It was quite fash­ion­able among academics and some central bankers in the 1990s to regard price stability and financial stability as mutually in­de­pen­dent objectives. I would call this view the separation princi­ple, and I do not buy into ­ ere such an approach. The Bank of Japan, in contrast, claimed that the two w inseparably linked and having a financial supervision function was essential in conducting monetary policy. In the end, the new Bank of Japan Act clearly stipulated that the bank had powers to conclude agreements with financial institutions allowing on-­site examinations. The bank actually conducts examinations based on the provision, and it is an impor­tant tool in assessing the state of the financial system.

THE POWER TO INTERVENE IN THE FOREIGN EXCHANGE MARKET In the discussions leading up to the revision of the Bank of Japan Act, another focus was on who would have powers over exchange rate policy. While in ­every economy the government has the power to determine the exchange rate 84 | ­Career Building at the Bank of Japa

regime, such as a fixed rate versus a floating rate, a decision has to be made on the whereabouts of the power to intervene in foreign exchange in order to influence the exchange rate. The question has impor­tant implications for the conduct of monetary policy in a globalizing world, and especially so when confronted with the zero lower bound of the interest rate. In Japan the power to intervene in the foreign exchange market resides in the government (and, more specifically, the finance minister). During committee-­level deliberations in the National Diet, when the question of foreign exchange interventions was repeatedly taken up, the government insisted from two perspectives that interventions should be solely conducted ­under the authority of the government. One perspective was that in view of the potential risk of conflict between the two objectives of price and exchange rate stability, the central bank should not have the power to intervene. The other was that the power to intervene generally rested with the government outside Japan, pointing to the United States as an example, and thus the government should have complete control over interventions. Based on t­ hese justifications, the decision was made that the power to intervene remained with the Ministry of Finance, and it was clearly written into the new Bank of Japan Act, article 40(2) that the Bank of Japan would only buy and sell foreign exchange as an agent of the government when the purpose of the buying and selling was to stabilize the exchange rate. As for the second justification, it is not necessarily a common practice in the global context to withhold from the central bank the power to intervene in the foreign exchange market. While the US Trea­sury does indeed have powers to execute foreign exchange interventions in the United States, in other economies many central banks are vested with the power to intervene—as in, for example, the ECB, the Swiss National Bank, and most Asian central banks. Yet given that the level of the exchange rate often invites po­liti­cally charged debates in Japan, the current arrangements could be regarded as a practical solution. Nevertheless, the prob­lem was that despite the ­legal setup not allowing the Bank of Japan to intervene, overseas investors did not always realize who was in charge of exchange rate m ­ atters and the bank was frequently ­under pressure to purchase foreign-­currency-­denominated assets, as ­will be explained in chapter 14.

THE NEW ACT COMES INTO FORCE The revision of the Bank of Japan Act was completed in a relatively short time frame: it was only one and a half years ­after the kickoff of the po­liti­cal proj­ect The New Bank of Japan Act | 85

team that a bill was a­ dopted by the National Diet. If many more months had been spent on it, the revision effort could have lost momentum and might have faltered. On the other hand, the speed also meant that thoughtful debates w ­ ere wanting with regard to why central bank in­de­pen­dence was essential, though again such discussions might have resulted in a loss of momentum. As Paul Tucker, former deputy governor of the Bank of ­England, has argued, “Duly passed legislation is necessary but not sufficient. Embedded, stable preferences, generated by experience and s­ haped through debate, are also needed—in a democracy.”7 Unfortunately, this was not so in late 1990s Japan. A heavy pall was cast over the Bank of Japan as the new Bank Act came into force on April  1, 1998. In January of that year, public prosecutors raided the premises of the bank in their investigation of a wine-­and-­dine scandal that engulfed the bank and the Ministry of Finance. Taking responsibility for the ­whole affair, bank governor Yasuo Matsushita and a se­nior deputy governor, Toshihiko Fukui, both resigned the same month. Consequently, Masaru Hayami, who was a former c­ areer central banker returning to the bank a­ fter an absence of nearly twenty years, was appointed as governor, and respected economic journalist Sakuya Fujiwara and c­ areer central banker Yutaka Yamaguchi w ­ ere appointed as deputy governors. Operation u ­ nder the new Act began with this team.8 The Bank of Japan faced three challenges at this time. First, it had to establish the credibility of an in­de­pen­dent central bank ­under the new act, which called for a delicate balancing act with re­spect to its relationship with the government. Second, the bank had, without formal in­de­pen­dence, attained price stability already in the 1980s, which was the goal other economies had tried to reach through central bank in­de­pen­dence or inflation targeting. Japa­nese inflation during the 1980s was at 2.5 ­percent. That figure was not only very low among the developed economies but even lower than the 2.9 ­percent of West Germany, which had the most in­de­pen­dent central bank (see t­ able 4.1). In other words, the bank had to start from a position where an additional in­de­pen­dence dividend would be difficult to observe. Fi­nally, the Bank of Japan had l­ittle policy space in the case of a further downturn of the economy. When the new act came into force, the official discount rate of the bank was already at 0.5 ­percent. The interest rate for call money was at 0.46 ­percent, and the yield of ten-­year Japa­nese Government Bonds was 1.86 ­percent. It was not literally a “zero-­interest” environment, but ­there was ­little additional room to cut interest rates. That was unfolding against the backdrop of severe turbulence in the financial system from the autumn of 1997 onward, and financial institutions ­were undercapitalized. If one ­were to 86 | ­Career Building at the Bank of Japa

Table 4.1 An international comparison of consumer price inflation rate in 1980s

Japan United Kingdom United States West Germany

1980

81

82

83

84

85

4.9 12.2 10.4 6.3

2.7 8.5 6.2 5.3

1.9 5.2 3.2 3.3

2.3 4.4 4.4 2.4

2.0 0.6 5.2 3.6 3.5 1.9 2.1 -0.1

86

87

88

89

0.1 4.1 3.6 0.2

0.7 2.3 3.1 4.6 5.2 7.0 4.1 4.8 5.4 1.3 2.8 2.7

Annual change (%) 2.5 6.4 5.4 2.9

put this in the US context, it was as if the FRB had recovered in­de­pen­dence not in 1951 when the famous accord was reached between the FRB and the US Trea­sury, but in 2008 just ­after the collapse of Lehman ­Brothers. Though it was pos­si­ble to conduct additional easing by deploying unconventional policy mea­sures, the effectiveness of policy was constrained compared with more normal times. Such a difficult environment, however, would not serve as an excuse for avoiding responsibilities as the central bank. That was indeed how the Bank of Japan took up the challenges, and the bank embarked on its voyage as a newly designed central bank ­under the new Bank of Japan Act beginning in April 1998.

The New Bank of Japan Act | 87

| CHAPTER FIVE |

The Zero Interest Rate Policy and Quantitative Easing Short-­term interest rates in Japan had already reached close to zero ­percent by the mid-1990s, but a zero interest rate policy in the literal sense, coupled with a form of forward guidance, was embraced by the Bank of Japan in February 1999. In retrospect, this was the start of the unconventional monetary policy that has been ongoing in Japan ever since—­w ith only a few brief respites—­and subsequently was a­ dopted by many central banks in developed economies. The next year, amid a heated debate, the zero interest rate policy was terminated, but against the backdrop of a global economic downturn following the bursting of the dot-­com ­bubble, the bank de­cided to move back to zero and adopt so-­called quantitative easing (QE). Meanwhile, the global economy emerged from its slump to resume what was dubbed the ­Great Moderation period of extended growth with relatively l­ittle financial volatility from 1982 to 2007. In an environment of improving global growth, the bank ended its QE program in March 2006 and then raised interest rates in July of that year.

THE CONDUCT OF MONETARY POLICY ­U NDER THE NEW BANK OF JAPAN ACT In June 2000, I received a new assignment at the Bank of Japan—­what would be called ­today the director-­general of the Monetary Affairs Department. Six years had passed since May 1994, when I had last been directly involved in the formulation of monetary policy. Before that assignment I had held vari­ous responsibilities in the same function on three occasions for a total of seven years, but all ­were before the revision of the Bank of Japan Act. My first experience of the bank’s monetary policy ­under the new act thus began during the tenure of bank governor Masaru Hayami and deputy governors Sakuya Fujiwara 88

and Yutaka Yamaguchi. Eventually I was appointed as executive director in July 2002 for a term of four years by the finance minister, with the recommendation of the Policy Board of the bank. As executive director, I looked ­after the Monetary Affairs Department, the Financial Markets Department (which conducted market operations), and the Institute for Monetary and Economic Studies (which conducted basic research). The framework for the conduct of monetary policy had changed significantly ­under the new Bank of Japan Act. The most impor­tant change was that the bank could conduct policy in­de­pen­dently, and the Policy Board became the decision-­making body for policy in both letter and substance. ­Under the old act, monetary policy was formally determined by the board, but in substance, the governor had the ultimate say, with impor­tant supporting roles played by the executive director in charge of the Monetary Affairs Department, the director general of the department, and the division chief supporting the director general. When the new act took effect, the Monetary Policy Meetings (MPMs) of the board ­were inaugurated; ­these ­were to be the key meetings for decision making on the conduct of monetary policy. The nine voting members attending the MPMs are the governor, two deputy governors, and six other members of the Policy Board. The act also allows the minister of finance and the minister in charge of economic policy or their representatives to sit at the meeting t­able representing the government. They do not have voting powers, but have powers to submit proposals or request a postponement of decisions. In addition, staff responsible for preparing policy discussions attend the meetings.

­R UNNING THE MONETARY POLICY MEETINGS When the arrangement began in 1998, the MPMs at the Bank of Japan ­were held more than twenty times a year, following a provision in a cabinet order that stipulated that they be “convened twice a month, as a practice, at sufficient intervals.” The Bank’s MPMs seemed too frequent.1 Most members of the MPMs thought that once a month, like similar meetings at overseas central banks, would suffice. Accordingly, the number of meetings w ­ ere gradually pared down within the bounds of the cabinet order provision, and eventually, when I was governor, the practice was to hold fourteen meetings—in princi­ple, once a month and two in April and October. The meetings lasted for two days, except for the extra meetings in April and October, which w ­ ere one-­day meetings. Through deliberation at the MPMs, the bank had to articulate its views on economic and monetary developments and set guidelines for money market The Zero Interest Rate Policy | 89

operations. ­These guidelines took the form of an operational target given to the Financial Markets Department, which was the frontline section for the ­actual implementation of monetary policy. In many cases, such operational targets w ­ ere the level of the short-­term interest rate, or more specifically, the call rate (the overnight interbank rate), but as the rate approached the zero lower bound (ZLB) of interest rates, other operational targets ­were selected. What­ ever the target, the Financial Markets Department would, as instructed, purchase financial assets from banks and securities ­houses or lend money to them against collateral. In other words, the department would supply funds, which would appear as additional balances of current accounts that banks and securities h ­ ouses held at the bank. Financial institutions could draw down their current accounts with the bank and obtain banknotes. The funds that the central bank supplied w ­ ere the sum of the current account balances and banknotes in circulation, and called the monetary base. The central bank managed the levels of current accounts or the interest rate levels of funds supplied. This ­affected the availability and demand of current account balances, which, through vari­ous channels, resulted in vis­i­ble outcomes. The way MPMs are run has remained more or less the same over the years. On the first day, the meeting begins with staff members from vari­ous departments briefing and take questions from Policy Board members on economic and monetary developments. The second day is devoted to discussion among members. This discussion is divided into two parts, with members’ views on economic and monetary developments in the first part and views on the conduct of monetary policy in the second. The order of members’ opening remarks is determined before each meeting, and rotates from one MPM to another. The governor, who is also the chair of the MPM, always speaks last, a­ fter all other members have spoken. This practice takes into account the risk that ­free expression of views might be discouraged if the governor speaks ­earlier. Of course, once all the members have made their opening remarks, members freely speak out, and a­ fter voting members’ views are exhausted, it is the turn of the government representatives to speak. A ­ fter all of this, a vote is taken to determine the course of monetary policy u ­ ntil the next MPM. On the day the MPM is concluded, a brief document is released, followed by a press conference by the chair of the MPM at 3:30 p.m., which lasts for about an hour. During my time as governor, the publication of the minutes of the MPMs came approximately one month l­ ater. This lag was due to the provision in the act mandating its approval by the next MPM. A verbatim transcript would be published a­ fter ten years. Such transparency provisions are generally 90 | ­Career Building at the Bank of Japa

more comprehensive than ­those of other central banks. For example, at that time, the only major central banks that held press conferences ­after each policy meeting w ­ ere the Eu­ro­pean Central Bank and the Bank of Japan, and transcripts ­were released only by the Federal Reserve Board (FRB) and the Bank of Japan.2

THE ADOPTION AND TERMINATION OF THE ZERO INTEREST RATE POLICY When I moved to the Monetary Affairs Department, one big issue that had emerged was ­whether it was appropriate to wind up the zero interest rate policy. Looking back, the overnight interbank rate had already been lowered to around 0.5 ­percent in 1995. This level was already so low that some p ­ eople might regard it as “practically zero.” In fact, ­after the global financial crisis (GFC) of 2007–9, the use of this phrase became rather common. What the Bank of Japan ­adopted at the MPM in February 1999 was a zero interest rate policy in a literal sense. At that time it was de­cided that the interest rate on call money would be allowed to fall to zero, and that such policy would be maintained ­until concerns over deflation had dis­appeared. The latter was a policy that attempted to ease monetary conditions in the face of the ZLB of interest rates by driving down long-­term interest rates through committing to sustain a zero interest rate into the ­future. This approach, which is now usually described as forward guidance, was then coined as the policy duration effect. Unconven­ tional monetary policy is the term describing policy mea­sures ­adopted ­after ­there is no longer room to make use of the conventional mea­sure of controlling short-­term interest rates, and the Bank of Japan was the first central bank to adopt such a policy, despite extreme uncertainty as to its effects.3 I had not the slightest idea at that juncture that, ten years on, many central banks around the world would be adopting vari­ous unconventional mea­sures. Prob­ably nobody had such thoughts. In the first half of the year 2000, the Japa­nese economy was in a cyclical upswing, and according to the summary of the Bank of Japan’s Monthly Re­ port of Recent Economic and Financial Developments, “The improvement in Japan’s economy is becoming distinct. Recovery has started in some areas of private demand, as seen in a gradual upturn in business fixed investment.” 4 Looking at the Tankan business survey, business sentiment fell in December 1998 at −51 percentage points for manufacturing large enterprises, which had improved to a positive 3 percentage points by June 2000. Since the bank The Zero Interest Rate Policy | 91

had committed itself to maintaining a zero interest rate u ­ ntil concerns over deflation had dis­appeared, in the discussions on the course of monetary policy, economists hotly debated ­whether “concerns over deflation” remained or not. Eventually, at the MPM in August 2000, the policy interest rate was raised from zero to 0.25 ­percent, with seven votes for and two against it. At that meeting, the government proposed that the decision be delayed, but that proposal was defeated by a vote of eight to one. Leading up to this decision, I had rather mixed feelings regarding the termination of the zero interest rate policy. As the head of the department, my mission was to follow the decisions made by the MPM and ensure that agreed-­upon policy was implemented as de­cided and was appropriately communicated to the public. At the time I began to lead the department, discussions among MPM members ­were broadly pointing in the direction of ending the zero interest rate policy. While I had reservations about increasing interest rates at that moment, the consensus of MPM members had already formed, and it was my responsibility to see that their views w ­ ere not thwarted. My view was heavi­ly influenced by my experiences at the Financial System Department in the first half of the 1990s; I knew that financial institutions had not gotten rid of their nonperforming loans and the balance sheet adjustment of the ­whole economy was not complete. I believed that in such an environment it was difficult for the Japa­nese economy to return to a path of sustained growth. ­Today the termination of the zero interest rate policy in 2000 is often criticized as a m ­ istake. Some critics argue that the termination led to the deterioration of business conditions and subsequent deflation. I believe that this assessment is invalid, even though I was not for a rate hike. The reason is found in the fact that the increase in the ­actual borrowing cost of businesses was only minuscule. As was stated in the postmeeting policy statement, the end of the zero interest rate policy was only “a small adjustment to the degree of monetary easing in line with the improvement of the economy.”5 Nobody at the Bank of Japan had dreamed of successive rate increases, and financial markets participants seemed to concur. In fact, the yield on ten-­year Japa­nese Government Bonds (JGBs), which was at 1.65 ­percent at the end of July, peaked at only 1.95 ­percent on September 6 and remained between 1.5 ­percent and 1.8 ­percent from October onward. The extremely accommodative monetary environment had not changed. Accordingly, I doubt that the ending of the zero interest rate policy had any meaningful effect on the subsequent path of business conditions or prices. Nevertheless, it gave detractors of the bank ammunition to blame it for the subsequent deterioration of economic conditions and defla92 | ­Career Building at the Bank of Japa

tion. Ten years hence, in the midst of the Eu­ro­pean debt crisis, other central banks, including the Eu­ro­pean Central Bank and the Swedish Riksbank, had to backtrack on their rate increases within a short period of time. They, too, received the same kind of criticism, which I felt was a bit unfair.

DEFINING PRICE STABILITY The decision to terminate the zero interest rate policy in 2000 hinged on ­whether you believed that the threat of deflation had been dispelled. Debates on this question led to a strong call on the Bank of Japan from the po­liti­cal establishment and economists to clearly outline what it meant by “price stability.” Consequently, the bank was practically pushed into conducting a study on the subject, the launch of which was announced in March 2000. The report of a comprehensive study of price stability was then published in October of the same year ­after deliberate discussion at the MPM.6 It concluded that the bank should regularly publish its views on its outlook of the economy and prices twice a year, in April and October, in a publication titled Outlook and Risk Assessment of the Economy and Prices. This is the origin of the Outlook Report, which has been regularly published ever since, and which is a peer of inflation reports or monetary policy reports issued by overseas central banks.7 That report on price stability had a detailed account of discussions regarding the Bank of Japan’s view on price stability. Some economists and politicians at that time ­were adamant that the bank should adopt a 2 ­percent inflation target, but the bank de­cided against any quantitative definition or target. Instead it ­adopted and published a qualitative definition: “Price stability, a situation neither inflationary nor deflationary, can be conceptually defined as an environment where economic agents including ­house­holds and firms can make decisions regarding such economic activity as consumption and investment without being concerned about the fluctuation of the general price level,” which was essentially what Paul Volcker and Alan Greenspan had embraced when they each chaired the FRB.8 One reason for not adopting a quantitative definition was very practical: the differences in views among the members of the Policy Board was so large that it was almost impossible to arrive at one number. Th ­ ere was also a substantive reason: the board had an acute concern over announcing a 2 ­percent target, which it regarded as unattainable in the short term. Notwithstanding this, once such a target w ­ ere set the bank might have been forced into aggressive strengthening of monetary easing in a mechanical manner so as to realize the The Zero Interest Rate Policy | 93

target, which could have brought about serious side effects. Nevertheless, members of the board generally shared the view that a slightly positive inflation was desirable in the long term, and the October  2000 report carefully reflected the divergent opinions within the board. The following excerpts regarding the stability of prices show that the board left no stone unturned, covering all the impor­tant issues that subsequently came up: • Price indexes entail bias, but it is not easy to obtain a reliable estimate of the magnitude of bias. Furthermore, the magnitude can vary. • Considering that nominal interest rates cannot be reduced below zero, monetary policy should be conducted carefully with due attention given to preventing the economy from falling into a deflationary spiral. From such a viewpoint, it is worthwhile examining a policy whereby the central bank conducts monetary policy aiming at a small but positive mea­ sured inflation rate. • The conduct of monetary policy may change depending on ­whether price fluctuation is due to demand-­side or supply-­side ­factors. • In light of experience during the ­bubble period, fluctuation in asset prices may have a big impact on the economy even though mea­sured price indexes are stable.9 Of ­these four points, the first two w ­ ere impor­tant issues to be considered if a 2 ­percent inflation target was to be set. The latter two ­were essential in determining the appropriate role of inflation rate within the monetary policy framework. Unfortunately, the importance of the latter points was not sufficiently appreciated.

THE ESTABLISHMENT OF THE COUNCIL ON ECONOMIC AND FISCAL POLICY In early 2001 the government made two impor­tant decisions that afflicted the subsequent conduct of monetary policy by the Bank of Japan. One was the establishment of the Council on Economic and Fiscal Policy, in January, and the other was the “declaration of deflation,” issued in March. The decision to establish the council had already been made ­under Prime Minister Ryutaro Hashimoto in 1997. According to the Act for Establishment of the Cabinet Office, the council was to “[carry] out surveys and discussions on impor­tant economic and fiscal policies,” including “basic policies for general 94 | ­Career Building at the Bank of Japa

economic management, basic princi­ples of fiscal management and basic princi­ ples of bud­get formulation” in response to “inquiries by the Prime Minister.” When the Council on Economic and Fiscal Policy was established, the Bank of Japan was confronted with a very difficult decision: Should the bank’s governor attend the council’s meetings? The council was chaired by the prime minister, and its membership consisted of key government ministers responsible for economic policy, including the finance minister and the minister of state for economic and fiscal policy, and four experts from the private sector. It was to conduct fact-­finding and discussions leading to the formulation of the government’s basic policies for general economic management. The law stipulating its establishment has a provision allowing the prime minister to appoint the head of relevant organ­izations, which envisages the governor becoming a council member. Whereas the council was supposed to play only an advisory role on policy, if and when the government’s “basic policies for general economic management” ­were debated, it was unlikely that monetary policy would ­ ere the case, the governor, who is just one memfall out of its purview. If that w ber of the bank’s Policy Board, would be forced to be in the awkward position of having to discuss the conduct of monetary policy at the council with government ministers. In my view, both at the time and ­today, this was an inappropriate institutional arrangement. Nevertheless, it was practically impossible for the Bank of Japan to decline the invitation from the government to be part of the Council on Economic and Fiscal Policy, especially against the backdrop of the row between the government and the bank regarding the termination of the zero interest rate policy a few months ­earlier. In the end, the bank allowed the governor to become a member of the council, a­ fter obtaining the approval of the bank’s Policy Board. At the first meeting of the council, the bank governor, Hayami, attempted to warn against discussing monetary policy by noting that “the conduct of monetary policy must be determined by the MPM.” Against this, Masaaki Homma, a professor at Osaka University and one of the private-­sector members, immediately jumped in to stress the importance of “not creating any taboos,” which foreshadowed the awkward discussions at subsequent meetings of the council.10 ­ ntil July 2002, I was pre­sent at the meeting of the council as an observer u when I was promoted to executive director. The council was utilized by the government as a con­ve­nient mechanism for exerting pressure on the Bank of Japan, although the mechanisms through which the government expressed its view on monetary policy ­were clearly stipulated in the Bank of Japan Act: attendance of representatives of the government at the MPMs, disclosure of The Zero Interest Rate Policy | 95

government views thorough a release of MPM minutes, and so on. While I do not dispute the necessity of maintaining good direct communications between the leaders of the government and the bank, the council was a most unusual forum in which to exchange views on monetary policy for a mature economy.

THE GOVERNMENT DECLARES DEFLATION Along with the establishment of the council, another impor­tant decision—­ seemingly scholarly but potentially most harmful—­was made at the time by the government. That was the change in the long-­held definition of the term deflation. The year-­on-­year change in the Consumer Price Index (CPI) turned negative in 1998, and remained in slightly negative territory for some time. The latest available reading just before the end of the zero interest rate policy was the June 2000 number, which registered negative 0.3 ­percent for all items excluding fresh food. Previously, deflation was commonly understood as a situation in which price declines coexisted with weak economic conditions. In other words, it had been understood that the decline in prices alone did not signal deflation. Such understanding was suddenly turned on its head by the declaration of deflation by the government in March 2001. The Cabinet Office submitted a report to the regular ministerial meeting on monthly reports on economic developments, which is also attended by the governor of the Bank of Japan, claiming that “the Japa­nese economy is in mild deflation.” The new definition looked only at a sustained decline in prices irrespective of economic conditions. This declaration, together with the new definition of deflation, had a huge impact on subsequent policy debates. The mechanism for affecting such debates was subtle. First, the word deflation fueled a sense of horror associated with the ­Great Depression of the 1930s, which created the impression that it was something to be avoided at all costs. Second, despite the new definition, which focused exclusively on price declines, p ­ eople w ­ ere naturally using the word deflation to loosely describe unsatisfactory economic per­for­mance of any sort. As a result, the popu­lar debate on deflation became ever more confused. Third, the new use of the term deflation created the impression that the prob­ lem could be easily solved by “printing money.” From 2001 onward, it became quite customary for the government to say “Beating deflation is the most impor­tant challenge facing Japan.” It was almost a mantra. ­There w ­ ere other prob­ably more impor­tant circumstances in Japan, such as the rapid aging of the population, the low birth rate, and fiscal shortfalls, 96 | ­Career Building at the Bank of Japa

that ­were more fundamental and worthy of a declaration from the perspective of arousing national consciousness, but that was not to be. I believe that it was wrong to assert that putting an end to the decline in prices, or exiting from deflation, ­were the most impor­tant issues facing the Japa­nese economy. The declaration of March 2001 was one of the most ill-­advised government actions I can remember in the context of the subsequent conduct of economic policy.

VIEWS IN ACADEMIA Meanwhile, views emphasizing the perils of deflation w ­ ere beginning to catch on among academics. One of the leading professors of macroeconomics in Japan, Takatoshi Ito of the University of Tokyo, published a book titled Infla­ tion Target Policy in November 2001, claiming that “Japan is already in a deflationary spiral” and advocating the adoption of inflation targeting. More specifically, he called for a target inflation rate between one and three p ­ ercent, to be achieved within two years. Certain section headings in his book—­“the Bank of Japan Must Show Its Resolve,” and “Change the Expected Rate of Inflation!”—­best captured his argument. In a section ­under the heading “Inflation Can Be Perfectly Achieved,” he argued, “The monetary authority only needs to adopt policies that have been deemed ‘inappropriate’ in a conventional inflationary environment. For example, it can conduct large-­scale quantitative easing, increase its outright purchases of long-­term government bonds, or purchase equities.”11

THE ADOPTION OF THE QUANTITATIVE EASING POLICY In the real economy, global economic conditions w ­ ere deteriorating rapidly following the bursting of the dot-­com ­bubble. The speed of weakening surprised many central banks, including the Bank of Japan. Looking at the decisions of the Federal Open Market Committee in the United States, where the prob­lems originated, the outlook of the central bank changed suddenly: the central bank was showing concerns over inflation instead of a recession as late as November 2000, but put the emphasis on the latter by December. Such a sea change in the global economy affected the Japa­nese economy as well. The Bank of Japan changed its economic outlook accordingly, and ­after showing caution regarding the possibility of slowing exports in December 2000, it clearly downgraded its assessment of economic conditions as the new year The Zero Interest Rate Policy | 97

dawned. Reflecting such changes in views, the bank changed the course of its monetary policy ­toward easing in February 2001 and lowered the policy rate from 0.25 ­percent to 0.15 ­percent. At the MPM of March 19, the bank ­adopted QE policies, which ­were the first of their kind. Quantitative easing, though a somewhat misleading expression, had three pillars. The first was the change in the operational target from a price to a quantity, from the level of the interest rate charged on call money to the quantity of the aggregate balance of current accounts at the Bank of Japan, which was initially set at 5 trillion yen. The second involved the bank committing itself to maintaining the QE u ­ ntil such time as the year-­on-­year increase in the consumer prices remained stably above zero ­percent. Given that an ample supply of current account balances would effectively drive down the call money rate to zero, the second commitment essentially implied that the zero interest rate would be maintained for a while. This was “forward guidance” in t­ oday’s parlance. The third pillar involved increasing the bank’s purchases of long-­ term JGBs if that was deemed necessary by the bank to efficiently maintain a supply of current account balances. With regard to this pillar, in order to clearly show that the purchases w ­ ere not for the purpose of assisting the government’s fiscal funding, the purchases ­were to be ­limited to the outstanding amount of the bank’s banknotes in circulation.12 This limit came to be known as the “banknote rule.”

THE BANK’S VIEW ON THE ROLE OF QUANTITY Quantitative easing consisted of two ele­ments from the viewpoint of how monetary policy would influence the economy. One was the expansion of the current account balances, which corresponded to the “quantitative” moniker. The other was a commitment to sustain the zero interest rate, or the forward guidance, which might not fit entirely well with the image engendered by the quantitative description. The former invoked overtones of the quantity theory of money, envisaging a mechanism through which an increase in the current account balances at the central bank should positively affect economic conditions and prices through an expansion of lending and the money supply. The latter, on the other hand, focused on the pro­cess where lower medium-­and long-­term interest rates brought about by the forward guidance benefited business conditions and prices. Regarding the latter, its magnitude was an open question, but it had already been embraced once by the Bank of Japan when it had a­ dopted the zero interest 98 | ­Career Building at the Bank of Japa

rate policy, and ­there was a consensus among bank Policy Board members that it could work. Accordingly, it was ­adopted without much trou­ble. The difference from the zero interest rate policy period was that the commitment was much more specific: “The new procedures for money market operations continue to be in place ­until the CPI (excluding perishables, on a nationwide statistics) registers stably a zero p ­ ercent or an increase year on year.”13 At the same time, however, ­there was a heated debate on the role of quantity right up to the moment of voting. While the words quantitative easing suggested that the impact would come not from interest rates but from quantity, many board members ­were skeptical of the benefits of increased quantity. One ardent supporter was board member Nobuyuki Nakahara, who was a longtime advocate of targeting the current account balances. But several members ­were concerned that if the bank seemed to attach significance to quantity, communication regarding monetary policy could become difficult in the f­ uture. The remarks by a deputy governor, Yutaka Yamaguchi, ­were an illustration of the disquiet among members: I would say that our discussion is now leaning ­toward some sort of reserve targeting. While I do not want to destroy the emerging consensus, I believe that we need to further discuss some caveats. One is that we are taking a leap from our current policy framework centered on interest rates. Should we say so easily that we are moving t­ oward quantity? A short while ago, member [Kazuo] Ueda noted that we cannot deny taking advantage of some fantasy on quantity, and that, I admit, is inevitable if we attempt to influence expectations. I w ­ ill not block the decision for that reason, but the longer we continue with such explanation so as to take advantage of such illusion, the risk becomes larger. . . . ​We duly need to note such a risk.14 Reading this ­today, we can understand how prescient Yamaguchi’s remarks ­ ere. In spite of his concerns, which foreshadowed what would unfold over the next w two de­cades, QE was ­adopted in other developed economies in the end. The Policy Board of the Bank of Japan made the decision ­because it prob­ably concluded that given the grim outlook for the economy, risks should not deter the board from trying new mea­sures. At the time another conceivable option was to stop at returning to the zero interest rate policy and making a firmer commitment on the duration of policy, but that was not taken up, most likely b ­ ecause ­there was no scalability if and when the economic outlook worsened further. The target for the aggregate current account balances was increased successively from 5 trillion yen at the beginning to 17 to 22 trillion when governor The Zero Interest Rate Policy | 99

Hayami retired in March 2003. Toshihiko Fukui became governor, and on the day of his appointment, a co­ali­tion led by the United States began its invasion of Iraq. Fukui was supportive of increasing current account balances, and the target was increased in a stepwise fashion from 17 to 22 trillion at the time of his appointment to 30 to 35 trillion. Since aggregate required reserves amounted to about 5 trillion yen at that time, that final target meant that excess reserves would top 30 trillion yen. That amount might seem miniscule compared with current levels (496 trillion yen at the end of January 2021), but it was then a staggering amount, corresponding to 7 ­percent of nominal gross domestic product. In order to raise the current account balances, the Bank of Japan basically used two types of market operations: short-­term-­fund-­supplying operations with private financial institution counterparties, and purchases of long-­term JGBs. The latter purchases began at 400 billion yen per month, and ­were eventually increased to 1.2 trillion yen per month. The approach ­here also differed between the regimes of Hayami and Fukui, with Hayami increasing both short-­ term and long-­term operations, and Fukui increasing only short-­term operations with private financial institution counterparties. In order to solicit a sufficient number of bids from financial institutions to take up funding, the duration of operations had to be increased gradually, with the average duration exceeding six months by the ­middle of 2005.

EFFORTS TO INCREASE THE EFFECTIVENESS OF POLICY As noted above, most members of the Policy Board of the Bank of Japan believed that it was through a decline in interest rates that monetary easing would benefit the economy. The level of medium-­and long-­term interest rates was composed of medium-­and long-­term risk-­free interest rates that w ­ ere the sum of average expected ­future short-­term interest rates and a premium due to duration (the term premium), as well as a premium reflecting the credit risk of private borrowers. Accordingly, if the Bank of Japan wished to lower medium-­and long-­term interest rates faced by private borrowers, it had three options. The first was forward guidance, which would lower the risk-­free rate. The second was compressing the term premium by influencing the supply and demand of medium-­and long-­term JGBs through the purchases of such bonds. The third was to compress the credit risk premium through purchases of private risk assets. Over the course of deploying QE, the bank a­ dopted all three, but it placed the strongest emphasis on forward guidance. The purchases of medium-­and long-­term JGBs 100 | ­Career Building at the Bank of Japa

­ ere designed as tools for supplying funds, with incidental effects on the condiw tions of supply of and demand for bonds. For the Bank of Japan’s monetary policy to affect economic conditions and prices, it was necessary to have lower (risk-­free) interest rates translated into more accommodative credit conditions faced by the private sector. The first mea­sure a­ dopted was the purchase of stocks held by financial institutions, beginning in November 2002. This was deliberately designed as a policy mea­sure to restore the stability of the financial system and not regarded as part of monetary policy. Nevertheless, its purpose was to get rid of a vicious cycle: when prices of stocks held by financial institutions fell, ­those institutions had to hold back lending. At the end of March 2002, major Japa­nese banks held about 25 trillion yen worth of stocks, which was as high as approximately 140 ­percent of the banks’ Tier 1 capital.15 Most consisted of cross-­held shares, where banks and nonfinancial firms held the stock of each other. With the prob­lem of nonperforming loans not solved, t­ here w ­ ere concerns over the capital adequacy of banks, and in such a situation, once economic conditions deteriorated the fall in the value of stocks on the balance sheets of banks tended to hold up bank lending, thus creating a vicious cycle. Th ­ ere ­were growing calls for increasing the purchases of long-­term JGBs or current account balances, but I was skeptical of the benefits of such actions in view of the already low levels of medium-­and long-­term interest rates. I was e­ ager for the bank to adopt mea­sures that would make our policy actions more effective. Given the difficult economic conditions we still faced, I believed that anything was worth a try—­even if it was unconventional—­ provided that the mea­sures w ­ ere within the bounds of the Bank of Japan Act. That was my thinking as I entered the office of the deputy governor, Yutaka Yamaguchi, with Hirohide Yamaguchi, director general of the Monetary Affairs Department, a few days before the MPM on September 18, when I advised Yamaguchi that the time was ripe for the bank to begin purchasing stocks held by financial institutions. The deputy governor concurred immediately; I suppose he had been thinking along the same lines for some time. The idea that the bank should purchase stocks held by financial institutions was previously identified as an option to deal with the nonperforming loans prob­lem by bank staff responsible for financial stability affairs, but since it was unconventional in the extreme, I believe that few in the bank thought it would be implemented. As the MPM on September 18 noted, “A stock price decline could affect expenditures by the corporate and ­house­hold sectors through vari­ous channels. The Zero Interest Rate Policy | 101

Moreover, given the current economic and financial situation, it could threaten the stability of financial markets and the financial system.”16 In view of this assessment, a regular (non-­MPM) meeting of the Policy Board was convened to introduce the purchase of stocks held by financial institutions as a policy pursuing financial stability. The fundamental objective of the policy was to cut the linkage between stock prices and the real economy by transferring the risk of fluctuating stock prices from financial institutions to the Bank of Japan. Purchases began with an initial cap of 2 trillion yen, which was ­later increased to 3 trillion yen u ­ nder Fukui. This decision to begin purchasing stocks from financial institutions was greeted with much surprise. I believe that the mea­sure was effective in halting the vicious cycle of falling stock prices and hesitant banks, and in stabilizing the macroeconomy. It also underscored the view that monetary and financial stability policies are intertwined. The mea­sure was the Bank of Japan’s initial version of “credit easing”—­a strategy eventually ­adopted by the Bank of ­England and the Eu­ro­pean Central Bank ­after the GFC. Another unconventional mea­sure was the purchase of asset-­backed securities and asset-­backed commercial paper, beginning in July 2003. The intent of the mea­sure was to improve the functioning of credit intermediation channels outside the banking sector, which was not e­ ager to lend to small-­and medium-­ size enterprises. ­These securitized products ­were just beginning to be used, and the Bank of Japan made efforts to broaden their ac­cep­tance, in parallel with the bank’s purchases. The bank sponsored the “Securitization Market Forum” in cooperation with market participants, and advocated the removal of impediments to the development of the market for t­ hese products, including enhanced disclosure regarding securitization.

FOREIGN EXCHANGE MARKET INTERVENTIONS ­ fter the adoption of QE, one of the most widely discussed additional chanA nels to further ease monetary conditions was the exchange rate. One prominent example of such discussion was a paper presented by Lars Svensson of Prince­ton University (­later deputy governor of the Swedish Riksbank) at a Bank of Japan research conference in July  2000, which advocated pegging the yen to a significantly lower level through unlimited purchases of foreign exchange.17 In fact, during the period of QE, foreign exchange market interventions ­were quite frequent. In par­t ic­u ­lar, interventions between January 2003 and 102 | ­Career Building at the Bank of Japa

March 2004 amounted to 35.3 trillion yen in the aggregate. While I was skeptical of the effects of interventions, it was a ­matter for the Ministry of Finance to decide when and how to act, and the Bank of Japan was only acting as the ministry’s operational agent. The real question regarding the ministry’s interventions was w ­ hether a country would be “allowed” to conduct large-­scale market interventions for the purpose of depreciating its exchange rate. The answer might have been yes in the case of a small open economy, but most ­people thought that it would not be allowed for a large economy like Japan. Recognizing that direct intervention was not pos­si­ble, t­ here ­were active debates on an alternative scheme—­namely, the purchase of foreign currency denominated assets by the Bank of Japan. The line of the argument was that even if deliberate interventions by the ministry ­were not pos­si­ble, the bank should still be able to purchase bonds denominated in foreign currencies. Nevertheless, the new Bank of Japan Act explic­itly prohibited the bank from purchasing foreign exchange for the purpose of influencing the exchange rate (see chapter 4). Accordingly, if the bank ­were to purchase foreign currency, it must maintain that the purchase was a mea­sure to maintain price stability. Even so, every­one would be aware that the real objective of purchasing foreign currencies was the same no ­matter who was purchasing them. The answer would again depend on the seriousness of the issues facing that economy, the size of that economy, and the concurrent global economic conditions. In the period between the second half of the 1990s and the early years of the new millennium, I cannot categorically say that the bank could not have bought any foreign currency denominated bonds, but it was highly unlikely that international ac­cep­tance would be forthcoming by simply switching the purchasing body from the ministry to the bank.

THE MONETARY BASE AND THE EXCHANGE RATE Another thread of discussion regarding the exchange rate involved the view that the Bank of Japan could induce the exchange rate to depreciate by increasing the monetary base. If participants in the foreign exchange market believed in such a causality, an increase in the monetary base might result in a weakening of the yen in the short term, but when one examines ­actual data regarding exchange rates between the US dollar and the yen, the euro and the US dollar, or the euro and the yen over longer periods, no such relation is evident. In fact, the yen depreciated against the US dollar the most between early 2006 and July 2007, which was when the current account balances at the bank ­were declining The Zero Interest Rate Policy | 103

the most as a result of it ending its QE. Notwithstanding ­these facts, this mirage for many analysts linking the monetary base and the exchange rate never went away during the governorships of Hayami, Fukui, or myself. ­There was another, related, issue. E ­ very time foreign exchange market interventions ­were conducted, the Bank of Japan faced demands that it should not “sterilize” the interventions. ­Those who argued that interventions should not be sterilized assumed that if yen funds paid out by the government ­were left in the market, the yen would depreciate, and if ­those yen funds ­were taken away, the yen would not depreciate.18 In other words, considering that the difference between “sterilized” and “unsterilized” interventions is the level of the monetary base, they ­were saying that increases in the current account balances at the central bank or the monetary base would lead to a depreciated yen. But real-­world data did not show such a relationship. Moreover, interventions in Japan are conducted with yen funds obtained by the Ministry of Finance issuing short-­term government bills, which means that ­every intervention is automatically “sterilized.” Whereas monetary easing might influence the exchange rate when it created a perception that interest differentials could widen, that did not necessarily happen by just increasing the current account balances. The distinction between “sterilized” or “unsterilized” interventions is still often made by some academics, but it is a concept that loses meaning once the central bank sets a specific monetary policy stance. The distinction was an intellectual legacy of the debate in periods when central banks did not announce their monetary policy stance, but the w ­ hole debate was now futile. Nonetheless, when the Bank of Japan attempted to explain the fine points as thoroughly as pos­si­ble, it invited criticism that the bank was not keen to put the brakes on an appreciating yen. Consequently, Fukui de­cided not to discuss this issue head-on, and always said that “the bank is supplying ample funds to the market including yen funds made available through foreign exchange ­interventions” so as to avoid being dragged into this hollow debate.

THE YEN CARRY TRADE The ­actual exchange rate of the yen generally firmed up ­after the Bank of Japan ­adopted QE. From mid-2004 on, the yen gradually weakened (see fig. 5.1), which was the result of increasing interest rate differentials, reflecting the diverging orientation of monetary policy in Japan and abroad. Exchange rates are now increasingly determined by private economic agents’ choice among financial assets and liabilities of dif­fer­ent currencies, and against 104 | ­Career Building at the Bank of Japa

Japanese yen / US dollar exchange rate 100 105 110 115 120 125 Japanese yen / US dollar (invert scale) 130 135 2000

2001

2002

2003

2004

2005

2006

2007

Figure 5.1 ​The exchange rate between the US dollar and the Japa­nese yen. Source: Bank of Japan.

the backdrop of increasing global capital flows; in this environment, interest rate differentials strongly impact how investors select assets. More specifically, investors focus on the differences in the expected paths of monetary policy among economies—in other words, the expected paths of domestic and overseas policy interest rates into the ­future. When QE began, the global economy was in a downturn. Consequently, policy rates w ­ ere trending lower everywhere, and given that the Japa­nese policy rate was at zero with no further room for reduction, it was not pos­si­ble to expect any widening of interest rate differentials. In contrast, once overseas economies began recovering, investors began to expect increases in overseas policy rates, which resulted in wider interest rate differentials. That was the mechanism ­behind the weakening of the yen beginning in mid-2004. Looking at the nominal effective exchange rates of major economies, the yen’s depreciation was the most pronounced between 2004 and 2007 (see fig. 5.2). This period was marked by a surge in the yen carry trade, which is a transaction that invests yen borrowed at a low interest rate in a high-­yielding currency. According to the theory of open interest rate parity, the difference in yields between investing and funding currencies should be offset by movements in the exchange rate, which means that the expected rate of return for a carry The Zero Interest Rate Policy | 105

(Index, January 2000 = 100) 130 Japanese yen UK pound Australian dollar 120

US dollar Swiss franc

Euro Korean won

110

100

90 Appreciation 80

70 2000

Depreciation 2001

2002

2003

2004

2005

2006

2007

Figure 5.2 ​The nominal effective exchange rate (narrow index). Source: Bank for International Settlements.

trade is zero. Nevertheless, in the real world, such relation is not observed, at least in the short term, and carry trades are able to earn excess returns. When interest differentials are wide and for some reason it comes to be expected that exchange rate fluctuations w ­ ill remain muted, carry trades become increasingly popu­lar. The period from the beginning of 2004 to July of 2007 saw a considerable volume of yen carry trades as overseas interest rates began to climb reflecting improving economic conditions while Japa­nese short-­term interest rates remained at zero. “Mrs. Watanabe” then became a shorthand for Japa­nese retail investors who w ­ ere thought to be b ­ ehind t­ hose trades, even if, in real­ity, both Japa­nese and overseas investors ­were actively conducting trades.

ECONOMIC AND MONETARY CONDITIONS DURING THE PERIOD OF QUANTITATIVE EASING The Japa­nese went into a downturn in November 2000, and the bottom of the cycle was in January 2002. Few thought the economy was recovering in 2002 and early 2003, and a pessimistic mood prevailed. One of the reasons for such gloominess was the fact that the prob­lem of nonperforming loans at major fi106 | ­Career Building at the Bank of Japa

nancial institutions was not yet resolved, and t­ here remained concerns over the capital adequacy of such institutions. When Fukui came into office as governor of the Bank of Japan in March 2003, even though the economy turned out to have in fact reached its trough more than a year e­ arlier, not many viewed the economy as having begun to recover. Nevertheless, looking at the bank’s Tankan survey, business sentiment for manufacturing large enterprises improved to −10 points in March  2003 from the proximate weakest point in March 2002 of −38 points. Sighs of relief regarding the economic outlook fi­ nally began to be heard when the Nikkei Index began to visibly rebound from the bottom reached in May 2003.19 Real estate prices, which ­were in a prolonged ­ ubble, also began to turn around. Acslide from the bursting of the economic b cording to official land price data, the prices of commercial lots in the Tokyo region hit bottom in 2002, and year-­on-­year increases began to become more prominent: 1.0 ­percent in 2006, 9.4 ­percent in 2007, and 12.2 ­percent in 2008. ­ ntil February 2008, and The recovery that began in January 2002 continued u at six years and one month became the longest expansion since World War II. Against the backdrop of ­these developments, ­people gradually came to feel that the Japa­nese economy had fi­nally emerged from a long tunnel of darkness. ­There ­were four primary ­drivers of the recovery. First, the Japa­nese economy in the early 2000s was fi­nally beginning to work off the “three excesses”: excess employment, excess physical capital, and excess debt. As a footnote, with regard to adjustment of employment, it was still customary for major Japa­nese firms to uphold lifetime employment, and as a result, employment in Japan was more or less a fixed ­factor of production, unlike the practice in the United States, where unneeded workers tended to be rapidly cast off through layoffs. The ten-­plus years of extended adjustment of employment reflected such customs in Japan. Second, overseas economies ­were expanding. Annual growth of the global economy between 2004 and 2007 averaged 5.2 ­percent, which substantially exceeded that of the preceding fifteen years, at 3.8 ­percent. Third, the depreciating yen supported exports and capital investments. Th ­ ese three ­drivers, to some extent, ­were brought about by the unpre­ce­dented global economic expansion riding on a global credit ­bubble. Fi­nally, ­there was another impor­tant driver: microlevel institutional reforms in Japan that ­were bearing fruit. Pro­ gress in areas such as accounting and disclosure, corporate governance, and laws and practices on corporate reor­ga­ni­za­tion encouraged better resource allocation. While macroeconomists focus their analyses on macroeconomic ­factors alone, I would like to emphasize the impor­tant role played by microlevel institutional reforms. The Zero Interest Rate Policy | 107

In the meantime, the nonperforming loans prob­lem that had long dogged the Japa­nese economy was fi­nally resolved by 2004. This was made pos­si­ble by the recovery of the Japa­nese economy, as well as capital raising by major financial institutions since the end of 2002. The capital raising was prompted by the Financial Regeneration Program, also known as the Takenaka Plan (­after then state minister for financial affairs Heizo Takenaka), which aimed at halving the amount of nonperforming loans. But one should not forget that money began to flow to banks as the financial safety net, including the use of public funds, had been put together through many efforts since the second half of the 1990s. Policy responses from the Bank of Japan prob­ably contributed as well by dispelling funding concerns at financial institutions and alleviating the risk arising from stock price fluctuations.

THE TERMINATION OF QUANTITATIVE EASING As the economic recovery began to be felt, the year-­on-­year decline in the CPI (excluding fresh food) was gradually trimmed, and from November 2005 onward the index began to show year-­on-­year increases. Against this backdrop, the exit from QE became a focus of policy debate. The Bank of Japan, ­after confirming that the year-­on-­year increase in consumer prices reached 0.5 ­percent ­ ere stably inin January 2006, de­cided at the MPM of March 9 that prices w creasing on a year-­on-­year basis and it was thus appropriate to terminate QE (see fig. 5.3). Accordingly, the target for monetary operations ­was changed from quantity to the overnight interest rate on call money. The policy rate was to be steered to approximately zero p ­ ercent. With regard to ending QE, u ­ nder discussion was often w ­ hether to cut quantity first or to increase the policy rate first—­that is, a so-­called exit strategy. In the case of the Bank of Japan at that time, however, t­ here was no choice but to cut quantity first in view of the massive current account balances just before the termination of QE. As long as ­there was a huge amount of excess reserves (approximately 26 trillion yen), short-­term interest rates should hover around zero ­percent ­unless the central bank was allowed to pay interest on the reserves. Consequently, the practical operational issue was to first reduce the current account balances to a level consistent with required reserves and to allow the transition to a regime centered on adjusting the interest rate. At that time, the bank’s outstanding short-­term-­fund-­supplying operations totaled about 60 trillion yen, and the average duration was relatively short at just over three months. This enabled the bank to smoothly reduce quantity by not rolling over 108 | ­Career Building at the Bank of Japa

(Year-on-year, %) 1 0.8 0.6 0.4

CPI (benchmark, year 2005) CPI (benchmark, year 2000)

0.2 0 –0.2 –0.4 –0.6 –0.8 –1 –1.2 2001

2002

2003

2004

2005

2006

Figure 5.3 ​Consumer price inflation. Note: Excludes fresh food. Source: Japa­nese Ministry of Internal Affairs and Communications.

short-­term funding as it came due. Following such careful groundwork, the call money rate target was increased to 0.25 ­percent at the MPM held on July 14, 2006. Though I was involved in the preparations for the meeting, I was not pre­sent in the room ­because my term as executive director had ended two days ­earlier. The “exit strategy” had another ele­ment: the design of a new framework for ­ ere strongly the conduct of monetary policy. Many critics of the Bank of Japan w advocating the adoption of inflation targeting, and their argument had two parts. The first was to set a target rate of inflation, which was envisaged to be 2 ­percent, in line with the “global standard.” The other was to mandate the bank to reach this goal quickly, most often identifying a period of two years. If inflation targeting ­were correctly appreciated as a flexible framework for the conduct of monetary policy, its adoption would have posed no prob­lem. In Japan, however, ­actual proposals regarding inflation targeting ­were more rigid and mechanical. If ­every dislocation that endangered sustainable growth ­were to manifest itself in the rate of inflation, ­there would be no prob­lem in conducting monetary policy looking solely at inflation. In real­ity, Japan’s not-­so-­distant ­ ubble economy, its subsequent bursting, and the resultant experiences of the b The Zero Interest Rate Policy | 109

financial crisis w ­ ere at odds with such a naive view. The new Bank of Japan Act stipulated that the bank’s policy “­shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy,” by no means requiring a mechanical pursuit of 2 ­percent inflation. The Bank of Japan also had to consider the necessity of maintaining its accountability as an in­de­pen­dent central bank. I think that most members of the Policy Board believed that it was not acceptable to resist quoting a target number, just ­because ­there was a risk of it being taken out of context. That was my view as well. Accordingly, the bank made two impor­tant decisions that significantly influenced the framework for conducting monetary policy when it came off QE in March 2006. One was an attempt to outline the bank’s views on the rate of inflation to be pursued, Understanding of Medium-­to Long-­term Price Stability, which is explained below. The other was the design of two perspectives.

AN UNDERSTANDING OF MEDIUM-­ TO LONG-­T ERM PRICE STABILITY The views on the appropriate level of the target rate of inflation differed significantly among the members of the Bank of Japan’s Policy Board. Consequently, it was not practical to set one number and reach an agreement at the board. In such a situation, if the bank was to conduct monetary policy in an accountable manner, the most uncontroversial approach was to let each member numerically describe his or her understanding of stable prices, and to publish the aggregated result. This was the Understanding of Medium-­to Long-­ term Price Stability, which was described in a press release in March 2006. The specific language reads, “An approximate range between zero and two ­percent was generally consistent with the distribution of each Board member’s understanding of medium-­to long-­term price stability. Most Board members’ median figures fell on both sides of one p ­ ercent.”20 This description clarified the Bank of Japan’s view that it would not countenance falling prices; at the same time, it was inclusive of the diverse views actually pre­sent among the members of the board. I thought this a good outcome u ­ nder the circumstances. Nevertheless, many criticized this decision, particularly the point that the 1 ­percent that characterized “most Board members’ median figures” was too low. ­Others decried that the Understanding did not show the strong resolve of the bank to reach the target. ­These criticisms continued to be raised during my years as governor.

110 | ­Career Building at the Bank of Japa

THE TWO PERSPECTIVES For the a­ ctual conduct of monetary policy, it was de­cided to introduce a new framework for looking at economic and price developments from “two perspectives.” With regard to the first perspective, the bank was to determine ­whether the most probable path of the economy and prices over the next one or two years was consistent with sustainable growth ­under price stability. This was a standard procedure in a conventional inflation-­targeting framework. The second perspective was the examination of vari­ous risks that needed to be taken into account in conducting monetary policy, potentially in a longer time frame and with a view to achieving sustainable growth u ­ nder price stability. For example, the bank would look at low probability risk ­factors that could, if manifested, have had a major impact on the economy and prices, or plausible economic developments beyond the one-­to two-­year period. The second perspective incorporated the lessons of the experiences since the Japa­nese ­bubble economy and aimed at mitigating the potential shortcomings of inflation targeting.

REACTIONS TO THE TERMINATION OF QUANTITATIVE EASING Unlike what happened in August 2000 at the time of ending the zero interest rate policy, the government representatives at the MPM did not express opposition to the decisions to end QE in March 2006. Kozo Yamamoto, the chair of the Liberal Demo­cratic Party’s Monetary Policy Subcommittee, who was a longtime vocal critic of the bank, issued a surprisingly positive comment right ­after the bank’s decision. Newspaper editorials w ­ ere also sanguine, noting that it was not the amount of current account balances that mattered but the path of short-­term interest rates into the ­future. The government also removed the reference to deflation from its monthly economic report, the first time in five and a half years. Financial markets stayed essentially calm. The picture suddenly changed at the end of August, when the official series of revised CPI figures w ­ ere released, following a regular rebasing of the index, conducted ­every five years. In the revised series, the year-­on-­year changes of the index ­were on the average revised down by approximately 0.5 percentage points. Given that the condition the bank set for ending QE was to see the year-­ on-­year changes in consumer prices stably remaining above zero p ­ ercent, the new index series provided support for the bank’s critics.

The Zero Interest Rate Policy | 111

THE EFFECTIVENESS OF QUANTITATIVE EASING As explained ­earlier, QE consisted of two ele­ments: an increase in the quantity of the monetary base and a commitment to sustain zero interest rate policy. On the effectiveness of the policy, reflecting on the experiences between 2001 and 2006, I reached the following conclusions. As to the effects of quantity, the clearest impact was its stabilizing influence on the financial system. By the beginning of the 2000s, the most critical period of Japan’s financial crisis was over, but undercapitalization of financial institutions was still an issue. In such an environment, ample funds supplied ­under QE assuaged tensions over funding at financial institutions, and thus contributed to maintaining the stability of the financial system.21 Economic stimulus came from the forward guidance to continue the zero interest rate policy. We have to be clear about how forward guidance could become effective. A significant support for the economy was expected to come from the weakening of the exchange rate, resulting from the commitment to continue with the zero interest rate amid the recovery of overseas economies. In that sense it was largely a policy to take advantage of tailwinds, not a turbocharged engine. In the meantime, a mechanical stimulus of the sort suggested by the advocates of increasing the monetary base according to the quantity theory—an increase in current account balances leading to increased lending or money supply fueling the economy—­was not observed. Stimulus comes from conventional mechanics through lower interest rates. Unfortunately, such an understanding was not widely shared by analysts of the Japa­nese economy when the Bank of Japan was conducting QE.

COSTS AND BENEFITS The debate on the effectiveness of QE, which started raging at the end of the 1990s, was far from settled even a­ fter the termination of the practice. Economists who criticized the Bank of Japan’s monetary policy as less than forceful argued that QE was effective. On the other side of the debate, the most prominent was Ryutaro Komiya, who had been one of my professors during my university years. Komiya was well known for having leveled harsh criticism at the Bank of Japan’s monetary policy in the early 1970s, arguing that continued loose monetary policy was one of impor­tant c­ auses of rampant inflation at that time.22 But this time around Komiya rebuked the critics of the bank’s monetary policy for making unsubstantiated claims against the bank regard112 | ­Career Building at the Bank of Japa

ing the conduct of monetary policy since the 1990s.23 His view was that enlightened debates required identification of relevant issues, no ­matter ­whether one agreed or disagreed with the bank’s policies. This is reflected in a book, Issues in the Debates on Monetary Policy, which Komiya coauthored with the Japan Center for Economic Research. Komiya’s view was that QE had “modest costs and modest benefits.”24 As far as QE between 2001 and 2006 was concerned, it could be regarded as a policy within the bound­aries of modest costs and modest benefits, though ­there was a possibility that costs outweighed benefits. A ­ fter the GFC, however, I was no longer confident that the costs of QE would remain modest.

ISSUES RELATING TO IN­D E­P EN­D ENCE AND ACCOUNTABILITY Apart from the effectiveness issue, QE raised a series of difficult questions with regard to the in­de­pen­dence and the accountability of the central bank. First, the distinction between fiscal and monetary policies was blurred. In order to enhance monetary easing in the face of the ZLB of interest rates, the central bank should aim for compressing the term premium and/or the credit risk premium, on top of lowering risk-­free rates. In the case of lowering credit risk premiums, that would mean that the central bank might be pressured to intervene in the allocation of funds to individual private firms through purchases of debts and other instruments issued by ­those firms. This runs ­counter to one of the fundamental princi­ples of a demo­cratic society: that disbursements of funds by the public sector to individual private-­sector entities should be conducted as fiscal policy with parliamentary approval. Central bank in­ de­pen­dence is founded on the idea that the bank would only be responsible for ensuring the general availability of liquidity for determining the overall level of interest rates, leaving the specific allocation of funds to market forces. When the central bank purchases private risk assets, its actions begin to take on the ele­ments of fiscal policy, which could undermine the case for in­de­pen­dence in the medium to long terms. It remains a vexing issue to decide where to draw the line between fiscal and monetary policies.25 Second, one had to consider the relationship between structural reform and monetary policy. Th ­ ere was a broad consensus among the members of the Bank of Japan’s Policy Board that structural reform policies such as deregulation ­were essential for Japan, and without them the unambiguous return of the Japa­nese economy to a sustainable growth path would be difficult. In fact, when QE was ­adopted in March 2001, the bank’s public statement included language strongly The Zero Interest Rate Policy | 113

calling for governmental efforts to promote structural reform. Having said that, it takes time for structural reforms to bear fruit and enhance potential growth; and, further, it is difficult to discern w ­ hether observed low growth is due to low potential growth or rather due to cyclical ­factors. A call for action by the central bank could create an impression that it was reluctant to ease monetary policy. On the other hand, keeping quiet could only fuel the raging calls for more action. Meanwhile, critics of easy money would argue that monetary easing encouraged foot-­dragging in the implementation of structural reforms. Third, communication on monetary policy was not easy. Governor Fukui publicly highlighted, prob­ably intentionally, the increases in the target for the current account balances. Since I was quite skeptical of the effects of quantity as such, I was not entirely comfortable with such a communications strategy. At the same time, given that the Bank of Japan was targeting current account balances, I knew it would have been inconsistent to offer views that seemed to dispute the effectiveness of increased quantity. My deepest concern was that since the increases in current account balances did not have much effect, the bank would have to embrace unlimited increases, which for practical purposes would lead to ever-­increasing purchase of government bonds. Fortunately, as the global economy registered strong growth from 2004 onward, my fears remained unrealized, but the bank was only saved by the development of a global credit ­bubble. It did attempt to let the costs and benefits of QE be known, but any reference to costs invited criticism against the bank on the ground that such explanations themselves diluted the effectiveness of policy. Fi­nally, QE raised the issue of communicating u ­ nder a committee framework. The differences in views regarding QE ­were significant among the bank’s Policy Board members. An additional question was raised in the context of making forward guidance on the conduct of monetary policy. Even if this was expected to be effective, could a member commit to a policy that could continue long ­after the term of that member expired? ­There was ­little awareness of ­these challenges in ­earlier times. ­These awkward prob­lems regarding in­de­pen­dence and accountability became more acute following the GFC, and many central banks had to confront them.

114 | ­Career Building at the Bank of Japa

| CHAPTER SIX |

The Illusion of the ­Great Moderation The 2000s began with the bursting of the dot-­com b ­ ubble and the US recession, which spread to the rest of the world. This, however, appeared only to be a hiccup for the world economy as economic conditions improved markedly, especially from 2004 to 2007. This prompt return to the growth trajectory of the prior de­cades came to be seen proof of the so-­called G ­ reat Moderation of high growth, stable prices, and low volatility and as a vindication of monetary policy. Policy makers became much more confident of their ability to steer the economy and mainstream economic thinking. Eventually we would see that the robust economic per­for­mance of ­these years was a byproduct of a global credit b ­ ubble. But this had to wait ­u ntil the global financial crisis (GFC) of 2007–9 erupted. Meanwhile, Japan concurrently enjoyed what was at that point the longest economic expansion of the postwar era, greatly benefiting from the expansion of overseas export markets and a weak yen, both reflecting the global economic boom. Accordingly, Japan was no dif­fer­ent from the other economies in that it was not aware of the accumulating imbalances and the boost it was receiving from the global b ­ ubble.

THE GLOBAL ECONOMY PRIOR TO THE FINANCIAL CRISIS The new millennium dawned with the developed economies facing the bursting of the dot-­com b ­ ubble. But contrary to the initial pessimism, the recession in the United States was exceptionally short-­lived. The downturn, which began in March 2001, was already over by November; the US economy was in a slump for only eight months. Nevertheless, ­t here was ­little buoyancy in the economy for a while, and in view of the declining rate of inflation, between the autumn of 2002 and the summer of 2003, concerns ­were expressed about the risk of the United States sliding into a “Japanese-­style deflation.” The risk, however, remained just that, and the US economy was on the path to enjoying an extended period of growth from November 2001 to December 2007. The global 115

Year-on-year, % change 6 Average growth rate during the ten years preceding the financial crisis, 1998 to 2007 5

International Monetary Fund forecast

4 3 2 1 0 –1 –2

Emerging and developing economies Advanced economies World 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Figure 6.1 ​Global economic growth rates. Source: Shirakawa (2010b).

economy also enjoyed high growth during this period, with average growth reaching 5.2 ­percent between 2003 and 2007, which far exceeded the ten-­year average of 4.0 ­percent between 1998 and 2007 (see fig. 6.1). The highlight of this period was the rapid growth of the emerging economies, and the growth of China was the most impressive. In 2007 the size of the Chinese economy was seven times as large as it had been in 1990, registering an impressive annualized growth rate of 10.2 ­percent. The growth rate was even higher, at 10.5 ­percent, if the focus was on the period from 2000 to the end of US expansion in 2007. Very few policy makers or economists had foreseen such a growth streak at the beginning of the 2000s. I had not ­either. Comparing the size of the economies, as mea­sured by gross domestic product (GDP) in US dollars, China was only 13 ­percent of the size of Japan in 1990, but it had overtaken Japan in GDP by 2010. On reflection, many Japa­nese must have looked at China’s spectacular growth with mixed feelings in view of the fact that Japan had been the second largest economy in the world for a long time a­ fter its economy had overtaken that of West Germany in the late 1960s. Such high growth was achieved principally through the unleashing of market forces, which was essentially what Japan did during its high growth era from the mid-1950s to the early 1970s.1 China embarked on its “reform and 116 | ­Career Building at the Bank of Japa

opening-up” policy in the early 1990s, and increased its exports of labor-­ intensive manufactures, aided by its low wage costs. As this induced rising wage levels in the economy, a large-­scale repositioning of l­abor ensued from the agricultural sector to the more productive manufacturing sector and from the countryside to the cities. Consequently, real purchasing power increased (especially in the cities), the demand for infrastructure such as roads and railroads greatly expanded, and, reflecting rising income levels, the demand for housing and durables in cities r­ ose as well. Th ­ ese mechanisms for high growth can be sustained as long as ­there is room for ­labor movement from the countryside to the cities and the working-­age population is increasing in the economy. When the ­labor force is repositioned and the birth rate falls due to rising income levels, working-­age population growth ­will fall, and accordingly the growth of the economy ­will gradually decelerate. This cycle was what Japan has experienced over the past fifty years. The greatest challenge facing an economy in such a transition is to steer the economy to a new sustainable path in a smooth manner. In the case of Japan, double-­digit growth ended in the early 1970s, and the growth rate gradually declined from then on. In the case of China, the transition from high growth began before the onset of the GFC. Nevertheless, in 2007, one year before the collapse of Lehman B ­ rothers, China was still growing briskly and, in such an environment, the demand for commodities such as crude oil, iron ore, and coal was exploding, reflecting increasing infrastructure and housing investment; food consumption also soared in response to the rising national income. The resulting increases in the prices of commodities and foodstuffs induced a high growth of economies producing t­ hose commodities, which in turn contributed to the strong global growth. The Japa­nese economy greatly benefited from the robust global growth, experiencing what at that point was its longest economic expansion in the postwar era: six years and one month. Even so, the public viewed the economy as lacking vigor. One reason for such a divergence between statistics and public perception was the declining wage share of national income. The wage share in Japan ­rose above 52 ­percent during the height of the financial crisis in 1998, and then declined to below 49 ­percent in the early 2000s. Given that the lifetime employment system was still prevalent in Japan, the wage share tended to rise in an economic downturn and to decline in an upturn. The decline of the wage share in the upturn of the early 2000s followed past patterns, but it also reflected the tendency of firms to restrain wage growth, with an eye on increasing return on equity in order to meet expectations of The Illusion of the G ­ reat Moderation | 117

(Index, CY 2000 = 100) 150 140

Export deflator Import deflator Terms of trade

130 120 110 100 90 80 70 60

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Figure 6.2 ​Terms of trade. Source: Japa­nese Cabinet Office.

shareholders, against the backdrop of improved reforms of corporate governance in increasingly globalized capital markets. Another reason for a divergence between the statistics and public perception was the worsening terms of trade.2 Compared with the first years of the ­ ere lower by 20 ­percent in 2007 and by new millennium, the terms of trade w 30 ­percent in 2008 (see fig. 6.2). The worsening terms of trade meant that the growth of real purchasing power was lower than the growth rate of production as mea­sured by GDP. The loss of purchasing power amounted to more than 5 ­percent of GDP as the years wore on, reflecting both deteriorating competitiveness of Japa­nese products and the rise in international commodity prices. This appeared to be the inevitable outcome of Japan’s almost complete dependence on imported energy and raw materials. But in this Japan was no dif­fer­ ent from Germany. In the case of Japan, an impor­tant aggravating ­factor was the fall in export prices. As global competition intensified, Japa­nese firms ­were losing pricing power over their products and ser­v ices. When all is said and done, overall Japa­nese real purchasing power is not delineated by GDP but by income adjusted for the loss of purchasing power, and the fact that this figure did not grow as much as GDP was in part responsible for the public perception of a lack of robust economic recovery. 118 | ­Career Building at the Bank of Japa

ALARM OVER DEFLATION IN THE UNITED STATES The period between 2002 and 2003 was the first time since World War II that policy makers in developed economies genuinely feared experiencing deflation, though I myself thought such fear was excessive. A well-­k nown speech, epitomizing the mood of the time, was delivered by Ben Bernanke, who was then ­ nder the title “Deflation: a  governor of the Federal Reserve Board (FRB), u 3 Making Sure ‘It’ D ­ oesn’t Happen H ­ ere.” Bernanke, with a strong emphasis on the Japa­nese experience, made the case that in the United States deflation would not be tolerated and it was unlikely to happen. The speech attracted much attention. Against the backdrop of such concerns over deflation, the Federal Open Market Committee (FOMC) de­cided to cut the policy rate to 1.0 ­percent in June 2003, which was the lowest-­ever level at that time. While a statement made afterward carefully avoided the word deflation, it noted that the purpose of the rate cut was to improve inflation expectations through monetary easing. Shortly before this decision, Bernanke had a chance to visit Japan in May and to address the Japan Society of Monetary Economics in Tokyo, with a speech titled “Some Thoughts on Monetary Policy in Japan.” Compared with his past remarks as a Prince­ton University professor, Bernanke’s remarks ­were veiled, but he still sharply criticized the conduct of monetary policy by the Bank of Japan. In that speech Bernanke, with the recognition that deflation was one of the most impor­tant f­ actors holding back the Japa­nese economy, famously advocated “he­li­cop­ter money,” or overt joint action by fiscal and monetary authorities so as to escape deflation.4 On the day before the speech, I had a chance to join Bank of Japan governor Toshihiko Fukui and Bernanke for lunch, which was the first time I ever spoke with Bernanke. We had a lively discussion on deflation and quantitative easing, and it continued in my office a­ fter lunch. I had already read many of Bernanke’s papers when ­ ubble economy, and I was sympaI was writing a review of the Japa­nese b thetic to his “financial accelerator” interpretation regarding the ­Great Depression, as it seemed to offer a good framework for analyzing developments ­ ubble as well. Although I had been following the bursting of the Japa­nese b taken aback by Bernanke’s harsh criticism of the Bank of Japan during his academic ­career and by his “he­li­cop­ter money” speech, we overcame our differences in views and had a warm conversation. My impression would remain the same when Bernanke became the chair of the FRB and I became governor of the Bank of Japan. The Illusion of the G ­ reat Moderation | 119

A HOUSING ­B UBBLE EMERGES IN THE UNITED STATES In the end, deflation never materialized in the United States. As concerns over deflation receded, the economic recovery began to take hold. Nevertheless, the recovery significantly differed from past recoveries in that it was a “jobless recovery.” The orientation of monetary policy also changed in line with the recovery, and the FOMC declared that interest rates would be increased at a “mea­sured pace.” The target level of the federal funds rate was increased by 0.25 ­percent at seventeen successive meetings of the FOMC, from June 2004 to June 2006, to reach 5.25 ­percent. This series of rate increases was prob­ably not envisioned at the outset, but it reduced uncertainties in the interest rate outlook, which in turn convinced investors that the FRB would not tighten monetary policy rapidly. The resulting risk blindness was one of the ­factors that generated the US credit b ­ ubble. Between 1996 and 2006, h ­ ouse prices in the United States doubled in real terms. The increase in housing prices fueled housing construction, with pronounced booms in the states of Arizona, California, Florida, and Nevada. Against this backdrop, the rapidly rising prices and pos­si­ble monetary policy responses thereto became a fixture on the agenda of international gatherings of monetary policy experts at the Bank for International Settlements (BIS). In ­these sessions Eu­ro­pean and Japa­nese participants would often express concerns about the brisk rise in prices—­concerns that w ­ ere quickly dismissed by the US participants. This was the usual pattern. The US colleagues had essentially three lines of argument. First, they noted that the United States had not experienced an economy-­wide decline in ­house prices before. It was on June 9, 2005, that FRB chairman Alan Greenspan noted in his congressional testimony that t­ here could be local “froth” but no nationwide ­bubble.5 Second, they reasoned that it was difficult to identify an inflating b ­ ubble. In addition, they maintained that even if they could identify such a ­bubble, considering that the price of a home was essentially the net pre­sent value of the ­future stream of ­actual or imputed rent on the property, responding to it through monetary policy would require raising the interest rates to such a high level that it would excessively suppress real economic activity. Fi­ nally, it was claimed that even if ­there was a ­bubble, and the ­bubble burst, a significant decline in economic activity could be avoided by aggressive monetary easing.

120 | ­Career Building at the Bank of Japa

THE FEDERAL OPEN MARKET COMMITTEE TRANSCRIPT OF THE JUNE 2005 MEETING IN LIGHT OF JAPA­N ESE EXPERIENCES I was very much interested in the internal discussions at the FOMC. Now that we can look back, I was particularly intrigued to read the transcript of the FOMC meeting held on June 29–30, 2005, three weeks ­after Greenspan’s congressional testimony.6 The first day’s deliberations ­were almost completely devoted to “housing valuations and monetary policy.” Although I am now, of course, subject to the bias of hindsight, I am still surprised that the general tone of the discussions was so optimistic and the exchanges of views almost solely focused on the level of h ­ ouse prices with so l­ ittle discussion of h ­ ouse­hold debt—­and, particularly, mortgage debt. ­There also w ­ ere hardly any references to shadow banking and global capital flows. I still won­der how discussions at the FOMC would have unfolded had the participants not had so much faith in the effectiveness of monetary easing a­ fter the burst of a b ­ ubble. Two questions come to mind. The first is w ­ hether any central bank can conduct aggressive monetary policy actions quickly enough ­after a ­bubble pops. The second is ­whether such actions would be effective. The ­ ubble was often cited, anemic growth of Japan following the bursting of the b with a diagnosis that a failure to decisively ease policy was one of the impor­ tant ­causes of stagnation. The confidence of the US policy makers partly resulted from their success in guiding the economy swiftly out of the aftermaths of the dot-­com ­bubble. What they underappreciated was a clear recognition of the difference between the housing price increase itself—­which tended to be associated with the word ­bubble—­and the b ­ ubble economy that was laden with a huge increase in debt. The significance of the accumulation of debt was not r­ eally appreciated at that time. Reading the FOMC transcript t­ oday, I cannot dispel a sense of déjà vu. It is quite similar to what happened in Japan in the second half of the 1980s, both in terms of developments in the real economy and the reaction of the central bank.

THE ­G REAT MODERATION Up to the eruption of the global financial crisis, the developed economies flourished, and against this background policy makers became increasingly confident of their conduct of monetary policy and, along with economists, deepened their convictions in the under­lying economic theories. The mood of the day was perhaps best captured by the title of a speech delivered by Bernanke in The Illusion of the G ­ reat Moderation | 121

February 2004, “The ­Great Moderation.”7 To be fair, the title was not intended to label developed economies in the 2000s. Instead it was describing an observed fact regarding economic developments in the West over two de­cades beginning in the mid-1980s, where growth was relatively strong, inflation was declining, and the volatility of growth and prices was low.8 Nevertheless, the term “­Great Moderation” captured the optimism over the conduct of macroeconomic policy, which reached its peak between 2004 and 2007. The ­Great Moderation of the developed economies in the early 2000s and the huge ­bubble of Japan in the second half of the 1980s had much in common. First, while growth was strong, inflation was generally subdued and stable. Second, real estate prices went up. Third, debt ballooned and leverage reached extreme levels. Fi­nally, ­people began to embrace narratives that justified good economic performance—­for example, “the emergence of a new economy.” The policy orientation of the mainstream economics profession was that, in a nutshell, macroeconomic stability would be achieved if central banks focused exclusively on conducting monetary policy to achieve price stability. While I understand the importance of stable prices, I was (and remain) uncomfortable with this narrow orientation. I could not say with conviction that the United States was in the midst of a b ­ ubble. In retrospect, I was not aware of the expanding shadow banking sector, and relatedly, the role played by global capital flows. I ­will address ­these phenomena in ­later chapters, but for now I ­will describe a ­little more about the prevalent policy orientation before the GFC.

READING THE PROCEEDINGS OF THE JACKSON HOLE ECONOMIC SYMPOSIUM OF AUGUST 2005 One of the clearest illustrations of the prevailing views among policy makers and mainstream macroeconomists of the time can be seen in the rec­ord of proceedings of the August 2005 Jackson Hole Economic Symposium, the organ­ izing theme for which was “The Greenspan Era: Lessons for the ­Future.” Reading the proceedings ­today, one is struck by the praise heaped on the conduct of monetary policy ­under the FRB chair Greenspan, who would retire six months l­ ater. Alan Blinder (the former vice chair of the FRB) and Ricardo Reis (a fellow professor with Blinder at Prince­ton University) presented a paper, “Understanding the Greenspan Standard,” that explored the conceptual under­ pinnings of monetary policy that brought about good economic per­for­mance 122 | ­Career Building at the Bank of Japa

(%) 12 10 8

Japan United States Euro area

6 4 2 0 –2 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019

Figure 6.3 ​The policy interest rate. Sources: Bank of Japan, Eu­ro­pean Central Bank; Federal Reserve Board.

during the so-­called Greenspan Era and identify eleven princi­ples to be placed in the “top desk drawer” for the chair succeeding Greenspan. Many of ­these made good sense to me, but ­there ­were some that made me uncomfortable in the light of Japa­nese experiences. For example, the sixth princi­ple reads, “Risk management works better in practice than formal optimization procedures—­ especially as a safeguard against very adverse outcomes, . . . ​So, for example, Greenspan’s preoccupation with the dangers of deflation in 2002 and 2003 was seen by some observers as excessive, given the ­actual risk. But he was deter­ mined not to allow the Fed to follow the Bank of Japan into the zero-­nominal interest-­rate-­trap.”9 Notwithstanding this sanguine view, the United States faced the zero lower bound of interest rates just three years a­ fter this pre­sen­ta­tion (see fig. 6.3). Furthermore, the ninth princi­ple proclaims, “­Don’t try to burst b ­ ubble; mop up ­after. First of all, you might fail—or bring down the economy before you burst the b ­ ubble. . . . ​Furthermore, ­bubble bursting is not part of the Fed’s ­legal mandate, and it might do more harm than good. Fi­nally, the ‘mop up ­after’ strategy, which may require large injections of central bank liquidity, seems to ­ ubbles, work pretty well.”10 This princi­ple simply suggests that in responding to b after-­the-­fact monetary policy remedies ­will be sufficient. The Illusion of the G ­ reat Moderation | 123

At that time I had spent many uncomfortable hours in international meetings listening to frequent discussions of a variety of alleged policy failures in Japan. While I was strongly dissatisfied with the foot-­dragging evident in dealing with nonperforming loans in Japan, I could not embrace the argument that aggressive monetary easing would have prevented low growth following the bursting of a ­bubble. The paper on the bursting of the Japa­nese ­bubble economy by thirteen FRB economists, which I discussed in chapter 3, was a typical paper of the day.11 Many members of the FOMC referred to this work in their public speeches, but I could not agree with the paper’s purported takeaways. It is often said that one could only learn from history, but history cannot compensate for a lack of firsthand experience when it comes to sharing insights.12 In t­ hose days I was more sympathetic to the views offered by the se­nior officers of the BIS, such as Andrew Crockett (its general man­ag­er), William White (its chief economist), and Claudio Borio. They w ­ ere the few who would repeatedly contend that if the central bank did nothing in the face of rapid increases in asset prices and debt levels, macroeconomic stability could be endangered by a bursting ­bubble, even if the general price level remained stable. Obviously, robust bank supervision was essential to prevent such a catastrophe, but their view was not to rule out the possibility of tightening monetary policy. Such a position was succinctly outlined in White’s paper “Is Price Stability Enough?”13 To sum up, in response to b ­ ubbles, the “Fed view” supported a mop-up or clean-­ up-­the-­mess strategy, whereas the “BIS view” argued for a prophylactic or lean-­against-­the-­wind strategy.

MAINSTREAM MACROECONOMIC THINKING BEFORE THE GLOBAL FINANCIAL CRISIS The mainstream thinking before the global financial crisis was that macroeconomic stability would be achieved through a monetary policy that pursued price stability. This view gradually emerged in the late 1980s among policy makers and in academia, began to be widely accepted in the 1990s, and was solidly established as the new millennium dawned. First, it was believed that the path of the economy could be specified as cyclical fluctuations around a long-­term trend growth. Trend growth was determined by real ­factors—­that is, increases in the l­ abor population and productivity, and fluctuations w ­ ere regarded as “disturbances” around trends arising from supply or demand shocks. Second, monetary policy was viewed as contributing to maximizing social welfare 124 | ­Career Building at the Bank of Japa

through mitigating fluctuations in economic activity arising from shocks and through realizing low and predictable inflation. While it should be obvious that moderation of fluctuations in economic activity was desirable, it might need some explanation as to why price stability was desirable. It was thought that in an environment where prices remain stable, the resource allocation function of prices would operate most efficiently, which would underpin economic growth. If inflation was rampant and economic agents could not know relative prices of their product and thus make decisions with any confidence, firms would refrain from embarking on capital investment or long-­term product research, which are essential for economic growth. At the same time, ­house­hold and institutional investors would demand interest rate premiums to compensate for uncertainties regarding inflation. Consequently, investment—­and, in turn, overall economic growth—­would suffer. The best macroeconomic policy framework was thought to be one that would give price stability the central role of objective for an in­de­pen­dent central bank. At the same time central banks ­were, in return for in­de­pen­dence, expected to fulfill certain accountability requirements. Inflation targeting, which was first a­ dopted by Canada and New Zealand in the late 1980s and gained wider ac­cep­tance in the 1990s, was a typical policy framework ­under such thinking. The view that macroeconomic stability could be achieved through monetary policy pursuing low and stable inflation became a core ­policy philosophy in many countries, regardless of ­whether they formally ­adopted inflation targeting. One impor­tant additional feature of this mainstream view was the notion that separated the stability of prices and the financial system: price stability would be achieved through monetary policy and financial stability would be achieved through appropriate regulation and supervision of individual financial institutions—­that is, microprudential policy. It is not fair to say that such a viewpoint completely ignored the relationship between price stability and financial stability, but still, the prevalent thinking did not concern itself with the tension between the two and held that a stable macroeconomy resulting from price stability would positively influence the stability of the financial system. If this separation princi­ple is accepted, t­ here is no compelling reason for a central bank to have powers over the regulation and supervision of financial institutions. Instead it was reasoned that such powers could be dangerous ­because they could concentrate too much power in one institution, and this could result in conflicts if two objectives had to be si­mul­ta­neously pursued. This led to reviews of institutional frameworks, and from the second half of The Illusion of the G ­ reat Moderation | 125

the 1990s onward many economies, including Australia and the United Kingdom, established separate supervisory authorities, transferring bank regulation and supervision functions from the central bank to ­these institutions. On top of the trend t­oward institutional separation, policy makers themselves increasingly embraced the view that separated price and financial ­stability. In terms of organ­ization and staffing, monetary policy was the responsibility of a monetary policy department employing mostly macroeconomists. In the meantime, staff working for financial stability ­were largely ­lawyers and financial economists, whose academic affiliation was with finance rather than macroeconomics. Though practices among central banks ­were not uniform, the exchanges between the two policy areas w ­ ere generally not active. As Gillian Tett of the Financial Times pointed out, central banks ­were not immune to a “silo culture” before the GFC. Such a general orientation ­toward the “separation princi­ple” was quite pervasive and could indeed have been one of the c­ auses of the crisis.14 The Bank of Japan was rather unique with regard to this global tendency. The new Bank of Japan Act clearly stated the responsibility of the bank with regard to the stability of the financial system. In terms of organ­ization and staffing, t­ here w ­ ere efforts to break the silo culture. Beyond the traditional practice of transferring staff across functions fairly regularly as part of building expertise, the bank began around 2000 to consciously move experts between departments responsible for financial system stability and departments responsible for monetary policy. The b ­ ubble economy and its bursting w ­ ere still fresh in the bank’s institutional memory.

OUTSIZED CONFIDENCE IN THE POWER OF MONETARY POLICY Confidence in monetary policy reached its peak around 2003–6. In his “­Great Moderation” speech, Bernanke identified three ­factors contributing to superior macroeconomic per­for­mance: (1) good practices, such as improved supply management, sophisticated financial markets and globalization; (2) good policy, especially monetary policy; and (3) good luck. He went on to say, “My view is that improvements in monetary policy, though certainly not the only ­ reat Moderation.”15 ­factor, have prob­ably been an impor­tant source of the G With the U.S. economy growing at a brisk pace, confidence in the ability of monetary policy to deliver became widespread. In his address as the president of the American Economic Association in 2003, Robert Lucas Jr. of the University of Chicago famously remarked that the “central prob­lem of depression 126 | ­Career Building at the Bank of Japa

prevention has been solved for all practical purposes.”16 In 2000 the well-­known US journalist Bob Woodward published his biography of Greenspan, Maestro, the title of which revealed a sense that the head of the central bank was skillfully orchestrating developments in the entire economy.17 The gathering consensus was supported by the New Keynesian macroeconomics and its dynamic stochastic general equilibrium (DSGE) model, which depicted the economy as a set of linear functions. The model was used to conduct simulations on the effects of policies, and was constructed and employed by many central banks and international organ­izations. The Bank of Japan was no exception, developing the Quarterly Japa­nese Economic Model and other models for vari­ous purposes in the early 2000s. The DSGE model, however, had some serious shortcomings. It paid only scant attention to the mechanism through which the financial sector would affect the real economy. Another shortcoming was its view that the economy was composed of representative economic agents. As a result, impor­tant sources of heterogeneity, such as the existence of debtors and lenders, w ­ ere ignored. Furthermore, since it was a linear model, it could examine the effects of shocks that caused only small deviations from the equilibrium, making it useless to understand big changes in the economy, such as ­those that follow financial crises. The model’s failure to incorporate the financial system was its fatal flaw. I was then not comfortable with the perspective of New Keynesian economics or the DSGE model, but I also recognized that it would be difficult for the Bank of Japan’s staff to discuss anything with their overseas counter­ parts without the “common language” of the established econometric modeling frameworks. While I took pains not to discourage the development of the DSGE and related models by the bank staff, I viewed the models’ results with mixed feelings.

THE BUILDUP OF FINANCIAL IMBALANCES Although I was uncomfortable with the views of US policy makers on the potential US housing b ­ ubble, and with t­ hose of mainstream macroeconomists on the role of monetary policy in responding to ­bubbles, I did not recognize the magnitude of the prob­lems below the surface of the global economy. The GFC laid bare the many “financial imbalances” that had built up. One was leverage. Nobody was aware of the magnitude of leverage made pos­si­ble by the use of complex securitized products, which was not l­imited to the subprime mortgage market. As leverage ­rose, ­t here was a concurrent increase The Illusion of the G ­ reat Moderation | 127

in mismatches of duration and currencies—­largely on the books of Eu­ro­pean financial institutions. Duration mismatches arise when financial institutions “borrow short and lend long.”18 Currency mismatches arise when financial institutions use dif­fer­ent currencies in funding and investment. When t­ here are more of ­these mismatches, t­here is an increase in liquidity risk, especially foreign currency liquidity risk. Nevertheless, up to the GFC, ­there was ­little ­ ere w ­ ere also few who recognized that t­ hese mismatches awareness of this. Th ­were increasingly supported by shadow banks outside of the banking sector that we could readily observe. The robust global growth underwrote Japan’s economic expansion but also gave rise to imbalances, which mainly became evident in four areas.

RESHORING IN JAPAN First, the weaker yen induced large-­scale capacity increases for export-­oriented manufacturers. ­These firms sharply increased domestic production, as well as production capacity, as profitability increased against the background of expanding global demand and the weakening yen; this in turn reflected the yen carry trade. Reshoring was underway. Production and capacity increases ­were most pronounced in the automotive and electrical equipment sectors. At e­ very quarterly branch man­ag­ers’ meeting of the Bank of Japan, the man­ag­er of the Nagoya and Osaka Branches, which ­were located in the Japa­nese industrial heartland, reported severe ­labor shortages. The excessive capital investment was most pronounced in building factories for flat-­screen TVs and liquid crystal display panels. Its adjustment was severe a­ fter the GFC struck b ­ ecause the global economy contracted sharply and the yen became stronger due to the unwinding of the yen carry trade.

A MINI-­B UBBLE IN REAL ESTATE MARKETS IN THE TOKYO METROPOLITAN AREA Second, t­ here was a “mini-­bubble” in the real estate markets mostly in and around Tokyo. As I have noted, real estate prices in Japan experienced an extended decline a­ fter the bursting of the b ­ ubble. The rate of decline gradually became slower, and official data of land prices bottomed in 2006 in Tokyo and in 2007 for the ­whole economy. Even when they began to rise again, they r­ ose only gradually nationwide: 0.1 ­percent for residential plots and 2.3 ­percent for commercial plots. Increases in Tokyo w ­ ere much steeper, however: 8.0 ­percent 128 | ­Career Building at the Bank of Japa

for residential plots and 13.9 ­percent for commercial plots. Commercial parcels for the three largest metropolitan areas—­Tokyo, Osaka, and Nagoya—­a lso ­rose briskly at 8.9 ­percent on average. While such increase w ­ ere indeed l­ imited in scope—in the regional areas prices fell 2.7  ­percent for residential plots and 2.8 ­percent for commercial plots over the same period—the increases w ­ ere quite pronounced in areas where prices rose; ­for example, around 20 ­percent in the three central Tokyo wards. As a se­nior executive of a large Japa­nese real estate developer told me, “While I cannot say so publicly as someone representing the industry, from the perspective of a longtime observer of the real estate market, the Bank of Japan should end quantitative easing as soon as pos­si­ble to prevent further excesses in the real estate market.” Fortunately, this mini-­bubble that was centered on the Tokyo metropolitan area did not balloon into a massive ­bubble, as was the case in the United States and some Eu­ro­pean economies. The main reason for ­ ubble economy of the late 1980s. this was the fresh memories of the Japa­nese b In addition, from the perspective of monetary policy, the bank did raise interest rates, however small the amount was, and the Financial Ser­vices Agency reminded financial institutions of the importance of more stringent lending standards for real estate. Th ­ ese mea­sures also helped restrain the b ­ ubble from getting too big. In that regard, I cannot agree with the view criticizing the decision by the bank to end quantitative easing in March 2006, or to increase rates subsequently to 0.5 ­percent, as failed policies. If the orientation of monetary policy had not changed e­ arlier, adjustment in Japan a­ fter the GFC would have been more painful.

IMBALANCES AT FINANCIAL INSTITUTIONS Third, financial imbalances ­were also observed in financial institutions’ investments in securitized products. As the market value of ­these instruments fell steeply a­ fter the GFC, Japa­nese financial institutions had to write down considerable sums. Nevertheless, the damage was much smaller compared with that in major overseas institutions. The main reason ­here, similar to the case of the real estate “mini-­bubble,” was the fresh memory of the crisis following the bursting of the ­bubble. Furthermore, Japan was an early adopter of Basel II capital requirements for banks, which included capital requirements regarding the holding of securitized products.19 Fi­nally, ­there ­were financial imbalances in foreign currency funding at financial institutions. At the time, major Japa­nese banks, viewing the long-­term The Illusion of the G ­ reat Moderation | 129

decline of the domestic banking market, w ­ ere attempting to increase their overseas loans and securities investments, but only a small proportion of the funding of ­these overseas businesses could come from retail dollar deposits, which w ­ ere relatively stable. Consequently, t­ hese banks increased their reliance on uncollateralized funding in the dollar interbank market, and on the foreign exchange swaps, which is essentially the dollar borrowing against yen collateral. Banks faced ­little difficulty before the GFC, when ­there was ample liquidity in the dollar funding markets, but they would come to realize when the crisis erupted that such availability of liquidity could be ephemeral.

130 | ­Career Building at the Bank of Japa

| CHAPTER SEVEN |

My Appointment as Governor of the Bank of Japan On March 21, 2008, I was appointed deputy governor of the Bank of Japan, and si­mul­ta­neously became the acting governor. While my ­actual appointment as governor followed three weeks ­later, on April 9, I essentially had to hit the ground ­running as governor on March 21. As executive director I had on many occasions seen the governor perform his duties in close quarters. But actually being the governor was a completely dif­fer­ent experience; every­thing was new to me.

CHAIRING THE POLICY BOARD On the after­noon of the day I became acting governor, a meeting of the Policy Board was convened, and I was elected its chair. The Policy Board, which is the ultimate decision-­making body of the bank, comprises the governor, two deputy governors, and six other members. While the governor represents the bank and is responsible for executing the Policy Board’s decisions, the governor does not automatically become the board chair. The Bank of Japan Act only stipulates that the chair is elected by the board members. By tradition, however, the governor is elected the chair. ­Because it is called the Policy Board, it is often mistaken as a body that is responsible solely for the conduct of monetary policy. On the contrary, the Bank of Japan Act stipulates that the board makes all impor­tant decisions, such as performing its “lender of last resort” function, developing payment and settlement system infrastructure, making the bank’s bud­get, and compensating the bank’s executive officers and staff. In that sense, the moniker Policy Board is rather misleading. Of the meetings of the board, t­hose where monetary policy is de­cided are called Monetary Policy Meetings (MPMs), and their modus operandi is detailed in the Bank of Japan Act. Non-­MPM board 133

meetings, which would discuss ­matters other than the conduct of monetary policy, are called “ordinary meetings,” and are held, as a rule, twice a week, on Tuesdays and Fridays. As of April 11, 2008, shortly ­after I was appointed governor, the Policy Board consisted of only seven members, including myself. The other members ­were the deputy governor Kiyohiko Nishimura and members Hidetoshi Kamezaki, Atsushi Mizuno, Seiji Nakamura, Tadao Noda, and Miyako Suda. According to the Bank Act, members are to be appointed “from among persons with relevant knowledge and experience, including experts on the economy or finance,” by the Cabinet of Japan with consent from both h ­ ouses of the National Diet.1 As for the background of the board members at that time, Kamezaki was a deputy president of a major trading com­pany, Mizuno was an economist at an investment bank, Nakamura was a deputy president of a major shipping com­pany, Noda was a deputy president of a major commercial bank, and Suda was an economics professor. The board fell short of the nine members stipulated by the Bank Act b ­ ecause one of the deputy governor positions had become vacant a­ fter I was appointed governor, and one member position became vacant ­after member Nishimura became deputy governor. We had only seven members ­until October, when Hirohide Yamaguchi, who was an executive director of the bank, was appointed deputy governor. All members of the board are appointed for a term of five years, but only  the governor and deputy governors have executive responsibilities. Thus, the board makes decisions, and what has been de­cided on is implemented by the governor, deputy governors, executive directors, and other staff members. The Policy Board of the Bank of Japan meets more often than the board of directors of private corporations. In addition, t­ here are briefing sessions on vari­ous issues by the bank’s staff for the board. Consequently, board members are usually in their bank offices on a full-­time basis.

THE CODE OF CONDUCT Given that the Bank of Japan is an organ­ization that is expected to serve the public, in addition to the overarching responsibility of formulating policy it is essential that public trust in the bank be maintained. For that purpose, the bank has strict codes of conduct. All members of the board must disclose their assets at the time of their appointment and again when they leave the board. Permissible investments by board members are also restricted, effectively pro134 | The Days as Governor

hibiting the purchase of financial assets other than bank deposits or Japa­nese Government Bonds and limiting the timing of transactions. Members are also required to report any financial dealings to a compliance committee ­every quarter. ­There are also rules governing communication with the outside world that forbid externally expressing opinions pertaining to monetary policy or monetary and economic conditions, from two business days before an MPM ­until the end of the press conference by the MPM chair, except when appearing before the National Diet; this is known as the blackout period. Consequently, care is taken not to meet with ­people affiliated with the media or financial institutions during the blackout. Contacts with all ­people from outside the bank are handled in a prudent manner so as to avoid any pos­si­ble conflicts of interest and miscommunication. In conducting monetary policy, it is impor­tant to obtain candid, firsthand information and a feel for current economic and financial developments from a diverse range of ­people. But if such contacts with the outside world lack transparency or convey an unfair advantage, this would erode confidence in the bank. While I tried to meet as many leaders of financial institutions and nonfinancial corporations, as well as overseas visitors, as was pos­si­ble outside the blackout period, I had to be careful about the timing and venue of all of my external interactions.

MY FIRST MONETARY POLICY MEETING The first time I chaired an MPM was on April 9, 2008. The most impor­tant function of the chair of the MPM is to forge a consensus on the conduct of monetary policy, taking into account the diverging views among the MPM members. B ­ ecause staff briefings can sometimes become technical and filled with economic and central bank jargon, another role is to urge the staff members appearing before the MPM to frame their arguments so that they can be understood by the MPM members who lack prior experience at the Bank of Japan. Meanwhile, since the chair represents the bank as governor, the chair needs to demonstrate leadership ­after taking in vari­ous viewpoints. Furthermore, given that the governor is responsible for implementing the decisions of the MPM, it is not enough just to preside over discussing monetary policy conceptually; the governor also has to take into account operational implications of any policy decision. Two weeks before I became acting governor, the Bank of Japan released the following economic assessment: “Japan’s economy is expanding moderately as My Appointment as Governor | 135

a trend, although the pace of growth has been slowing mainly due to the drop in housing investment and the effects of high energy and materials prices. . . . ​ Due attention should continue to be paid to f­ actors such as uncertainties regarding f­ uture developments in overseas economies and global financial markets, as well as the effects of high energy and materials prices.”2 At that time it was not the Bank of Japan’s view that the Japa­nese economy had entered a downturn, but in retrospect, according to the determination of business cycle peak and trough, which comes from the Cabinet Office, economic activity had already peaked in February 2008. When I first chaired an MPM, the policy rate was at 0.5 ­percent, and ten-­year Japa­nese Government Bonds w ­ ere yielding 1.34 ­percent. Although some room to cut the policy rate was created as the result of the exit from quantitative easing in March 2006, it was just a modest half of a percentage point. While it was noted in the bank’s Outlook Report for October 2007 that “the Bank w ­ ill adjust the level of interest rates gradually in accordance with improvements in the economic and price situation,” the expectation of further rate hikes seemed to have receded against the backdrop of the worsening global economic activity since the publication of the report.3 As was evident from the extension of emergency credit by the New York Federal Reserve to JPMorgan Chase for its purchase of Bear Stearns in early March of that year, financial systems in Eu­rope and the United States ­were fragile. My sense was that the serious negative feedback loop between the financial system and the real economy would soon become apparent. While I believed that a downgrade of the outlook for the Japa­nese economy was appropriate, I was reluctant to adopt this view at my first MPM just two hectic weeks ­after having become an acting governor. I was concerned that if I tried to push through a downgrade at my first meeting it could have eroded collegiality among the board members. I both wanted to re­spect the board as a collective decision-­making body and was concerned that any discontinuity in the board’s posture might lead the public and market participants to expect similarly abrupt changes when new governors w ­ ere appointed. That would weaken faith in the communication of the central bank, which would in turn undermine the effectiveness of monetary policy in the long run. But as it was becoming evident that a change in the economic outlook was needed, I reasoned that the bank should downgrade its outlook only ­after conducting a thorough analy­sis at the end-­of-­April MPM, when the semiannual Outlook Report would be discussed. Thus, at the press conference following the early April MPM, I

136 | The Days as Governor

emphasized the high degree of uncertainty and did not change the central view of the bank. At the press conference t­ here w ­ ere a few in­ter­est­ing questions about issues other than concurrent economic conditions. One concerned a textbook, which I had written shortly before my appointment, Modern Monetary Policy in The­ ory and Practice.4 A reporter asked about the relation between what was in the book and the conduct of f­ uture monetary policy. While the question was in the context of the contemporaneous situation, I answered in more general terms: I believe that t­ here is naturally a difference between the role of an academic or a teacher and the role of a policy maker at the central bank. What is most impor­tant for an academic is to offer new perspectives. Even if such perspectives turn out not to be the most accurate, as often happens, it would suffice if the academic ­were then to adjust his views to the changing environment and offer a revised perspective. On the other hand, a policy maker cannot wait u ­ ntil theories are fully developed before embarking on a course of policy. The policy maker needs to take account of the state of theories as they are and make the best pos­si­ble decision at the time. Accordingly, while I believe that I have openly written down in the book what I have been thinking as an academic or a teacher, I am taking care not to cloud my eyes by what I have written regarding the economic or policy outlook.5 Another query was somewhat unexpected, asking my preference for e­ ither the “Fed view” (the mop-up strategy) or the “Bank for International Settlements (BIS) view” (the lean-­against-­the-­w ind strategy) with regard to the conduct of monetary policy.6 I replied, “If I may answer your question . . . ​ from the perspective of a university professor . . . ​I am in the m ­ iddle, rather than leaning to one side. In other words, the world is not as s­ imple as the Fed view, but it is difficult to conduct policy strictly following the BIS view, and ­actual monetary and financial systems policies must be conducted from such an awareness.”7 While I was sympathetic to the BIS view, as governor I was also aware that it would be a ­great challenge to put this approach into practice in the conduct of Japa­nese policy. That was the essence of my off-­the-­cuff remarks in response to unexpected questions from reporters. Both questions presaged what I would experience over the next five years.

My Appointment as Governor | 137

DOWNGRADING THE ECONOMIC OUTLOOK At the next MPM, at the end of April 2008, the Policy Board discussed the semiannual Outlook Report and downgraded its assessment of the economy compared with six months ­earlier. While it is easy to say “downgrade,” it is not at all straightforward to determine what “the Bank of Japan’s view” is when monetary policy decisions are taken by a collective decision-­making body. When the economic variables that underlie an outlook change, the outlook may have changed in line with prior projections, or it may be that the projected path itself was off the mark. In addition, the probabilities assigned to the state of each variable differ from one member to another. Each member’s reasoning ­behind pos­si­ble upward or downward revisions may be dif­fer­ent. Consequently, arriving at and publishing a consistent outlook of the decision-­making committee is no mean task, especially when views among members are widely divergent. The significance of this fact, which is quite familiar to p ­ eople who have experience working with monetary policy committees, may be underestimated by economists and the public at large. ­ ere made When the Bank of Japan published its Outlook Reports, efforts w to explain not only the numbers in detail but the under­lying mechanisms that sustained the economic and inflation projections acceptable to the majority of the Policy Board. Economists and market participants w ­ ere often more interested in the numbers. Members attending an MPM submit their expected growth and consumer price inflation rates before the meeting, and then revise them at the end of the discussions. In terms of the midpoint projection in the April 2008 Outlook Report, forecast growth for fiscal year 2008, ending in March 2009, was revised down from 2.1 ­percent six months e­ arlier to 1.5 ­percent, and for fiscal year 2009 the forecast growth was 1.7 ­percent. In short, the economic outlook was for a growth slowdown to continue into the ­future, with average growth around potential. The main reason for the deceleration was the downturn of overseas economies (especially the United States) and the increases in energy and commodity prices. A change to the assessment at the March MPM that “a virtuous circle of growth in production, income, and spending [was] expected to basically remain in place” was most necessary, and such wording was duly removed from the Outlook Report (and the chair’s press conference) from April onward. Turning to the inflation rate, the latest numbers then available indicated that year-­on-­year inflation had reached 1.2 ­percent in March 2008, which was the highest rate since August 1993, excluding the period between April 1997 and 138 | The Days as Governor

March 1998 when the consumption tax had been raised.8 While t­ here was no expectation of a further acceleration of inflation, forecasts ­were revised up reflecting increases in energy and commodity prices. The median forecast for the twelve months between April  2008 to March  2009 was dialed up to 1.1 ­percent from the prior forecast of 0.4 ­percent six months ­earlier. For the next twelve months following March 2009, the projected rate was 1.0 ­percent. The Policy Board, however, believed that ­these numbers by themselves did not convey the increasing uncertainties, and it de­cided to publish a “risk-­ balance chart,” which depicted the members’ views of the probability distribution of forecasts around our central tendency. This new chart showed that members thought the risks ­were higher of downward deviations for both growth and inflation. At the end-­of-­April MPM, the Policy Board also undertook an annual review of our Understanding of Medium-­to Long-­term Price Stability, reflecting the level of inflation that board members thought represented stable prices. It was envisaged that the appropriateness of the Understanding would be revisited regularly. This was partly b ­ ecause of its design. Since the Understanding compiled the views of nine board members, it was necessary to revise it as ­there had been changes in members. ­After some deliberation, the board de­ cided to maintain the Understanding as it was first published in March 2006. Meanwhile, on the direction of monetary policy, it was de­cided that “given the current situation where the outlook for economic activity and prices is highly uncertain, it is not appropriate to predetermine the direction of f­ uture monetary policy. Rather, close attention needs to be paid to f­ uture developments in economic activity and prices,” which changed the previous bias ­toward gradual rate increases.9 In a speech I gave at the Japan National Press Club soon ­after the publication of the Outlook Report, I offered the following views on the US economy: “Home prices have yet to stop declining, and t­ here are no signs that the financial market disruptions ­will abate. In addition, ­there are risks of a further tightening of financial institutions’ lending attitudes. The key is when and how the combined effects of disruptions in financial markets, asset prices, and economic activity ­will diminish, which is unforeseeable, and this is the biggest source of uncertainty.”10 In retrospect, a­ ctual growth considerably undershot the projections in our Outlook Report, reflecting the economic turmoil following the collapse of Lehman B ­ rothers. Like other central banks and most private-­sector economists, our forecasts had not anticipated this event. Even if we had contemplated My Appointment as Governor | 139

the possibility of the extreme events that subsequently unfolded, I do not think we could have reasonably a­ dopted them as part of our central tendency forecast. Even with hindsight, I believe that our approach of emphasizing downside risks u ­ nder lower forecasts was the right one. Rereading the April 2008 Outlook Report ­today, I am most struck by its optimistic assumption about potential growth, which was expected to remain around 1.5 to 2 ­percent. The potential growth number was an estimate calculated rather mechanically, using capacity and ­labor utilization rates, and the Bank of Japan’s number was not r­ eally higher than that of private-­sector economists. I did not doubt the forecast at the time. Our expectation that growth would pick up reflected the view that the “three excesses” that had been such a drag on the Japa­nese economy would fade ­unless ­there w ­ ere serious disturbances in overseas economies. This, however, was subsequently proven not to be the case. Looking back from the pre­sent day, the apparent fading of the excesses was partly a direct and/or indirect reflection of the global credit ­bubble—­that is, the acceleration of overseas economies and the resulting depreciation of the yen due to carry trades. Moreover, t­ here was even less recognition of the rapid decline in potential growth, resulting from the shrinking l­abor force due to rapid aging. The Policy Board’s outlook on inflation was not criticized at the time of publication as being too high. Instead t­here w ­ ere a number of questions at the press conference regarding the possibility of even further acceleration of inflation against the background of rising energy and commodity prices.

DETERIORATING ECONOMIC CONDITIONS AND HIGHER INFLATION In line with projections, the Japa­nese economy began to slow down. Accordingly, the MPM successively downgraded its assessment of concurrent economic conditions. The MPM changed its assessment to “sluggish” at the August meeting and forecast that “Japan’s economy is expected to gradually return onto a moderate growth path as international commodity prices level out and overseas economies move out of their deceleration phase.”11 That was the central scenario ­under the “first perspective,” and ­under the “second perspective,” the MPM emphasized the risk of further weakening of the domestic economy. The Japa­nese economy was at the mercy of overseas economic developments, and especially the consequence of the negative feedback loop ­between financial markets and the real economy in the United States. In July 140 | The Days as Governor

and August 2008, Consumer Price Index inflation reached 2.4 ­percent two months in a row, mainly caused by increases in international commodity prices. The price of a barrel of crude oil ­rose from around US$88 on February 7 to $US146 on July 11 at the West Texas Intermediate f­utures market. ­These developments prompted many reporters to ask if Japan was on the verge of stagflation, a case in which the economy experiences stagnation and inflation si­mul­ta­neously. Looking at what overseas central banks w ­ ere d ­ oing at that time, the direction of monetary policy was not uniform. The Eu­ ro­ pean Central Bank (ECB) raised its policy rate by 0.25 ­percent on July 4 out of concern over inflation. Many central banks in emerging market economies and commodity producers had also raised interest rates significantly. Central banks in the United Kingdom and the United States, which ­were the epicenters of the financial crisis, continued on their easing paths. Given that its outlook was relatively bearish, the Bank of Japan did not contemplate raising its policy rate and stayed put.

ATTENDING INTERNATIONAL MEETINGS One of the big changes I experienced a­ fter becoming the governor was the increase in the number of international meetings that I had to attend. The first was the April G7 meeting in Washington, DC. Following that, I attended for the first time the regular meeting of central bank governors held on May  4–5, 2008, at the BIS in Basel, Switzerland. Over my five-­year term as governor, I went abroad for business seventy times, an average of fourteen times a year. Basel was the most frequent destination. The BIS, which was founded in 1930, is a club-­like organ­ization for central banks aimed at fostering discussion and facilitating collaboration among central banks. While it is customary to refer to the “central bank governors’ meeting at the BIS,” in fact, ­there are a series of dif­fer­ent meetings over a Sunday and Monday ­every two months, with dif­fer­ent subjects and attendants for each meeting. A broad discussion on the economy and financial markets takes place at the Global Economy Meeting (GEM), which since 2010 has become the center of governance structure with re­spect to giving guidance to vari­ous central bank committees and to appointing the chairs of ­those committees, taking over from the G10 central bank governors’ meeting. Given that ­there ­were many more members attending the GEM, it was de­cided to establish a new committee, the  Economic Consultative Committee (ECC), which was tasked to lay the My Appointment as Governor | 141

groundwork for discussions and decisions at the GEM. When I was appointed governor, the G10 meeting was still in existence; the ECC came into being in 2010, and central bank governors from China, India, and Mexico joined ranks with G10 governors. I was a frequent visitor to Basel even before becoming governor. For three years, starting in 1997, I was a member of the Committee on the Global Financial System, which was one of the main central bank forums meeting at the BIS.12 I also had been a note taker at meetings of G10 governors a few times, but May  2008 was my first experience sitting at the main t­able and speaking as governor of the Bank of Japan. While a sense of comradeship should no doubt exist among finance ministers, ­there is a unique sense of camaraderie among central bank governors owing to their relatively long tenures. ­There is also a sense of shared interest as experts who transcend national borders. As Jean-­Claude Trichet, who was the president of the ECB, responded to a question by a Japa­nese reporter at his press conference regarding my impending appointment, I know Mr. Shirakawa. I have been in touch with him. In his previous position, he had been in touch with a lot of impor­tant persons in all the central banks, including h ­ ere in the ECB where he has a lot of friends. So I am expecting that we w ­ ill have a very close relationship with him and with the Bank of Japan as we had in the past. And this is very impor­ tant b ­ ecause the “brotherhood” of central bankers is certainly g­ oing to remain, particularly through a period of very difficult challenges and very demanding circumstances, of the utmost importance. We have a level of confidence between us which is priceless.13 Up ­until then, I had only spoken to Trichet once when he was governor of the Bank of France, on the occasion of a lunch during the BIS Annual Meeting weekend. I was, therefore, all the more thankful for the kindness and warmth of his remarks. I was also impressed with the heavy responsibility that comes with becoming a member of an impor­tant international policy makers’ community of central bank governors.

ATTENDING THE NATIONAL DIET Being the governor of the Bank of Japan also meant an increase in the frequency of attending committees of the National Diet. While I had some expe142 | The Days as Governor

rience of answering questions at the National Diet during my term as executive director, ­there ­were many more instances as governor. I was summoned to committee meetings for a total of 117 days, for an average of about twenty-­four times a year. The frequency fluctuated according to economic conditions, and reached as high as nine times in one month in February 2012. The most common venue was the Financial Affairs Committees of the House of Representatives (the lower ­house) and the House of Councillors (the upper ­house), and ­ ouses. I remember in par­tic­u­lar the espethe Bud­get Committees of both h cially tense atmosphere of the Bud­get Committee meetings, when all members ­ ere in attendance and TV cameras w ­ ere on. of the Cabinet w As stipulated by the Bank of Japan Act, the bank had to submit semiannual reports on the conduct of monetary policy to the National Diet and was required to face questioning from the committees of the Diet; this procedure followed the US example of semiannual testimony of monetary policy to Congress. The timing of the questioning could be somewhat unpredictable even though the bank prepared and submitted its report regularly ­every six months. When the reports ­were being considered, the committees ­were in session for about three to four hours, which necessitated long periods of testimony requiring much concentration. It is not uncommon for central bank governors to be summoned to parliaments, but in the case of Japan, the frequency is noteworthy. For example, in 2012, I was called to the National Diet twenty-­nine days, which was the most numerous during my term. In contrast, the chair of the Federal Reserve Board appeared before the US Congress for just five days. I absolutely agree with the view that the governor of the Bank of Japan should answer questions from the members of the National Diet but, having said that, the unpredictable timing of invitations more than their frequency sometimes made it difficult to discharge my other responsibilities as governor. For example, I had to be somewhat cautious in scheduling out-­of-­town business trips. It was my feeling then that it would have been more productive if the National Diet had de­cided, as a rule, to summon the governor only for regular reporting from the bank and have an intensive and or­ga­nized questioning session.

MEETING P­ EOPLE AND SPEAKING BEFORE THE PUBLIC An increase in the number of visitors to my office was also a noteworthy change ­after becoming governor. ­There ­were more opportunities to meet with heads of banks and nonfinancial businesses, current and former policy makers from My Appointment as Governor | 143

outside Japan, and leading academics. This was a ­great privilege as a central bank governor, with e­ very one of them providing me with fresh information and perspectives. One former central banker from abroad, who visited my office shortly ­after my appointment, advised me that the job of a central bank governor included serving as “the chief economic educator of an economy.” I interpreted his remarks as underscoring the obligation of the governor not only to conduct appropriate monetary policy in the short term but also to explain the issues facing the national economy in plain language based on robust analy­ sis. This was quite valuable advice with regard to the objectives and the institutional advantages of the central bank. In addition to attending international meetings, being summoned to the National Diet, and meeting p ­ eople, t­here w ­ ere numerous occasions to speak publicly. Looking back on the list of my speeches on the Bank of Japan website, t­ here w ­ ere 103 of them during my five-­year tenure (excluding ceremonial ­ ere outside Japan. As I have noted, anremarks), and twenty-­four of them w swering questions at the National Diet and at press conferences was impor­ tant, but it was not suited to proactively conveying the bank’s thoughts and analyses in a structured manner in view of the time constraints and the question-­and-­answer format. Accordingly, like overseas central banks, I endeavored to give speeches on a variety of topics so as to cultivate understanding of the bank’s vari­ous policy initiatives. My first speech open to the press was at the Japan National Press Club on May 12, 2008.14 Before standing at the podium, when I was exchanging pleasantries with the se­nior members of the club, I was informed that ­every speaker was asked to write some message in the guest book. I was not prepared and thus not able to come up with any witty remark, so I wrote down “sincerity and professionalism.” Most of the speech was devoted to explaining the Bank of Japan’s outlook on economic conditions and the conduct of monetary policy, but I was able to emphasize two aspects of central banking t­ oward the end of my speech. The first concerned the importance of the institutional culture of the central bank as always being open to learning: “The economy is constantly undergoing change . . . ​in a situation where economic globalization and development in information and communications technology are in pro­gress. This is why I re­spect central bank culture, which attaches importance to being h ­ umble and always learning. In addition, it is indispensable for a central bank to explain clearly the reasons for its policy decisions—­that is to say, it should ensure transparency. ­After all, a central bank’s in­de­pen­dence is based on years of 144 | The Days as Governor

experience in making policy decisions based on its accurate analy­sis, and on transparency with regard to its policy decisions.” The second was the importance of the banking operation conducted by the central bank: To cope with the disruptions in global financial markets since last summer, central banks have taken vari­ous mea­sures to provide financial markets with ample liquidity, or even acted as an intermediary. Their banking functions have played a crucial role in ensuring that ­those monetary policy actions take effect smoothly. Despite the unstable functioning of the markets since the summer, payment and settlement systems have not under­ gone major disruption. . . . ​Moreover, preparations for unexpected events are just as impor­tant as the banking operations, and central banks have been enhancing business continuity planning for emergencies including earthquakes, terrorist attacks, and system failures. . . . ​I hope that banking operations performed by central banks as “the bank for banks,” their other aspect, ­will gain more recognition. Through the conduct of the two policies—­monetary policy and banking policy—­I ­will dedicate my efforts to ensuring stability in both prices and the financial system.15

My Appointment as Governor | 145

| CHAPTER EIGHT |

The Collapse of Lehman B­ rothers The collapse of Lehman ­Brothers in September 2008 was a watershed event that pushed the global financial system and economy to the brink. The worst-­case scenario was avoided, however, when governments and central banks around the world began to liquefy markets and stabilize financial asset prices as the magnitude of the crisis became evident. The turmoil of the months following the collapse of Lehman was one of the most unforgettable episodes during my tenure as governor of the Bank of Japan, equaled only by the ­Great East Japan Earthquake of March 2011 and the negotiations leading to the joint statement of the Japa­nese government and the Bank of Japan in January 2013.

FROM THE BURSTING OF THE US HOUSING B­ UBBLE TO THE CRISIS IN THE SUBPRIME MORTGAGE MARKET I would like to start this chapter by winding the clock back somewhat to the collapse of the US housing ­bubble, which predated my appointment as governor. The so-­called G ­ reat Moderation was quietly morph­ing into turbulence. The first signs w ­ ere manifested in ­house prices in the United States. Looking at the Case-­Shiller 20-­City Composite Home Price Index, prices peaked in July 2006, and then fell 35 ­percent over more than five and a half years ­until fi­nally bottoming out in February 2012. The default rates of subprime mortgages, which mainly catered to lower income ­house­holds, crept up around the end of 2006 and began to rise markedly in 2007. The bursting of the American housing ­bubble quickly became evident in sluggish housing investments, but it took some time before the overall economy began to suffer. The US business cycle peaked in December 2007. In the case of the Federal Reserve Board’s semiannual report to Congress, submitted in February and July e­ very year, clear concerns over the economy did not appear u ­ ntil the July 2007 report. As for the impact on the financial system, ­there was still optimism for about one year ­after ­house prices took a downturn. For example, Frederick Mishkin, a 146

governor of the Federal Reserve Board (FRB), who was a well-­known academic, laid out his outlook in January 2007, referring to the Japa­nese experience as follows: The bursting of asset price ­bubbles often does not lead to financial instability. . . . ­There are even stronger reasons to believe that a bursting of a b­ ubble in ­house prices is unlikely to produce financial instability. . . . ​The financial instability that many countries experienced in the 1990s, including Japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices. . . . Many have learned the wrong lesson from the Japa­nese experience. ­ ubble but The prob­lem in Japan was not so much the bursting of the b rather the policies that followed. . . . ​[W]ith the benefit of hindsight, it seems clear that the Bank of Japan did not ease monetary policy sufficiently or rapidly enough in the aftermath of the crisis.1 FRB chairman Ben Bernanke also struck an optimistic note in May 2007, noting, “Given the fundamental ­factors in place that should support the demand for housing, we believe the effect of the trou­bles in the subprime sector on the broader housing market w ­ ill likely be l­imited, and we do not expect signifi­ cant spillovers from the subprime market to the rest of the economy or to the financial system.”2 One is struck by the similarity of such views of US policy makers of that period with ­those of Japa­nese policy makers just ­after the bursting of the Japa­nese b ­ ubble, when optimism was prevalent not only among policy makers but also among private-­sector economists.

BNP PARIBAS ROCKS THE MARKET ­ ere ­were rumblings in global markets, presaging what would turn out to be Th a most severe crisis. Even as ­house prices ­were beginning to fall, stock prices kept on rising. Meanwhile, many eyes ­were on the interbank US dollar funding market. Financial institutions would fail if they w ­ ere unable to roll over their short-­term debts. The most watched indicator was the Libor-­OIS spread, which moved in line with the rise and fall of tensions in the funding market. That spread mea­sured the difference between the cost of fixed-­term (for example, three-­month) funding and the cost of rolling over overnight funding The Collapse of Lehman B ­ rothers | 147

(%) 4.0 3.5 Euro US dollar Japanese yen UK pound

3.0 2.5 2.0 1.5 1.0 0.5 0.0 –0.5 2006

2007

2008

2009

2010

2011

2012

2013

2014

Figure 8.1 ​The Libor-­OIS spread. Source: Bloomberg.

for the same term. When concerns over defaults of borrowers increased, lenders would demand higher premiums for fixed-­term funding. The tensions in the interbank market was laid bare when the Libor-­OIS spread for dollar funds jumped on August 9, 2007 (see fig. 8.1). On that day, BNP Paribas, a major French bank, suspended redemptions on some investment funds it had sponsored. Following this action, strains on the interbank US dollar funding market became increasingly more acute. Since I was at the Kyoto University School of Government then, I cannot give a firsthand account of what central bankers around the world w ­ ere thinking at that time, but what unfolded was totally unexpected by the overwhelming majority of academics and private-­sector economists. As Olivier Blanchard and ­Lawrence Summers noted in October  2017, “Ten years ago, few would have predicted the events which w ­ ere to unfold, from runs on the largest world financial institutions, to interest rates at liquidity trap levels for close to a de­ cade, to inflation still below target ­today, to output gaps being still large and negative in many advanced economies.”3 Prob­lems in the financial system first became evident in the United Kingdom. In September, a bank run hit a medium-­size, mortgage-­oriented bank, Northern Rock, and the UK government had to announce on September 17 148 | The Days as Governor

that all depositors would be protected. It was the first bank run in the United Kingdom since 1866. The US stock market, which was still rising even when ­house prices began to fall, peaked on October 9, 2007. Before continuing, some explanation of terms is in order. The turmoil in the financial system following the action by BNP Paribas was originally described as the “subprime mortgage crisis.” As gradually became evident, however, the prob­lems ­were widespread, well beyond the subprime mortgage market. Given that events related to the subprime mortgage market only pulled the trigger of a much wider crisis, “subprime mortgage crisis” is not the appropriate term to describe the ­whole turn of events. Accordingly, I have referred to the global financial crisis (GFC) throughout this book to refer to the crisis between 2007 and 2009, which includes events in the subprime mortgage market. But as for the debt crisis that unfolded in Eu­rope from 2010 onward, I refer to ­t hose subsequent events as the Eu­ro­ pean debt crisis. Despite substantial effects on the real economy outside Eu­rope, the debt prob­lems in Eu­rope are considered separately, since the overall impact on the financial system and markets was not as severe as that of the GFC.

BEAR STEARNS WAS SAVED On March 16, 2008, it was announced that the fifth largest US investment bank, Bear Stearns, which was suffering acute funding difficulties, was to be purchased by JPMorgan Chase, with emergency financing provided by the Federal Reserve Bank of New York, commonly known as the New York Fed. That funding was extremely unusual in that the FRB invoked section 13(3) of the Federal Reserve Act. In the w ­ hole scheme, the most impor­tant mea­sure was to establish a special-­purpose fund to purchase the illiquid assets of Bear Stearns. ­There was an immediate uproar from politicians and economists against this decision, but u ­ nless uncertainty over the quality of assets on Bear Stearns’ balance sheet was dispelled by this action, JPMorgan Chase would not have purchased the firm. Had it not bought Bear Stearns then, an acute large-­scale disruption in the financial system, like what followed the collapse of Lehman ­Brothers, would have occurred. As such, I strongly supported this action by the FRB and respected its determination. Obviously, given that the heart of the prob­lem was a lack of capital, the action of the FRB alone could not have turned t­ hings around. Even so, it brought temporary relief to financial markets in Eu­rope and the United States. In fact, at a meeting between policy makers The Collapse of Lehman B ­ rothers | 149

and banking executives following a G7 meeting on April 11, t­ here w ­ ere a few who noted that “the worst is ­behind us.” The worst, however, was yet to come. As Japan had experienced exactly t­ hese circumstances ten years ­earlier, I recognized the core prob­lem of elevated asset prices backed by debt in excess of the income needed for repayment, and that this would set up the negative feedback between the real economy and the ­financial system. ­These effects w ­ ere already apparent, and on September  7, when the US government–­sponsored housing financing entities Fannie Mae and Freddie Mac ­were placed ­under government conservatorship, strains in the global financial markets became almost unbearable. Following the de facto failure of Bear Stearns, rumors w ­ ere rife that the fourth largest US investment bank, Lehman ­Brothers, would be the next to fall. Leh­man’s filing for protection u ­ nder Chapter 11 of the US Bankruptcy Code on September 15 triggered a series of events in global financial markets that had not been experienced since the 1930s, and the global financial system teetered on the brink of collapse.4

THE LEHMAN WEEKEND On the morning of September 12, just before Lehman B ­ rothers filed for protection, a teleconference was held among G7 finance ministers and central bank governors. In that call, Hank Paulson Jr., the US Trea­sury secretary, reported that US authorities ­were finding it difficult to find a buyer for Lehman. The financial system in both Eu­rope and the United States was extremely unstable, and it appeared likely that if Lehman w ­ ere liquidated, systemic risk would materialize in the sequential failure of financial firms around the world. Accordingly, many thought that the FRB would and should attempt to safeguard the stability of the financial system, even if it had to resort to emergency lending as it had done with Bear Stearns. I was thinking that finding a suitor for Lehman might be difficult, but in the end I thought that my US colleagues would not permit the ad hoc liquidation of the firm. Nevertheless, it turned out that final takeover negotiations broke down over the weekend, and during multiple rounds of teleconferences that followed, US policy makers remarked that Lehman could not avert filing for bankruptcy protection. It was a surreal moment for me to hear that a policy maker would let such a ­thing happen, but I knew that I had to move on. Policy makers around the world, confronted with this grim real­ity, did their best to mitigate the potential turbulences that would hit as the new week began. In Japan, the Bank of Japan and the Financial Ser­vices Agency coordinated their efforts, bracing for the worst. 150 | The Days as Governor

GLOBAL FINANCIAL MARKETS IN THE WAKE OF LEH­M AN’S COLLAPSE Lehman B ­ rothers filed for Chapter 11 on September 15, at 1:45 a.m. Its subsidiaries around the world followed suit. Given that September 15 was a public holiday in Japan, the Japa­nese subsidiary of Lehman filed a petition ­under the Corporate Reor­ga­ni­za­tion Act on the next day, September 16. Although substantial disturbances had been expected beforehand, the might of the storm that blew through global financial markets was beyond imagination. In the United States, on September 16, a large money market fund (MMF) “broke the buck” as its shares could only be redeemed below par  value, prompting a flight from similar MMFs as money flowed out of the sector in the following days. On September 17, American International Group (AIG), a major insurance com­pany, was placed ­u nder public control, and the New York Fed announced that it was providing a credit line of $80 billion. This came as a shock to many p ­ eople, b ­ ecause only a few days separated the fall of Lehman ­Brothers, which could not receive funding from the FRB, and that of AIG, which received a substantial bailout. Extraordinary news continued to follow. On September 19, the US Trea­sury announced a temporary guarantee scheme for MMFs. On September 22, two major investment banks, Goldman Sachs and Morgan Stanley, filed with the FRB to become bank holding companies, which meant the two entities ­were now supervised by the FRB.5 On September 25, Washington Mutual, with assets totaling approximately $300 billion, was placed into receivership with the FDIC. This was the largest bank failure in US financial history, and with investors in its bonds suffering haircuts, the US financial system was rocked ever more violently. Despite ­t hese developments, on September 29 a bill to enable the use of public funds was voted down in the US House of Representatives. In response the Dow Jones Industrial Average shed a stunning 778 points, or about 7 ­percent, on that day alone. In the dollar funding market, concerns over counterparty credit risk led to an acute liquidity shortage. If one looks at the Libor-­OIS spreads from the day before the collapse of Lehman B ­ rothers to October  10, the United States dollar spreads jumped from 1.3 ­percent to 3.6 ­percent. For the euro, the spreads ­rose from 1.2 ­percent to 2.1 ­percent. The commotions in the funding market impacted not only banks but also nonfinancial businesses. In the United States, the epicenter of the crisis, MMFs halted new purchases in the commercial paper (CP) market, as they faced The Collapse of Lehman B ­ rothers | 151

redemptions, which necessitated selling CPs they had on their balance sheets. Consequently, even the most creditworthy companies w ­ ere finding it difficult to issue new CPs maturing beyond the next day. This quickly resulted in liquidity issues at businesses such as automobile financing companies, which had generally met extensive funding needs in the CP and bond markets. In most countries, short-­term money markets ­were destabilized and flight-­to-­safety be­hav­ior prevailed. The global financial markets practically froze over.

THE G7 MEETING IN WASHINGTON On Friday, October 10, a meeting of G7 finance ministers and central bank governors was held in Washington, DC, and I attended the meeting with Shoichi Nakagawa, who had just been appointed finance minister in the new cabinet of Prime Minister Taro Aso that had been launched on September  24. The meeting was prob­ably the tensest of the many international meetings during my tenure as governor. It also had the clearest shared objective among the members: every­one at the ­table shared the sense that a repeat of the ­Great Depression of the 1930s must be avoided at all costs. U ­ nder the chair of the US Trea­sury secretary, Hank Paulson  Jr., the focus was on the messaging to be conveyed in the communiqué, which was to be released ­after the meeting. The final communiqué came to just 266 words, considerably shorter than the 1,350 words from the previous G7 meeting in April. Despite its shortness, the message clearly stated a five-­point action plan outlining the resolve of the governments and central banks of the G7 economies. The statement released began by firmly stating, “The G7 agrees ­today that the current situation calls for urgent and exceptional action. We commit to continue working together to stabilize financial markets and restore the flow of credit, to support global economic growth.”6 The first three of the five action points ­were as follows. First, the G7 was to “take decisive action and use all available tools to support systemically impor­ tant financial institutions and prevent their failure.” Second, the G7 would “take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.” Third, the G7 would “ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-­establish confidence and permit them to continue lending to h ­ ouse­holds and businesses.”7 152 | The Days as Governor

­These action points communicated the shared conviction of the governments, central banks, and regulatory authorities of the G7 economies following the collapse of Lehman ­Brothers.

ACTIONS BY THE BANK OF JAPAN The Bank of Japan did every­thing within its powers to maintain the stability of the financial system and the economy. First and foremost was to ensure that Leh­man’s Japa­nese subsidiaries would be resolved in an orderly manner. Staff in the Bank Examination Department provided extensive information to the Tokyo District Court and the Financial Ser­vices Agency. The fact that bank staff gained much hands-on knowledge during the Japa­nese financial crisis of the second half of the 1990s contributed greatly to the orderly resolution of Lehman in Japan. Another impor­tant role for the bank was to ensure that the settlement of  funds and Japa­nese Government Bonds, which ­were handled through BOJ-­NET, continued without disruption, as well as to maintain the smooth functioning of financial markets. In order to signal the bank’s resolve in this regard, on the first business day following the collapse of Lehman ­Brothers, September 16, the bank publicly released the following statement: “The Bank of Japan ­will carefully monitor recent situations surrounding the U.S. financial institutions and their influences, and ­will continue to strive to ensure smooth settlement of funds and maintain stability in financial markets through mea­ sures such as appropriate money market operations.”8 ­After putting ­these stopgap mea­sures in place, the bank took three additional actions. The first was providing ample liquidity so as to maintain the stability of financial markets. The second was to lower interest rates to support economic activity, and the third was to adopt mea­sures that restored credit intermediation. The collapse of Lehman B ­ rothers had the unintended benefit of enabling the government to fill the bank’s vacant deputy governor’s seat. Kaoru Yosano, who became the minister in charge of economic and fiscal policy as a result of a cabinet reshuffle by Prime Minister Yasuo Fukuda on August 2, confided to me privately that Leh­man’s failure provided a rare opening to give impetus to the appointment pro­cess for the Bank of Japan’s deputy governor, which had become bogged down in the midst of po­liti­cal wrangling between the government and the opposition of the Demo­cratic Party of Japan. Consequently, the bank was able to take on Hirohide Yamaguchi, who was my preferred choice as the other deputy governor. The Collapse of Lehman B ­ rothers | 153

POLICY NUMBER 1: PROVIDING AMPLE LIQUIDITY The first and foremost function of a central bank facing a financial crisis is to provide ample funds liquidity to domestic financial markets as the “lender of last resort.” The Bank of Japan followed this time-­honored doctrine and provided ample yen funds to financial markets. As Japa­nese financial institutions ­were relatively less exposed to complex securitized products compared with peers in Eu­rope and the United States, short-­term money markets in Japan ­were far more stable than t­hose elsewhere. In fact, the peak Libor-­OIS spread for yen was 0.7 ­percent, which was much lower than that for US dollars or euros. The liquidity prob­lem for Japan was not in yen funds but in US dollar funds. Japa­nese banks, especially the larger ones, ­were actively investing in overseas markets, which necessitated substantial dollar funding, and such funding rapidly became difficult following the collapse of Lehman B ­ rothers. Dollar funding was also an issue for Japa­nese nonfinancial firms, including auto manufacturers. For example, ­Toyota had an essentially debt-­free operation in Japan, but in terms of its global consolidated balance sheet, which included overseas markets accounting for 77 ­percent of consolidated sales, t­ here was 11 trillion yen of short-­ term and 6 trillion yen of long-­term debt.9 Given that the markets for CPs and corporate bonds in the United States had seized up and it was becoming difficult to tap Japa­nese banks for dollar funds, concerns over the availability of dollars ­were rapidly building up among large Japa­nese nonfinancial corporations. Japan’s foreign exchange reserves amounted to US$1 trillion; 95 ­percent of that was held by the government in the Foreign Exchange Funds Special Account, and the Bank of Japan’s holding of foreign exchange was equivalent to only 5.5 trillion yen. Since ­t here was only a ­limited amount of immediately available dollar funds, if a non-­US central bank wished to become a lender of last resort to domestic banks for dollars, that central bank had to secure dollars from the New York Fed. For this purpose, swap lines ­were established between non-­US central banks and the New York Fed, which enabled ­these non-­US central banks to obtain dollar funds by providing domestic currencies as collateral. The non-­US central banks would then decide which domestic banks would receive the dollar funds thus obtained. Accordingly, the New York Fed did not assume any default risk for the dollar funds. Swap lines with the New York Fed ­were already established for the Eu­ro­pean Central Bank (ECB) and the Swiss National Bank in December 2007, a­ fter BNP Paribas had rocked the market. At that time the Bank of Japan did not become ­ ere not facing any funding a party to the swap lines b ­ ecause Japa­nese banks w 154 | The Days as Governor

difficulties. Circumstances suddenly changed following the failure of Lehman ­Brothers, and the Bank of Japan de­cided to establish a swap line along with the Bank of Canada and the Bank of ­England. Given that any announcement of such a decision had to be made si­mul­ta­neously around the world, an extra­ ordinary Bank of Japan Monetary Policy Meeting (MPM) was convened in the ­middle of the night on September 18 to approve the establishment of a swap line. Announcements by all participating central banks followed immediately. The arrangement was up and ­running in a ­matter of a few days, without any information leaks before its launch. It reflected the strong mutual trust among central banks, which was an invaluable asset. The number of participating central banks expanded to fourteen, with ­t hose of Australia, Brazil, Mexico, New Zealand, Norway, Singapore, South K ­ orea, and Sweden eventually joining ranks. The cap on US dollars drawn by the Bank of Japan began at $60 billion, then increased to $120 billion. As the dollar funding market r­ eally seized up, the cap was abandoned altogether on October 13. Aggregate dollar funds supplied by the bank to private banks reached $127.6 billion by the end of December. Central banks around the world thus cooperatively performed the role of “global lender of last resort.” Supplying US dollar funds utilizing swap lines was the most appreciated action of the Bank of Japan during the GFC by market participants. Since financial stability is often taken for granted, appreciation for central bank contributions to it are rather rare and, accordingly, it is not common for central bank staff responsible for financial stability to vividly feel that their actions are having a tangible impact. The actions just described ­were what central banks might naturally have been expected to do in t­ hose conditions, but hearing the words of appreciation must have been the most rewarding moment to bank staff, who had to negotiate and hammer out practical solutions with overseas counter­parts, sometimes without sleep.

POLICY NUMBER 2: CUTTING THE POLICY RATE AND INTRODUCING INTEREST-­B EARING RESERVES The next mea­sure undertaken by the Bank of Japan following the failure of Lehman ­Brothers was cutting the policy rate. In an environment where banks and nonfinancial corporations ­were faced with existential risks, the impact of a rate cut on economic conditions would be ­limited, but it was impor­tant for a central bank to show that it was d ­ oing every­t hing within its powers to mitigate the economic downturn. Accordingly, the bank cut its policy rate The Collapse of Lehman B ­ rothers | 155

by 0.4 percentage points in two installments of 0.2 percentage points on October 31 and December 19, 2008. At the October MPM t­ here was a disagreement on the magnitude of the cut. One group preferred a 0.2 ­percent cut and the other a 0.25 ­percent cut, resulting in a split vote. As a result, the chair was in the extraordinary position of having to cast the deciding vote. At the next MPM, the vote was seven for and one against the cut. ­After t­ hese two cuts, the policy rate had been lowered from 0.5  ­percent to 0.1  ­percent. The rate cuts ­were indeed smaller than ­those made by central banks in Eu­rope and the United States, but this was simply a reflection of the already low level policy rate in Japan before the collapse of Lehman. The Japa­nese policy rate had been at 0.5 ­percent at that time, and that was far lower than that of the FRB (at 2.5 ­percent), the ECB (at 3.75 ­percent), and the Bank of ­England (at 5.0 ­percent). Unfortunately, ­there was ­little room for maneuver left for the Bank of Japan. Concurrently with the October 31 rate cut, a mea­sure was introduced to pay interest on excess reserve balances. As I have noted, following the failure of Lehman B ­ rothers, the Bank of Japan aggressively supplied funds so as to maintain the stability of the financial system. In such an environment, the resulting excess reserves—­that is, the number of current accounts exceeding the level stipulated by the Reserve Requirement System—­would push the overnight interbank rate to zero b ­ ecause excess reserves would not earn any interest. The issue was that the level of interest rates reached through the ample supply of funds with the aim of maintaining financial stability was not necessarily consistent with the optimum level of interest rates from the perspective of the macroeconomy. But if the bank was allowed to pay interest on current accounts, it would be able to supply ample funds in response to financial instability and, at the same time, set a policy rate consistent with its views on macroeconomic conditions. In other words, the mea­sure to pay interest on excess reserves enabled the bank to pursue the most appropriate liquidity provision, or the most appropriate credit policies, separate from its monetary policy decisions on the level of interest rates. The introduction of the new mea­sure was inspired by the introduction of a similar mea­sure in the United States. Th ­ ere, the FRB had been asking Congress for some time to give it powers to pay interest on central bank balances, which ­were fi­nally granted in 2006.10 Originally it was envisaged to begin paying interest ­after 2011, but, reflecting the growing sympathies with the view of the FRB that such powers w ­ ere essential in combating financial instability, the Emergency Economic Stabilization Act of 2008 was passed by the US Congress on October 3, and thereafter the FRB was authorized to begin paying interest. 156 | The Days as Governor

It was then unusual for a central bank to pay interest on balances, and the mea­ sure would have faced stiffer re­sis­tance ­under calm market conditions. ­There would have been criticism that such a mea­sure amounted to pampering banks, or that the US Trea­sury should not be supportive ­because of lost seigniorage revenue. When I heard the news that the United States had de­cided to allow paying interest to balances at the FRB, I immediately de­cided to seize the opportunity to introduce a similar mea­sure in Japan. One reason for this decision was based on the lesson that I drew from the prior experience of quantitative easing between March 2001 and March 2006: the most appropriate level of the short-­term interest rate for the macroeconomic stability seemed to be not literally zero but slightly positive. During quantitative easing, the overnight rate fell to 0.001 ­percent, which was as close to zero as one could get, destroying any incentive to trade in the interbank market ­after accounting for transaction costs. Accordingly, ­there ­were barely any interbank transactions, and the functioning of the interbank market deteriorated as financial institutions became fearful of not being able to obtain funding from the other market participants in a timely manner.11 Put differently, when short-­ term interest rates fall below a threshold, the stimulative effects of “easier” monetary policy would perversely turn negative. The same could be said for the lending decisions by banks. Looking at the maturity structure of the banks’ balance sheets, the duration of deposits on the liability side is short and the duration of assets, composed mostly of loans and securities held, is long. Consequently, when interest rates go down, the ­actual level of interest rates on the banks’ liability side would come down faster than t­ hose on the asset side, thereby increasing the interest rate spread. That would prompt banks to increase lending. But when interest rates are already quite low, the room for lowering funding costs is ­limited and the rates of return on invested funds w ­ ill continue to decline, eventually resulting in weaker incentives to lend and l­ ittle stimulus for the economy. The ensuing hit to bank profitability might be detrimental to financial stability, which, in my view, w ­ ill also eventually erode the effectiveness of monetary policy. I believed that while it was not pos­si­ble to pin down the exact level below which monetary policy would cease to be effective, the level was not literally zero. That level would be dif­fer­ent from one economy to another and also dif­ fer­ent at dif­fer­ent times within a single economy. For example, in the United Kingdom, the policy rate was maintained at 0.5 ­percent from March 2009 ­until ­ ngland August 2016 in the aftermath of the Brexit vote, even as the Bank of E expanded its asset purchases. In the United States, the FRB refrained from cutting The Collapse of Lehman B ­ rothers | 157

the policy rate below 0.25 ­percent. Unfortunately, this notion that ­there was a lower bound for the policy rate in terms of effectiveness of monetary policy was not widely shared at that time. This fi­nally dawned on p ­ eople only ­after Benoit Cœuré, a member of the Executive Board of the ECB, began to use the terms “economic lower bound” and “reversal rate” in a speech he made in July 2016.12 Another reason for the necessity of introducing interest-­bearing deposits was related to my concern about the need for an eventual exit policy, which I avoided publicly discussing at the time. As a part of the exit policy from quantitative easing in 2006, quantity was compressed by not rolling over fund-­ supplying market operations as they matured, and this was followed by an increase in the policy rate. It was then pos­si­ble to reduce the quantity in a relatively short time frame (about three months), reflecting the relatively short duration of funds-­supplying market operations at the time. But if the amount of current account balances ­were increased significantly or if the duration of operations became longer, the time required to drain a huge quantity of current account would become so long as to preclude timely conduct of monetary policy. While it was certainly pos­si­ble in theory to introduce interest-­bearing deposits when an exit was imminent, that would prompt speculation about monetary policy actions and could be highly disruptive for financial markets. Accordingly, I thought it would be imperative to have the option to raise interest rates before we might reduce the quantity of reserves; interest-­bearing deposits made that pos­si­ble.

POLICY NUMBER 3: CREDIT-­E ASING MEA­S URES ­ fter the collapse of Lehman B A ­ rothers, the Bank of Japan also implemented mea­sures to restore credit intermediation and ease lending to businesses. New issues in the CP and corporate bond markets became difficult, and corporate funding rapidly shifted to bank loans. Accordingly, the year-­on-­year growth of bank lending jumped from 1.8 ­percent in September 2008 to 4.1 ­percent in December. The Bank of Japan was fully committed to maintaining an environment where banks could meet demand for credit from the economy. In addition, the bank de­cided to employ slightly more direct mea­sures to encourage business lending, and introduced a series of mea­sures at MPMs held from October onward, calling extraordinary meetings when necessary. The mea­sures ­were similar to t­ hose the FRB undertook around the same time, which w ­ ere named 158 | The Days as Governor

as credit easing by the FRB. The first of such mea­sures in Japan was called the Special Funds-­Supplying Operations to Facilitate Corporate Financing. ­Under this scheme, the bank eased the requirements for corporate debt accepted as collateral in fund-­supplying operations to private banks and, at the same time, indicated readiness to accept all bids for funds from financial institutions, lending at an interest rate equal to the prevailing policy rate. A difficult issue was ­whether or not the Bank of Japan should purchase CPs and corporate bonds. ­A fter the failure of Lehman ­Brothers, extreme uncertainty prevailed, and banks and investors focused solely on their own survival. Consequently, investors ­stopped purchases of CPs and corporate bonds irrespective of the creditworthiness of the issuer, and ­those markets froze up. One option to thaw the markets was to have a public body buy CPs and corporate bonds, thereby restoring market functioning. The question was who should be tasked with buying the CPs and corporate bonds. Purchases by the Bank of Japan was certainly an option. A sticking point, however, was that Japan already had government-­sponsored financial institutions, which ­were very large, and without peers in other developed economies. Accordingly, it would have been most natu­ral to let ­those institutions, such as the Development Bank of Japan, bear the credit risk of individual firms and purchase CPs and corporate bonds. In fact, the Development Bank began buying CPs in December 2008. The ­legal status of the Development Bank of Japan was then in a transitional phase, however. It was 100 ­percent owned by the Japa­nese government, but on October 1, 2008, its l­egal structure was changed to that of a private com­pany or­ga­nized ­under the Companies Act, with the ultimate aim of g­ oing public. As a result, the Development Bank seemed to hesitate in conducting large-­scale purchases of CPs. On the side of the Bank of Japan, ­there was a question of the fundamental division of l­abor between the government and the central bank in a demo­cratic society. Before the GFC, the Bank of Japan and other central banks around the world did accept CPs and corporate bonds as collateral in their day-­to-­day monetary operations, but ­there was a fundamental difference in terms of risk between accepting them as collateral and conducting outright purchases.13 If a central bank purchased the CPs and corporate bonds of a firm, it would be directly bearing the credit risk of that firm. If the issuer defaulted, the central bank would suffer, decreasing seigniorage payments to the national trea­sury, which in effect meant the taxpayers would have to absorb the losses. At the same time, central bank rules could draw a line between eligible and noneligible issuers, which meant that the central bank The Collapse of Lehman B ­ rothers | 159

was influencing microlevel resource allocation—­that is, conducting a type of quasi-­fiscal policy. Given that in demo­cratic socie­ties fiscal policy has generally ­ nder the government and the been placed in the hands of the po­liti­cal pro­cess u parliament, a central bank that conducted quasi-­fiscal policy as monetary policy would undermine its neutrality, which is indispensable for in­de­pen­dence. That would, in turn, erode confidence in the conduct of monetary policy. While the role of the Bank of Japan called for caution, corporate financing at the time was in dire straits. Balancing t­ hese concerns, at the MPM on December 19, 2008, the bank fi­nally announced its decision to purchase CPs and stated that it would be examining the conditions for the purchase of other financial instruments. The bank began its a­ ctual purchase of CPs in February  2009, and of corporate bonds in March of that year. The mea­sure was dif­fer­ent from the traditional function as the lender of last resort, but in the sense that it aimed to maintain the functioning of credit markets by purchasing financial instruments, it was broadly performing a similar role. Some described the mea­sure as the “market maker of last resort.” The amount of outstanding CPs purchased by the bank reached 1.3 trillion yen by the end of February and increased to 1.6 trillion yen by the end of March. Aggregate purchases reached approximately 6.9 trillion yen. I believe that t­ hese purchases contributed significantly to stabilizing corporate financial conditions in Japan. In addition to the purchases of CPs and corporate bonds, the Bank of Japan reopened its program of buying stocks from private financial institutions. The aim was to end the vicious feedback of falling stock prices negatively impacting the balance sheets of banks that owned stocks, thus eroding capital positions, resulting in reduced lending capacity and inviting further falls in stock prices.

THE DIVISION OF L­ ABOR BETWEEN THE GOVERNMENT AND THE CENTRAL BANK Dif­fer­ent economies responded differently in terms of purchasing CPs and corporate bonds. The Bank of ­England, Bank of Japan, and FRB purchased them, but the ECB did not. Even among central banks that made purchases, t­ here was no convergence in the institutional bodies that ­were to absorb any losses that might arise. In the United Kingdom, a fund named the Asset Purchase ­ ngland, and while the Fa­cil­i­t y was established as a subsidiary of the Bank of E bank provided funding for purchases via this vehicle, indemnity was promised by the government for any losses that might arise. In the United States, 160 | The Days as Governor

the New York Fed provided funding to a special purpose vehicle u ­ nder the assumption that credit risk was sufficiently compensated by purchase spreads, with residual losses to be covered by the US Trea­sury up to a certain amount. In contrast, the Bank of Japan sought authorization from the Japa­nese government for the purchases, but the specifics of purchases ­were to be the bank’s decision and responsibility, and it sought no loss compensation from the government. Government involvement is desirable from the perspective of giving legitimacy to an action by the central bank, which almost resembles fiscal policy as a result of assuming credit risk from individual firms. On the other hand, the possibility of government compensation might give rise to the risk that purchasing standards could be compromised, which could distort the pricing of financial assets over the long term and compromise allocative efficiency and thus the sound development of the economy. At the same time, one would also have to recognize that the central bank would be heavi­ly criticized for incurring any loss, regardless of ­whether ­there was government indemnity or not. The central bank has a privilege to be able to supply unlimited liquidity, but ­ ill be “a that goes hand in hand with the expectation of the society that it w 14 good steward of public funds.” I believe that the diverging actions by central banks in this case was the result of each central bank pursuing the most appropriate response ­under dif­fer­ent economic and social constraints in its respective jurisdiction.

THE YEN RAPIDLY RISES The rapid appreciation of the yen was another big challenge following the collapse of Lehman B ­ rothers. Just before the collapse, the exchange rate was 107.45 yen to the US dollar. The yen then began to visibly appreciate into October, and reached 92.78 yen to the dollar on October 27. By the ­middle of December, the exchange rate was hovering in the 80s. Against the euro, the yen’s appreciation was more rapid, jumping from 153.42 before the collapse to 118 by October 24 (see fig. 8.2). Looking at the nominal effective exchange rate, the yen bottomed in July 2007, one month before BNP Paribas shocked the global financial markets. From ­there the yen began to appreciate ­until the trend was checked in April 2008, reflecting a sense of relief in global financial markets. From September 2008 on, however, the yen not only resumed its appreciation but did so at a much faster pace. Pressure on the Bank of Japan to prevent further yen appreciation in the autumn of 2008 was relatively muted compared The Collapse of Lehman B ­ rothers | 161

115

200

110

190 180

105

160 100 140 95

Japanese yen / US dollar Japanese yen / euro (right-hand scale)

90

130 120

85

110

80 2008/1 2008/2 2008/3 2008/4 2008/5 2008/6 2008/7 2008/8 2008/9 2008/10 2008/11 2008/12

100

Figure 8.2 ​The US dollar and euro exchange rates vis-­à-­vis the Japa­nese yen. Source: Bank of Japan.

with subsequent periods of yen appreciation, perhaps b ­ ecause more attention was focused on the existential prob­lems with dollar funding and the CP markets at the time. Looking at the movements in the nominal effective exchange rates from August 2008—­that is, from just before the collapse of Lehman B ­ rothers—­one can see that the demand for safe-­haven currencies significantly increased as the effects of the collapse reverberated through global financial markets. Currencies of economies with unstable financial systems or structural weaknesses, such as the euro, pound sterling, and Korean won, depreciated. On the other hand, currencies that w ­ ere viewed as safe havens, such as the yen and the Swiss franc, appreciated. The US dollar also appreciated, even though the United States was ­ ecause of the tendency of market participants to the epicenter of the crisis, b buy the reserve currency in times of extreme uncertainty (see fig. 8.3). The Bank of Japan was hard-­pressed in this environment ­because it was placed in a position in which it could not widen the interest rate differentials. Japan’s policy rate was already low, at 0.5 ­percent, and ­there was obviously ­little room for additional cuts. Japan’s long-­term rates at the end of August ­were also the lowest in the world: yields on ten-­year government bonds ­were around 1.4 ­percent in Japan, 3.8 ­percent in the United States, and 4.2 ­percent in Germany. This meant that even if the bank cut its policy rate in the hopes of damp162 | The Days as Governor

(Index, August 1, 2008 = 100) 140 Japanese yen US dollar 130 Euro UK pound Swiss franc 120 Korean won Australian dollar 110 100 90 80 70 60 2008/8

Appreciation

Depreciation 2008/9

2008/10

2008/11

2008/12

Figure 8.3 ​Nominal effective exchange rates (narrow index). Source: Bank for International Settlements.

ening the appreciation of the yen, the fall in the long-­term rates would have been l­imited. It was not pos­si­ble to widen the interest rate differentials meaningfully. In this regard, an expression of the yen as a safe-­haven currency is somewhat misleading. It reflects this intrinsic tendency of the exchange rate to appreciate in times of a global downturn due to interest rate differentials, as well as Japan’s net external investment position, which is the largest in the world. Unfortunately, ­these sobering constraints ­were not well understood. As a result, the Bank of Japan would continue to be beleaguered by the criticism that it was the bank’s lethargic conduct of monetary policy that invited the appreciation of the yen.

THE COORDINATED RATE CUTS BY MAJOR DEVELOPED ECONOMIES With regard to the conduct of monetary policy by the Bank of Japan at this juncture, it has often been criticized for not taking part in the coordinated rate cuts by major developed economies that ­were conducted on October 8, 2008. It was immediately a­ fter the extraordinary MPM on October 7 ended that I was asked by the FRB if the Bank of Japan wanted to take part in the coordinated The Collapse of Lehman B ­ rothers | 163

action. Since the Japa­nese financial system was in much better shape than that of Eu­rope or the United States, and we ­were not overly concerned about inflation in the first place, ­there was no compelling reason to overturn the judgment that had just been made a few minutes before and announce joint rate reduction only for the purposes of solidarity.15 If our policy rate had been at the same level as that of other developed economies, a dif­fer­ent conclusion might have been pos­si­ble. But given that our policy rate was as low as 0.5 ­percent, we judged that this was not the time for using such a solution and that it was time instead to concentrate our efforts on preventing the collapse of the financial system. Even if the bank did not cut its policy rate, it fully recognized the necessity of showing solidarity as a major developed economy and released a statement strongly supporting the rate cuts of participating central banks as it si­mul­ta­neously announced its own coordinated actions.

THE GOVERNMENT IN ACTION In parallel with the actions of the Bank of Japan, the Japa­nese government also aggressively implemented vari­ous policies so as to mitigate the rapid deterioration of economic activities. The first was fiscal expenditure. The second was to encourage the purchase of automobiles and ­house­hold appliances by introducing a variety of subsidies and incentives. Other mea­sures included facilitating the financing of small-­and medium-­size enterprises (SMEs) through emergency guarantees and stabilizing employment through an employment adjustment subsidy. The former empowered credit guarantee corporations owned by local governments in their respective prefectures to extend full guarantees when SMEs ­were borrowing from banks; in the case of the default of the borrower SMEs, the guarantor corporations would repay the loans. The latter mea­sure subsidized the wages of employees who had no work but ­were kept on the payrolls.

THE RELATIVE CALM IN JAPA­N ESE FINANCIAL MARKETS Looking at the state of the Japa­nese economy and financial markets in the wake ­ rothers, t­here was a stark contrast between their reof the failure of Lehman B spective per­for­mances. The financial markets and the financial system ­were stable relative to other developed economies, and ­there was only a ­limited widening of the Libor-­OIS spread. Such relative stability reflected the fact that Japa­nese financial institutions, fresh from the memories of the financial crisis of the 164 | The Days as Governor

1990s, w ­ ere largely steered prudently, whereas Eu­ro­pean and US financial institutions w ­ ere aggressively increasing their investments in securitized products. Given that the financial systems of Eu­rope and the United States w ­ ere u ­ nder intense pressure, their central banks had to supply extremely large amounts of funds as lenders of last resort. Consequently, their balance sheets expanded significantly. In contrast, the balance sheet of the Bank of Japan did not expand as much, reflecting the relative stability of the financial system. Ironically, this led to a misunderstanding as regards the conduct of the bank’s monetary policy: even as the bank was most successful in maintaining an environment in which firms and ­house­holds enjoyed easy financing conditions by any international comparison, it still suffered the criticism that it was not aggressive enough in easing monetary policy.16

THE CONTRACTION OF ECONOMIC ACTIVITY Whereas the Japa­nese financial system enjoyed relative stability, Japan’s real economy suffered a huge setback. Gross domestic product (GDP) for the fourth quarter of 2008 and the first quarter of 2009 recorded steep quarter-­to-­quarter (i.e., before annualizing) declines of 3.3 ­percent and 4.0 ­percent, respectively.17 Looking at the components of GDP, exports decreased over ­those six months by 35 ­percent and capital investment decreased by 10 ­percent. Industrial production was hit even harder, and the declines registered for automobiles, electrical equipment, and construction machinery w ­ ere especially pronounced. The business sentiment index of the Bank of Japan’s Tankan survey for large manufacturing enterprises sank from −3 points in September 2008 to −24 points in December and −58 points in March 2009. Comparing the GDP of the third quarter of 2009 and the first quarter of 2009 across several economies (see fig.  8.4), the fall in Japa­nese GDP was 7.0 ­percent, slightly exceeding Germany’s, at 6.3 ­percent. It was much larger in absolute value than the 3.5 ­percent decline scored by the United States. On the other hand, though Japan could not escape an increase in unemployment, the increase was muted compared with other developed economies (see fig. 8.5). One contributing ­factor was Japa­nese employment practices: large firms tended to absorb shocks by lowering wages instead of shedding workers in the face of falling demand. As to the reason for such a sharp contraction of GDP, some commentators point to the impact of the appreciating yen. I doubt that this was the case, ­because a higher yen in one quarter would not immediately have impacted The Collapse of Lehman B ­ rothers | 165

(Index, 2008Q3 =100) 102

100

98

96 Japan United States United Kingdom Germany

94

92

90

2008Q3

2008Q4

2009Q1

2009Q2

Figure 8.4 ​Real gross domestic product. Source: Federal Reserve Economic Data, Federal Reserve Bank of St. Louis.

(%) 11 Japan United States United Kingdom Germany

10 9 8 7 6 5 4 3 2 2007

2008

2009

2010

2011

2012

Figure 8.5 ​The unemployment rate. Source: Federal Reserve Economic Data, Federal Reserve Bank of St. Louis.

2013

exports in the same quarter. Incidentally, the German GDP also recorded a steep decline, but the exchange rate of the euro fell substantially ­after the collapse of Lehman ­Brothers. A sharp decline in Japa­nese GDP reflected, to a large extent, the industrial structure of vari­ous economies, as is explained below. ­After the Lehman collapse, demand evaporated globally, which was reflected in the rapid shrinking of international trade. Trade volume shrank by a whopping 15 ­percent between the third quarter of 2008 and the second quarter of 2009. Obviously, economies dependent on the goods whose demand evaporated most would be hit the hardest by the crisis. Such goods w ­ ere e­ ither big-­ticket consumer durables such as automobiles or industrial machinery purchased by firms conducting capital investment. House­holds are not inclined to purchase expensive durable goods when t­ here are substantial uncertainties about f­ uture income or employment, and firms ­will not invest in new factories. If a firm spends a lot of money on building a factory in a highly uncertain environment, and if it turns out that the decision is a ­mistake, the firm suffers significantly. Considering the risks of such irreversible decisions, it was much better to put decisions on hold at the time. Furthermore, financing was a serious prob­lem, as bank credit was not forthcoming. In the case of automobiles, sales ­were hit hard when automotive financing companies, which ­were the largest issuers in the US CP market, could not obtain sufficient funding when the CP markets froze up. Given that Japan was most competitive in the areas of consumer durables such as automobiles and capital goods, and almost half of Japa­nese industrial production was in the three sectors of transportation equipment, electrical machinery, and general machinery (including construction and production machinery), it had to face the full-­force headwinds of the GFC. The effects on the US economy ­were much smaller, where t­hese sectors only accounted for about 20  ­percent of ­industrial production. Germany, which had a similar industrial structure to ­Japan’s, also suffered a deep slump in GDP, second only to Japan’s among the advanced industrial economies.

AVOIDING A REPEAT OF THE ­G REAT DEPRESSION The global economy went into a tailspin, but signs of stabilization began to be observed around the spring of 2009, benefiting from the gradual stabilization of financial markets. This in itself was a ­great achievement considering that the initial decline in global economic activity paralleled that of the ­Great Depression of the 1930s. The greatest difference between the two events was that, The Collapse of Lehman B ­ rothers | 167

in 2009, governments and central banks moved aggressively so as to prevent the meltdown of financial systems. For governments, such actions included injecting capital and extending guarantees to financial institutions, as well as conducting “stress tests” aimed at verifying sufficiency of capital in severe economic scenarios. As for central banks, they decisively acted as the lenders of last resort. This was pos­si­ble in the GFC b ­ ecause governments and central the 1930s: the stability of the financial system was banks heeded the lessons of crucially impor­tant, monetary systems had long since moved away from the gold standard, and currencies ­were f­ ree to float. With regard to preventing a further contraction of economic activity, fiscal policy actions ­were deployed, complementing the steps being taken by central banks. In this context the contribution from China was impressive along with  ­those of other developed economies. On November  9, 2008, China announced a “four trillion yuan economic stimulus package,” which was more than 10 ­percent of its GDP and supported the recovery of not only the Chinese economy but also the global one. Yet one should also note that while this mea­ sure had a big impact in the short term, it eventually became evident that it created a larger long-­term prob­lem: it brought about large capacity increases in the industrial materials industries (such as steel, chemicals, and cement) and significant increases in credit, which made it difficult for China to transform its economy from a stage of high growth to a more stable and steady growth. Furthermore, the increases in the demand for commodities induced by the mea­sure resulted in rising commodity prices and the expansion of commodity-­producing economies, which also led to big prob­lems some years l­ater.

REFLECTING ON THE US AUTHORITIES’ RESPONSE TO THE LEHMAN B­ ROTHERS FAILURE Looking back on how the GFC unfolded, and especially the days following the failure of Lehman B ­ rothers, I am struck by the many similarities and some dissimilarities with the Japa­nese financial crisis of the last half of the 1990s. In both countries the government and the central bank realized as the crisis unfolded that sufficient ammunition was necessary to combat the crisis. The stark fact was that, in both cases, ammunition was utterly lacking. This is underscored in the memoirs of Ben Bernanke, Timothy Geithner, and Hank Paulson Jr., and when one reads the book coauthored by them, one is impressed by their repeated references to authority, tools and ­viable options.18 It was only ­after the chaos caused by the collapse of Lehman that the necessary powers 168 | The Days as Governor

and tools ­were granted to the government and central bank. In fact, it took only sixteen days for this to happen. In view of the subsequent sharpening of the partisan divide in the US Congress, the bipartisan efforts during the crisis are striking. How, then, should one interpret the fact that the US authorities did not provide public support to Lehman ­Brothers? Following Leh­man’s collapse, and faced by the deepening crisis, the central banks of developed economies took decisive action, discharging their responsibilities as the lenders of last resort. This became necessary b ­ ecause of the collapse of Lehman itself—­the defining event. It is quite reasonable, therefore, to won­der how events would have unfolded if the US authorities threw a public lifeline to Lehman, as they had in the case of Bear Stearns before it and AIG only two days a­ fter it. In fact, many non-­US bank governors, including myself, ­were critical of the ­handling of the prob­lems at Lehman, though we did not loudly say so. The answer from the United States is shown in Bernanke’s testimony to Congress shortly ­after the collapse of Lehman: The Federal Reserve and the Trea­sury attempted to identify private-­sector approaches to avoid the imminent failures of AIG and Lehman ­Brothers, but none was forthcoming. In the case of AIG, the Federal Reserve, with the support of the Trea­sury, provided an emergency credit line to facilitate an orderly resolution. The Federal Reserve took this action ­because it judged that, in light of the prevailing market conditions and the size and composition of AIG’s obligations, a disorderly failure of AIG would have severely threatened global financial stability and, consequently, the per­for­mance of the US economy. . . . ​In the case of Lehman ­Brothers, a major investment bank, the Federal Reserve and the Trea­sury declined to commit public funds to support the institution. The failure of Lehman posed risks. But the trou­bles at Lehman had been well known for some time, and investors clearly recognized—as evidenced, for example, by the high cost of insuring Leh­man’s debt in the market for credit default swaps—­that the failure of the firm was a significant possibility. Thus, we judged that investors and counterparties had had time to take precaution­ ary mea­sures.19 Reading this testimony one gets the impression that the FRB was of the view that financial markets would be able to manage the failure of Lehman ­Brothers. Yet in subsequent testimonies to Congress and his memoir, it seems that The Collapse of Lehman B ­ rothers | 169

Bernanke emphasizes the lack of ­legal authority as the reason why the FRB  declined to support Lehman. As he explains in his memoir, “Leh­man’s insolvency made it impossible to save with Fed lending alone. Even when invoking our 13(3) emergency authority, we ­were required to lend against adequate ­collateral. The Fed has no authority to inject capital or (what is more or less the same ­thing) make a loan that we ­were not reasonably sure could be fully repaid.”20 Section 13(3) of the Federal Reserve Act stipulates that a federal reserve bank may, in “unusual and exigent circumstances,” extend credit to individuals, partnerships, or firms u ­ nder the authorization of the Board of Governors of the Federal Reserve System, which is analogous to the “special lending” undertaken at the Bank of Japan. The extension of credit needs to be secured by collateral, and must be “secured to the satisfaction of the Federal Reserve Bank.” The FRB had conducted vari­ous operations to stabilize the financial system ­u nder section 13(3) during the GFC, including the emergency extension of credit to JPMorgan Chase when it was purchasing Bear Stearns, and, particularly given the original testimony, I still won­der if insufficient collateral was the real reason for letting Lehman ­Brothers go u ­ nder. I do not have any concrete evidence to confirm or refute the availability of sufficient collateral, nor do I have any expertise in interpreting the Federal Reserve Act.21 The memoirs of ­those who ­were in charge basically offer the same explanation, but ­there seems to be slight differences in nuance. In this regard, Geithner’s account is in­ter­est­ing and somewhat nuanced; he notes, “I worried that all the anti-­bailout rhe­toric was jeopardizing our ability to find a buyer for Lehman.”22 Reflecting on the Japa­nese financial crisis, I believe that the recoverability of central bank credit is not a static concept. The central bank may or may not extend credit, and that may well determine ­whether a systemic event is averted. Macroeconomic conditions would then be vastly dif­fer­ent, and that consequently affects the asset quality of troubled financial institutions. In other words, w ­ hether the central bank can secure credit to its own satisfaction depends on its very decision to extend or not extend credit. My speculation is that, in the end, the most fundamental reason for not rescuing Lehman B ­ rothers was that it was judged difficult for the FRB to act against strong opposition from the public and the po­liti­cal establishment. As Bernanke, Geithner, and Paulson note, the failure of Lehman happened when the hostility of the public and Congress was boiling over following the emergency extension of credit to JPMorgan Chase ­after it bought Bear Stearns in

170 | The Days as Governor

March 2008 and the US Trea­sury’s placing of Fannie Mae and Freddie Mac ­under public conservatorship in September. If one would look for an equivalent environment in Japan during the 1990s, one might point to the period following the enactment of the law that enabled the use of public funds in the resolution of jusen (housing finance companies) in 1996—­against the strong opposition from the po­liti­cal establishment, the public, and the media, which delegitimized any use of public funds for larger financial institutions for some time in a critical situation.

THE FAILURE OF LEHMAN B­ ROTHERS VERSUS THE FAILURE OF JAPA­N ESE SECURITIES HOUSES With regard to the responses of US authorities to the failure of Lehman ­Brothers, I always compare it to the Japa­nese events in the autumn of 1997: the successive failures of Sanyo Securities and Yamaichi Securities. As I explained in chapter 3, Sanyo defaulted on its call money obligations in the interbank money market, a phenomenon that had never been seen in the postwar period. The amount was not very large, but its impact was massive, since nobody then had ever ­imagined that call money would not be repaid. Immediately afterward, financial institutions could not lend or borrow in the call money market, which triggered a rapid chain reaction that destabilized the financial system. Yamaichi faced severe liquidity prob­lems as off-­balance-­sheet liabilities w ­ ere suddenly disclosed at its overseas subsidiary. The failure of Lehman ­Brothers and Yamaichi Securities had much in common. Each firm was the fourth-­largest security h ­ ouse (investment bank) in its country. The state of the financial system in both cases—in Japan in November 1997 and in the United States in September 2008—­was precarious. ­There was no financial institution willing to purchase a doomed peer. The ­legal framework that would have enabled an orderly resolution of a securities h ­ ouse was non­ex­is­tent. The same was true for the authority of injection of public funds. Without such authority it was impossible to inject the funds to recapitalize and thus aid orderly resolution. Moreover, at both junctures, the idea of using public funds was extremely unpop­u­lar. Notwithstanding this difficulty, the Bank of Japan de­cided to provide unlimited liquidity to Yamaichi Securities. When Yamaichi was fi­nally wound up, it became evident that the firm was insolvent, and the Bank of Japan suffered a large loss. Obviously, in assessing the actions against Yamaichi, one needs

The Collapse of Lehman B ­ rothers | 171

to ask if it had been wise for the government and the Bank of Japan to let Sanyo Securities fail ­earlier. Nevertheless, the fact that even a smallish financial institution such as Sanyo could wreak havoc galvanized the government and the bank into taking action when the far bigger Yamaichi was collapsing. At a minimum, the extraordinary extension of credit to Yamaichi did forestall the worst consequences of the failure of a systemically impor­tant institution, and I believe that was truly valuable. Having said this, the response of Japa­nese authorities since the 1990s is often criticized as representing too much forbearance (see chapter 3). Decisive action by the central bank as the lender of last resort is essential in times of financial crises, but the provision of liquidity alone w ­ ill not solve the prob­lem. An injection of public funds—or, more precisely, the injection of capital using public funds—is an indispensable tool. In this regard, the liquidity provision by the Bank of Japan did avert a grave financial crisis comparable to that following the collapse of Lehman ­Brothers. At the same time, the actions of the bank might have prevented the stakeholders from recognizing the magnitude of the crisis.

THE SUCCESSFUL CONCLUSION OF “STRESS TEST” IN THE UNITED STATES Comparing the GFC of 2007–9 with the Japa­nese financial crisis, I am intrigued by the aptness of the strategy ­adopted by the US authorities, which resulted in a relatively rapid resolution of the GFC. What was most impor­tant in my view was their conducting of strict stress tests, and not taking up the option of nationalizing banks. Supervisors and regulators presented extremely tough stress scenarios to financial institutions, and financial institutions had to calculate potential capital shortfalls u ­ nder ­those scenarios. While the financial institutions ­were obliged to raise capital in the market to cover ­these shortfalls, authorities provided a backstop—­the injection of public funds—in case the efforts ­were not successful. This succeeded in dispelling the concerns over the viability of financial institutions. In the case of the Japa­nese financial crisis, it was widely recognized that ­there ­were capital shortfalls at financial institutions, but the difficulty of raising capital was also due to the uncertainty of the amount of capital shortfall itself. In this situation it was not pos­si­ble to persuade the market that capital was adequate without conducting a stress test backed up by public funds. In fact, Geithner’s memoir is aptly titled Stress Test, which illustrates the importance of the tests as a crossroads for the financial system at the time.23 172 | The Days as Governor

CONTRIBUTIONS FROM IMPROVED PAYMENT AND SETTLEMENT SYSTEMS Although in the context of crisis resolution t­ here is wide recognition of the importance of restoring the stability of the financial system, the public might be less aware of the relentless contributions from central banks to improve the payment and settlement systems.24 It is noteworthy that, even as financial systems around the globe w ­ ere g­ oing haywire, the functioning of the foreign exchange market was maintained. This was remarkable ­because, given that foreign exchange transactions involve a pair of currencies, ­t here was considerable settlement risk due to inevitable time differences. Fortunately, a scheme called Continuous Linked Settlement, which links the ­settlement of two currencies (such as the yen and the US dollar), had been launched in September 2002 for the settlement of foreign exchange transactions between major currencies and contributed to preventing severe disruptions in the foreign exchange markets. Had that system not come into being, the foreign exchange markets would prob­ably have suffered severe consequences from the fall of Lehman, and this would have added to the turmoil in other financial markets. Over the past quarter ­century the risks in payment and settlement systems have been reduced considerably through efforts—in addition to t­ hose in the foreign exchange market—­such as the introduction of gross real-­time settlement of funds and delivery versus payment for securities. Such reduction in risk was the result of joint efforts among private financial institutions and central banks. As for the responses to Leh­man’s failure, the focus is usually on the aggressive fiscal and monetary policies, while the continuous efforts by central banks to improve the payment and settlement systems are often overlooked. Even if it is understandable that the public might be fixated on eye-­catching “fire-­fighting exercises,” the notion of “fire prevention” (i.e., forethought) is just as—or perhaps even more—­impor­tant. I believe ­there should be more appreciation of the fact that the central bank contributes to the stability of the economy and finance through its banking operations.25

THE IMPORTANCE OF B­ UBBLE PREVENTION EFFORTS The rerun of the events of the 1930s was avoided by the aggressive efforts of governments and central banks. Having noted the importance of such ex post facto responses, it is imperative to reflect on why such an unpre­ce­dented global The Collapse of Lehman B ­ rothers | 173

credit ­bubble came into being. Credit ­bubbles lead to financial crises and extended stagnation of the economy; consequently, the most pressing policy issue is how to prevent them. The housing b ­ ubble in the United States and the excesses in securitized products that triggered the failure of Lehman ­Brothers developed through an interaction between fragile private financial institutions and inadequate public-­ sector responses. On the side of financial institutions, ­there was, for example, excessive leverage, too much reliance on short-­term funding, and deficiencies in risk mea­sure­ment and internal controls. ­These shortcomings w ­ ere not confined to US financial institutions. The fact that the first signs of the GFC came into view as a result of failings at BNP Paribas demonstrated that the issues ­were shared by Eu­ro­pean financial institutions as well. On the side of the public sector, one impor­tant flaw was the ­handling of financial firms that are situated outside a traditional perimeter of supervision and regulation, a shorthand for which is “shadow banking.” In addition, regulated and supervised entities had been on too long a leash. And, of course, an extended period of easy money was also a ­factor in the emergence and expansion of the ­bubble. All too often it becomes evident ­after the fact that ­there are complex interdependencies between the real economy and the financial system, as well as within the financial system itself. One usually comes to this realization too late. ­ ubble economy and globally in the years preThat was the case in Japa­nese b ceding the GFC. Considering this, we need to be a ­little humbler when we ­observe the economy and the financial markets, keeping in mind that our knowledge is ­limited. The GFC demonstrated the need to rethink our intellectual frameworks, which had been so influential prior to the crisis.

174 | The Days as Governor

| CHAPTER NINE |

The Increasing Clamor for Beating Deflation In the spring of 2009 the tide turned in financial markets around the world, and financial systems began to stabilize gradually. That was a g­ reat relief, but a return to a path of sustainable growth was a long way off. It was the beginning of the “false dawn,” which was to persist for some time. In September 2009 the Demo­cratic Party of Japan (DPJ) became the lead governing party, which was followed by an official declaration of a state of deflation in November. Public debate about deflation became intense and was widespread ­until the end of my term as governor of the Bank of Japan in 2013.

THE FALSE DAWN On February 13–14, 2009, I attended a meeting of finance ministers and central bank governors of the G7 economies in Rome. Around the t­ able, members expressed pessimistic views on the economy, just as the G20 economies had done at a meeting in São Paulo, Brazil, in November 2008. In the communiqué released a­ fter the meeting, it was noted that “the stabilisation of the global economy and financial markets remains our highest priority.”1 At the meeting, drawing parallel with the Japa­nese experience following the bursting of the ­bubble, I voiced concerns about the f­ uture path of the global economy. In contrast, the next G7 meeting, held in Washington, DC, on April 24, noted some improvements in the economy for the first time a­ fter the outbreak of global financial crisis (GFC) of 2007–9, although the overall tone was still downcast: “Recent data suggest that the pace of decline in our economies has slowed and some signs of stabilization are emerging. Economic activity should begin to recover l­ ater this year amid a continued weak outlook, and downside risks persist.”2 175

In the US stock market, the Dow Jones Industrial Average bottomed on March 9, 2009, at 6,547 points, which was less than half its peak before the GFC, and then began to rise. The mortgage market began to show some signs of life around the same time. In fact, Ben Bernanke, chair of the Federal Reserve Board (FRB), began to use the term “green shoots” to describe the nascent recovery in March 2009.3 ­These words and developments, if one examined them carefully, only indicated that t­ hings w ­ ere improving in the financial markets and w ­ ere not founded on a view that the economy would recover quickly. As such, I felt some uneasiness with the rather optimistic tone that was emerging. I thought that my role was to communicate the pitfalls of being too optimistic in the light of the Japa­nese experience following the bursting of the ­bubble. Accordingly, on the occasion of traveling to Washington for the regular International Monetary Fund (IMF) and World Bank meetings held in April, I delivered a speech in New York titled “Way Out of Economic and Financial Crisis: Lessons and Policy Actions,” emphasizing my unenthusiastic outlook on the global economy. In the address I highlighted the extended period before sustainable growth could return, which saw many false dawns ­after the bursting of the economic ­bubble: Even in the low-­growth 1990s, ­there ­were some tentative recoveries in Japan’s economy, which led p ­ eople to hastily believe that the economy has fi­nally regained traction. They turned out to be false dawns, but it is ­human nature to become optimistic when t­ hings improve a l­ ittle. . . .4 Japan’s economy did not resume sustainable recovery u ­ ntil it eliminated excess debt, excess capacity and excess l­ abor. The same goes for the current crisis. I think the US economy needs to work out excesses, which include unsustainable financial leverage, ­house­hold over-­indebtedness, and perhaps the over-­extension of the financial industry. This ­w ill be painful but inescapable. In view of Japan’s decade-­long experience, t­ here are no palatable alternatives.5 Around that time, I made similar remarks in vari­ous forums, including the international meetings held in Washington in the days following my New York speech. In retrospect, with regard to the global economy, international organ­izations and central banks around the world repeatedly released optimistic outlooks on economic growth, only to revise them ­later in the year (see fig. 9.1). 176 | The Days as Governor

(2008 = 100) 3 2 1 0 –1 –2 –3 –4 –5 –6 –7 –8 2008

World

United States

2 0 –2 –4 –6 –8 –10

2010

2012

2014

2016

2018 2008

2010

Japan

6

2012

2014

2016

–12 2018

2016

2 0 –2 –4 –6 –8 –10 –12 –14 –16 –18 2018

Euro area

4 2 0 –2 –4 –6 –8 2008

2010

2012

2014

2016

2018 2008

October 2013 WEO September 2011 WEO

2010

October 2010 WEO April 2009 WEO

2012

2014

October 2008 WEO

Figure 9.1 ​Real gross domestic product, percentage of precrisis trend. Source: International Monetary Fund (2013).

While the overall tone in the communiqué released ­after the G20 meeting in London on September 4–5, 2009, was cautious regarding the global economic outlook, ­there was, for the first time, a reference to “exit strategies”; we agreed upon “the need for a transparent and credible pro­cess for withdrawing our extraordinary fiscal, monetary and financial sector support as recovery becomes firmly secured. Working with the IMF and the FSB [Financial Security Board] we ­will develop cooperative and coordinated exit strategies, recognising that the scale, timing and sequencing of actions ­w ill vary across countries and across the types of policy mea­sures.”6 With regard to the conduct of monetary policy, most developed economies maintained accommodative policies, but some economies, commodity producers, and, in par­tic­u­lar, emerging market economies began to raise policy rates beginning in the autumn of 2009. Among the developed economies, the first to raise rates was Australia, in October; the second was Canada, in June 2010. Increasing Clamor for Beating Deflation | 177

ECONOMIC RECOVERY IN JAPAN The Japa­nese economy also bottomed out in the spring of 2009. A low for the Nikkei Index of stocks was reached on March 10, at 7,054 points, which turned ­ ubble. At the out to be the lowest point since the bursting of the Japa­nese b Monetary Policy Meeting (MPM) at the end of April, the Bank of Japan pointed out that “the pace of deterioration in economic conditions ­will likely moderate gradually and start to level out,” which was the first upgrading, though slight, of the Bank’s outlook since the collapse of Lehman ­Brothers.7 The worst was also over in the l­abor market in the summer of 2009, where unemployment began to fall in July and the job opening-­to-­application ratio began to rise in August. It was at the May 2009 MPM that the Bank of Japan upgraded its assessment of concurrent economic conditions for the first time, noting that “exports and production are expected to level out and start recovering, mainly due to pro­gress in inventory adjustments both at home and abroad.”8 The improvement, however gradual, continued, and this enabled the bank to declare at the September MPM that “Japan’s economic conditions are showing signs of recovery.”9

THE DEMO­C RATIC PARTY OF JAPAN COMES TO POWER In an environment of gradual economic recovery, ­there was a dramatic change in the Japa­nese po­liti­cal landscape. At the general election held on August 30, 2009, the DPJ won in a landslide, capturing 308 seats in the House of Representatives, which was almost a two-­thirds majority. Consequently, a co­a li­tion government was formed by the DPJ, the Social Demo­cratic Party, and the ­People’s New Party on September 16, led by Prime Minister Yukio Hatoyama. The Liberal Demo­cratic Party (LDP)—­which had held power almost continuously since its formation in 1955, except for a short break between July 1993 and April 1994, when a co­a li­tion led by Prime Minister Morihiro Hosokawa came to power—­moved into opposition. Whereas it is now difficult to recall the enthusiastic welcome of the electorate, the DPJ government was inaugurated with high expectations from the general public. When the DPJ came to power, many friends told me that my job would be made easier ­because of the party’s support for my appointment as governor. I was less sanguine. The relationship between a central bank and the government often does not reflect how the governor is appointed. It is almost a uni178 | The Days as Governor

versal rule that the party in power, irrespective of its po­liti­cal leanings, w ­ ill tend to demand easier monetary policy to stimulate the economy. So I was not surprised when the voices calling for aggressive monetary easing within the DPJ grew even louder when the DPJ formed its government. The relationship between the government and the bank would also be influenced by the personal chemistry between the governor and the prime minister, as well as the chief cabinet secretary, the finance minister, and the minister in charge of economic and fiscal policies. In terms of personal chemistry, I was rather fortunate in most cases. Two days a­ fter the general election, on September 1, I visited the headquarters of the DPJ, which was not far from that of the LDP, and met with the party’s leader, Yukio Hatoyama, to give a quick briefing regarding the condition of the economy and the conduct of monetary policy on the part of the Bank of Japan. It might have been unusual for a central bank governor to call on the headquarters of a po­liti­cal party, but I thought it impor­tant to get acquainted with the person who was to be next prime minister and to get him acquainted with the bank’s thinking. On September 16 the new cabinet was inaugurated, with Hirohisa Fujii as finance minister and Naoto Kan as the minister in charge of economic and fiscal policies. The DPJ had run on a platform of shifting spending “from concrete to ­people,” advocating massive social security spending increases. The ruling co­ ali­tion government quickly found, however, that the revenues to support such spending promises ­were lacking. From the perspective of the Bank of Japan, which was carefully monitoring the government’s macroeconomic policies, ­there w ­ ere two major policy initiatives that had significant implications. One was the facilitation of financing for small-­and medium-­size enterprises (SMEs), and the other was the declaration of deflation. The idea of facilitation of SME financing was brought to the forefront of the government’s agenda by the minister of state for financial ser­vices, Shizuka ­Kamei, reflecting the ruling parties’ agreement to prevent overly cautious lending and overly aggressive debt collection, which was often dubbed the “moratorium act.” Accordingly, the government put in force the Act concerning Temporary Mea­sures to Facilitate Financing for SMEs in December 2009, and at the same time, the Financial Ser­vices Agency published its supervisory guideline and bank examination manual reflecting the act. The act obliged financial institutions to accommodate changes in contractual lending conditions, such as temporary halts in repayment, reduction of interest charged, and abandoning collection if and when ­there ­were requests from SME or mortgage borrowers. Increasing Clamor for Beating Deflation | 179

While t­ hese mea­sures to increase lending to inefficient SMEs may have supported demand in the short term, I think it is likely that they had a negative impact on the potential growth rate of the Japa­nese economy and thus weighed down the economy in the coming years. According to standard growth theory that presupposes a dichotomy between nominal and real variable, productivity is predominantly a function of real variable such as technology and ideas. But strictly speaking, this is not necessarily correct. I w ­ ill examine this issue in chapter 20.

THE DECLARATION OF DEFLATION FROM THE JAPA­N ESE GOVERNMENT The DPJ government was rather ­silent on the conduct of monetary policy in the days immediately following its inauguration. But this changed abruptly when the government announced that policies to beat deflation ­were of the utmost importance and calls for the bank to ease policy further became louder and louder. In March 2009, just as global financial markets and the Japa­nese economy appeared to hit bottom and begin recovering, the year-­on-­year changes in the Japa­nese Consumer Price Index (CPI) turned negative. Mainly as a result of rapidly falling international commodity prices, reflecting the lagged effect the decline in global economic activity ­after the collapse of Lehman ­Brothers, the price declines became even more acute, with the August figure (released in September) reaching −2.4 ­percent (see fig. 9.2). Looking at the price of crude oil, which had a particularly large impact on CPI, the most widely quoted mea­ sure, the price of West Texas Intermediate (WTI) crude oil ­futures index, nosedived from a peak of US$145.29 per barrel on July 3, 2008 to just $34.41 on December 22. In addition to falling commodity prices, the appreciation of the yen also contributed to the fall in CPI by bringing about a general decline in import prices. ­These early stages of price declines did not become a focus of economic policy, as they ­were overshadowed by the imperative of avoiding a meltdown of the financial system at all costs. ­There had been a declaration of deflation in 2001 u ­ nder the LDP government. But references to deflation ­were removed from the government’s monthly economic reports in July 2006, and the government of the DPJ was initially rather ­silent on deflation. Then ­there was a sudden shift in tone on November 20, when the Cabinet Office declared that “recent price developments show that the Japa­nese economy is in a mild deflationary phase.”10 The view was duly 180 | The Days as Governor

(Year-on-year, %) 3 CPI (benchmark, year 2010) CPI (benchmark, year 2005)

2

1

0

–1

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2007

2008

2009

2010

2011

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2013

Figure 9.2 ​Consumer price inflation. Note: Excludes fresh food. Sources: Bank of Japan; Japa­nese Ministry of Internal Affairs and Communications.

endorsed at the ministerial level. Only three weeks before this declaration, at my press conference on October 30, ­there had been only one question regarding deflation, which illustrated that the issue of ­whether Japan was in deflation or not did not attract much public attention. I still do not know why this declaration was made.

LONG-­R UN TRENDS IN JAPA­N ESE PRICES Before directly considering deflation itself, a longer-­term view of the history of prices in Japan may be helpful (see fig. 9.3). At the time I joined the Bank of Japan in 1972, the focus regarding prices was firmly centered on overcoming inflation. The year-­on-­year increase in the CPI excluding fresh food jumped ­after the first oil crisis in 1973 and peaked at 24.7 ­percent in October 1974. The annual inflation rate for 1973 was 11.3 ­percent, and reached an eye-­watering 22.5 ­percent in 1974. The lessons taken from the first oil crisis ­were successfully applied to the second oil crisis in 1978 and 1979, when monetary policy was tightened in a preemptive manner and ­labor ­unions held back on their wage demands. As a result, Japan was able to escape stagflation, a combination of Increasing Clamor for Beating Deflation | 181

(Index, CY 2010 = 100) 120

(Year-on-year, %) 30

100

25

80

20 Level Year-on-year inflation rate (right-hand scale)

60 40

15 10

20

5

0

0

–20 –5 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020

Figure 9.3 ​The long-­term trend of inflation. Note: Consumer Price Index, excluding fresh food; figures prior to 1970 are from the Tokyo Consumer Price Index. Source: Japa­nese Ministry of Internal Affairs and Communications.

high inflation and stagnant growth, which had dogged other developed economies. The CPI inflation rate in Japan was already around 2 percentage points lower in the 1980s compared with other developed economies. In fact, it was lower than in West Germany, which was known for its low-­inflation economy.11 In par­tic­u­lar, during the years of the ­bubble economy in the second half of the 1980s, CPI inflation was on the average below 1 ­percent, with some months actually turning negative. The highest CPI inflation rate excluding the effects of the increase in the  consumption tax was 3.3  ­percent in December  1990. From t­here it fell gradually, but it took some years for the Bank of Japan to fully recognize the pro­g ress of significant change. It was only in July 1992 that references to “inflationary pressures” w ­ ere dropped completely in the bank’s quarterly assessments of economic activities.12 In ­those days a positive bias of inflation outlook was not confined to the bank but shared by academics and private-­ sector economists.13 The conventional wisdom was that consumer prices, including prices of imported goods, w ­ ere artificially elevated by restrictive business practices, and the prevalent argument was that price declines re182 | The Days as Governor

flecting the removal of competition-­restraining business practices ­were most welcome. The CPI registered its first annual decline in 1998. Following that, t­ here w ­ ere years that showed an increase, but on average consumer prices mildly declined. The aggregate fall in prices between 1998 and 2012 amounted to just less than 4 ­percent overall, translating into an annual decline of 0.3 ­percent. Deflation was a focal point of policy discussions during the tenure of bank governors Masaru Hayami and Toshihiko Fukui, which was illustrated by the fact that quantitative easing (QE) a­ dopted ­under Hayami began with a commitment to maintain the policy ­u ntil the year-­on-­year increases in the CPI ­were stably above zero. When QE was terminated ­a fter five years ­u nder Fukui in March 2006, the main point of contention was still deflation, with the CPI year-­on-­ year increase at 0.5 ­percent (a figure subsequently revised to 0.1 ­percent). ­After that, ­until 2008, inflation began to pick up against the background of a global economic boom, rising international commodity prices and the depreciation of the yen, eventually reaching a peak of 2.4 ­percent year-­on-­year shortly before the collapse of Lehman ­Brothers. The period from 1998 to 2012 could indeed be called a period of deflation in the sense that prices declined. Nevertheless, the Japa­nese deflation of this era was quite dif­fer­ent from the archetypal deflation episode described in macroeconomics textbooks, during which prices would fall 20–30 ­percent within the short win­dow of a few years, as happened in the 1930s in many countries, including Japan.

THE AMBIGUITY OF THE TERM DEFLATION Traditionally, the Japa­nese government had taken the view that deflation was a situation in which both price declines and economic stagnation occur at the same time. To put it differently, t­ here was an understanding that declining prices alone would not be regarded as deflation. This view was turned on its head by the declaration of deflation issued by the government in March 2001. The government ­adopted a mechanical benchmark, defining deflation as an environment where prices w ­ ere trending lower irrespective of economic conditions, and determined that Japan was in a period of mild deflation. From then on, deflation took center stage in the macroeconomic policy debate. The definition of deflation a­ dopted by the government was counterproductive. First, it obfuscated the policy debate itself. Notwithstanding the government definition, the public at large, business executives, and the press naturally Increasing Clamor for Beating Deflation | 183

understood the term much more loosely and broadly based on its previous usage. In some cases, deflation referred to the phenomenon of declining prices, but it was often a more general term describing declining business sentiment or lackluster corporate results. In other cases, it was about the falling prices of assets instead of goods and ser­vices. It was, more generally, a summary term for describing an unsatisfactory state of the wider economy. Second, since the term was inextricably tied to the ­Great Depression of the 1930s, it fueled strong public concerns. As a result, even if it was being used differently among dif­ fer­ent commentators, once ­people heard it, it seemed to signal a situation to be avoided at all costs, precluding sensible discourse. Third, as deflation was associated with a lack of sufficient money, the government definition created the impression among the public that the prob­lem could be solved simply by printing money. Since the inflation rate is understood to be ultimately determined by the central bank, for mainstream macroeconomists ­t here was no question that the solution to Japa­nese deflation was aggressive monetary easing. The lesson that the G ­ reat Depression of the 1930s was caused by policy failures of the Federal Reserve was deeply ingrained. I still do not believe that the public at large ­really believed ­t hese narratives about deflation. In this regard, the results of the quarterly opinion poll conducted by the Bank of Japan are very intriguing (see fig. 9.4). The results had been quite consistent with regard to the public’s view on inflation: ­people overwhelmingly believed that prices ­were rising rather than falling and expected prices to rise in the ­f uture as well. Another thought-­provoking result was ­people’s answers to the question regarding the desirability of price increases. Posed with this question, the plurality of respondents—­irrespective of gender, age group, or occupation—­consistently chose the answer “not desirable.” At the same time, ­people ­were definitely using deflation in a negative context. Both then and now, it seems to me that most p ­ eople equate the term with insecurity regarding their jobs and livelihoods and not simply with declining prices. Deflated prospects, not just lower prices, are what m ­ atter for most ­people. Beating deflation, as much as stopping the appreciation of the yen, was at the forefront of policy objectives advocated by corporate leaders. With re­spect to the sources of deflation, business leaders always pointed to a lack of demand. On the conduct of monetary policy, in private one-­on-­one conversations, many believed that with money floating around and with interest rates so low, an additional supply of money from the bank would not help in beating deflation. As to the c­ auses of deflation in t­ hose conversations, leaders always pointed to 184 | The Days as Governor

100% 80% 60% 40% 20% 0% June 2004 2005

2006

Rather favorable

2007

2008

2009

2010

Neither favorable nor unfavorable

2011

2012

Rather unfavorable

Figure 9.4 ​Opinion survey about views on price rise, by ­house­hold. Source: Bank of Japan (2013b).

price wars resulting from excess capacity or corporate be­hav­ior characterized by too much emphasis on market share. Sometimes I heard calls for aggressive monetary policy aimed at beating deflation, but the main focus of Japa­ nese business leaders, many of whom ­were ­running manufacturing firms, was not on beating deflation but on halting the appreciation of the yen. All in all, the meaning of the term deflation in Japan was quite loose, and public debate was correspondingly imprecise.

THE DISTINCTION BETWEEN DEFLATION AND A DEFLATIONARY SPIRAL ­ fter World War II, deflation was not a serious real policy issue in developed A economies. Initially it was an issue confined to Japan, but following the GFC, other developed economies began to be confronted with low inflation, thus suffering the same fate as Japan. In that context, the definition of deflation attracted some attention. At a press conference in February 2014, Mario Draghi, president of the Eu­ro­pean Central Bank, outlined two defining features of deflation: “a broad-­based fall in prices” and “self-­feeding onto itself.”14 In other words, in order to judge that t­ here was deflation, t­ here needed to be an expectation that prices of a wide range of goods and ser­vices would generally fall and that this expectation would constrain expenditure, resulting in a further fall in prices. It was, in the terminology of economists, a deflationary spiral. The description of deflation outlined by Draghi was common sense and was quite similar to my own view. Increasing Clamor for Beating Deflation | 185

While it might seem that the definition of deflation was a minor ­matter of terminology, the choice of words in fact often influenced the policies ­adopted. Once ­people believe in a specific narrative, ­there develops a shared feeling that no more questions should be asked. The word deflation brought about exactly such a reaction. For this reason, during my tenure as governor, I used the term only when it was unavoidable in the context of my remarks. More often I sought to use the more objective, and less dramatic, term falling prices. Moreover, when I was explaining policy responses, I took care to note if ­there was any deflationary spiral. But I carefully avoided references to “good deflation” and “bad deflation” (which ­were used by some economists and members of the press, both ­ ecause such usage could provide ammunition to p ­ eople in Japan and abroad) b who asserted that the Bank of Japan was acquiescing to deflation. As Japan had experienced during its b ­ ubble period, t­ here could be times when the economy would overheat in spite of low inflation. At the same time, t­ here could also be situations in which falling prices could feed into a further decline in prices. Accordingly, I believed that the assessment of price developments could not be undertaken in a vacuum; it had to be done in the specific context of the state of the economy and finances of the time. What is crucial is ­whether or not ­there was a sign of a deflationary spiral. On October 30, 2009, shortly before the declaration of deflation by the Japa­ nese government, the Bank of Japan published its semiannual Outlook Report and projected that prices would continue falling during the forecasting period, up to the end of March 2012, even though the year-­on-­year decline would gradually narrow. More specifically, according to the bank’s projection, prices would fall 1.5 ­percent during the 2009 fiscal year (April 2009–­March 2010), and 0.8 ­percent and 0.4 ­percent during the 2010 and 2011 fiscal years, respectively, in an environment where growth would initially be negative (–3.2 ­percent in the 2009 fiscal year) but would return to positive territory (1.2  ­percent and 2.1 ­percent in the 2010 and 2011 fiscal years, respectively). At the press conference regarding the report, I carefully avoided any mention of deflation, noting that “downward pressure on prices is projected to continue into year 2011. I would not go into a discussion of ­whether such price developments should be deemed deflation, ­because that would depend on the definition of deflation, which could be dif­fer­ent from one commentator to another. The impor­tant point is to determine ­whether the Japa­nese economy is on a sustainable growth path ­under price stability, from a medium-­to long-­term perspective.”15 186 | The Days as Governor

On the day the government made its declaration of deflation, I fielded a question about the possibility of falling into a deflationary spiral at a press conference. My answer was basically the same as before: “The question, I believe, was about the possibility of some additional ill effects beyond a situation of ‘stagnant business conditions,’ which would be caused by the decline in prices itself. In that regard, ­there are a few ave­nues through which a decline in prices would bring about a further decline in prices. One would be a situation where expected inflation would decline, and another would be a situation where a decline in prices would negatively impact the economy ­under financial instability. Accordingly, the Bank of Japan is very carefully monitoring both such possibilities.”16 Such efforts to explain the difference between deflation and a deflationary spiral received harsh criticisms, such as “the Bank of Japan was tolerating deflation,” or “the government and the bank are not on the same page on the seriousness of deflation.” Most p ­ eople, including corporate leaders, w ­ ere not interested in the precise definition of deflation or the differences between deflation and a deflationary spiral. In such an environment, it dawned on me that ­there would be consequences if the bank continued to refrain from using the word deflation. When the general public saw that the bank was unresponsive to their hardship, even if such perceptions ­were misplaced, the confidence in it could be eroded and undermine the very foundation of the conduct of sound monetary policy. Accordingly, ­after weighing the benefits and costs, I de­cided to firmly say that the bank had “the same recognition with [the] Government’s view,” and accepted using the word deflation to describe price developments in a speech delivered on November 30 in Nagoya.17 On the next day, December 1, the bank held an extraordinary MPM and ­adopted mea­sures for further monetary easing. The post-­MPM statement that was approved unanimously declared, regarding the objectives of the mea­sures, that “the Bank recognizes that it is a critical challenge for Japan’s economy to overcome deflation and return to a sustainable growth path with price stability.”18 The crux of this statement was to say “to overcome deflation” but at the same time to avoid using this expression without any qualification. Our intention was to state clearly the ultimate objective of the bank by continuing with the phrase “and return to a sustainable growth path with price stability.” If the bank was to be a responsible central bank, it was extremely impor­tant to have robust logic b ­ ehind e­ very policy move, and the actions had to be described with carefully chosen words. That was my conviction, reflecting my experiences regarding the Japa­nese economy and monetary policy over the previous twenty Increasing Clamor for Beating Deflation | 187

years or so. The bank needed to be particularly careful not to have its words taken out of context.

REVISING “THE UNDERSTANDING OF MEDIUM-­ TO LONG-­T ERM PRICE STABILITY” At the MPM of December 18, 2009, the Policy Board de­cided to clearly demonstrate that the Bank of Japan was not tolerating deflation, and thus revised Understanding of Medium-­to Long-­Term Price Stability, which was first ­adopted at the MPM of March 2006, noting that “each Policy Board member’s ‘understanding’ falls in a positive range of 2 ­percent or lower, and the midpoints of most Policy Board members’ ‘understanding’ are around 1 ­percent.” Th ­ ere was no change in the “midpoints of most Policy Board members’ ‘understanding,’ ” but by clearly stating that it was in “a positive range,” the bank endeavored to more unmistakably convey its view of not tolerating deflation or a sustained fall in prices.19 At the press conference announcing this decision, ­there ­were questions as to ­whether the change meant the adoption of duration effect policy—­that is, a policy that made clear the bank’s intention to maintain low interest rates for an extended period. I answered that “the mea­sure was not a duration effect policy in the sense of making commitments regarding the ­future conduct of monetary policy,” but “given that the more precise public understanding of the bank’s view on price stability would certainly influence the determination of interest rate levels” in the ­future, in that broader sense this could be understood as a duration effect policy.20

JAPAN DID NOT FALL INTO A DEFLATIONARY SPIRAL The argument that one hears most often u ­ nder the heading of deflation is that declining prices would nurture an expectation of further price declines and thus induce economic agents to postpone expenditures, thus weakening demand and causing a deterioration of economic conditions. That is essentially a description of a deflationary spiral. According to economists, t­ here are three forces at work ­behind such a deflationary spiral. The first force is, in view of the downward rigidity of nominal wages, a decline in prices that would result in an increase in real wages, the consequence of which would be an increase in unemployment. The second force is the debt deflation argument by the ­great American economist Irving Fisher, which holds that declining prices would bring about increases in the real burden of debt, leading to a dampening of 188 | The Days as Governor

expenditure and a deterioration of business conditions.21 This happens ­because the propensity of expenditure is generally higher for debtors than for creditors. The third force is the zero lower bound (ZLB) of interest rates. Given that interest rates could not be lowered beyond zero even if prices w ­ ere falling, it would be impossible to stimulate the economy through monetary policy in such an environment and thus would lead to a deflationary spiral. Th ­ ere ­were Japan was in a deflationary spiral as early as 2001 (see chapalready claims that ter 5). Nonetheless, t­ here was no deflationary spiral as such. As Martin Feldstein, a respected US scholar, stated very clearly, Fortunately, we have relatively l­ ittle experience with deflation to test the downward-­spiral theory. The most widely cited example of a deflationary economy is Japan. But Japan has experienced a low rate of inflation and some sustained short periods of deflation without ever producing a downward price spiral. Japan’s inflation rate fell from nearly 8% in 1980 to zero in 1987. It then stayed above zero u ­ ntil 1995, ­a fter which it remained low but above zero u ­ ntil 1999, and then varied between zero and −1.7% ­until 2012. Moreover, low inflation and periods of deflation did not prevent real incomes from rising in Japan. From 1999 to 2013, real per capita GDP ­rose at an annual rate of about 1% (which reflected a more modest rise of real GDP and an a­ ctual decline in population).22 During my tenure as governor, deflation in Japan was a focus of discussion in many international meetings. The questions I received from se­nior officers of overseas central banks focused on why Japan was not in a deflationary spiral. In fact, from January 2002 to February 2008, Japan had enjoyed the then longest postwar economic expansion amid ­gently falling prices. The rate of unemployment did climb higher compared with the years before 1997, but the level was much lower and the increases ­were much smaller than ­those of other developed economies. A deflationary spiral in Japan was a mirage. In my view, t­ here ­were two reasons why Japan did not fall into a deflationary spiral. The most impor­tant was the fact that the stability of the financial system was maintained, even if precariously. The concept of deflationary spiral is heavi­ly influenced by the debt deflation view advocated by Fisher, which fits well with the state of the US economy between 1929 and 1933.23 At that time the FRB failed to take proper action as the “lender of last resort,” which brought about the failure of many banks, with a decline of 30 ­percent in the money supply and of nearly 20 ­percent in prices. Such an environment is well explained Increasing Clamor for Beating Deflation | 189

by the debt deflation framework. The first and foremost lesson to be learned regarding the prevention of deflation is the importance of preventing a meltdown of the financial system. Preventing deflation boils down to preventing collapse of the financial system. I strongly agree with what former FRB chair Paul Volcker wrote one year before he passed away: “The lesson, to me, is crystal clear. Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk.”24 In that regard, the Bank of Japan prioritized maintaining financial system stability by supplying massive liquidity as the lender of the last resort during both the Japa­nese financial crisis in the late 1990s and the GFC and thus succeeded in preventing a deflationary spiral. Another ­factor for Japan not falling into a deflationary spiral was the flexibility of nominal wage. Looking at the history of per-­worker nominal wages, a fall in absolute numbers can be observed starting in 1997. This macrolevel decline in per capita nominal wages could be explained by both the structural shift of firms employing more “nonregular” workers and the gradual fall of the wages of “regular” workers. At larger firms in Japan, a large proportion of the workforce enjoy lifetime employment, though this is not a formal contract. This employment practice, which was rational in a period of high growth, gradually lost its rationale as Japa­nese economy transit to stable growth path. So, the practice became less pronounced but still widespread, ­because firing t­hose workers covered by lifetime employment practice is a breach of an implicit employment contract. This meant that the profits of large firms ­were squeezed in the face of weak demand amid the financial crisis. One of the responses was a downward adjustment of the wages of regular workers covered by lifetime employment. This was consistent with the incentives of lifetime workers and their employers. For the regular workers of such firms, who tended to accumulate firm-­specific skills, the cost of losing one’s job was very high. For the management of ­those firms, the cost of losing skilled regular workers was also high; additionally, the management had to pay attention to their firms’ reputations, which would suffer if the firms had to fire workers. Regular workers and management thus had a common interest, which resulted in regular workers accepting pay cuts and management maintaining the head count as much as pos­si­ble. This adjustment was effective, but not sufficient. Thus, large firms also reduced new hiring of school gradu­ates who ­were expected to become regular workers and instead increased employment of workers who ­were not covered 190 | The Days as Governor

by the employment practice applied to regular workers. Th ­ ose new workers are often called nonregular workers in Japan. The exact form of nonregular employment practice varies, such as temporary employment, part-­time employment, dispatched employees, and so on. Generally speaking, wage levels of ­those workers are relatively low, but more impor­tant, firms can avoid the fixed costs associated with lifetime employment. In essence, since the m ­ iddle of the 1990s, when Japan was confronted with severe economic hardships, it prioritized maintaining employment through cuts in nominal wages.25 Accordingly, Japan was to avoid the increasing unemployment experienced by the Eu­ro­pean and US economies. The payback for that was a chronic mild decline in prices that reflected falling wages. This decline in prices and low unemployment ­were the two sides of the same coin. Turning back to the argument of a deflationary spiral, it is definitely rational be­hav­ior for economic agents to hold back the purchase of goods or ser­ vices when their prices are expected to fall, and to increase their purchase of them following an a­ ctual decline of prices. Yet if such a mechanism was in play during a period of deflation, the h ­ ouse­hold savings rate should have been on an uptrend. On the contrary, the h ­ ouse­hold savings rate in Japan has been constantly declining. When all was said and done, Japan experienced declining prices not temporarily but for a period extending more than fifteen years, though the speed of decline was very modest. House­holds and firms might decide to withhold the purchase of some goods or ser­vices, say, for one year. In such cases they would usually have to purchase them the next year or two years ­later. If they did not do so, the reason for not purchasing was prob­ably not ­ ecause of their outlook regarding ­because of temporary price declines but b stagnant income in the ­future. It should also be noted that the postponement of purchases is not pos­si­ble for many goods and ser­vices. It may be pos­si­ble for durable goods to some extent, but in the case of ser­vices, it w ­ ill be difficult given that production and consumption of services—­including housing, utilities, medical attention, and old-­age care—­a re simultaneous. ­Those ser­v ices cannot be stored. On top of that, for life’s necessities, such as food, it would be impossible to withhold consumption for any length of time.

THE ORIGINS OF DECLINING PRICES IN JAPAN Japan did not experience a deflationary spiral, but ­there remains the question as to why prices continued to fall for many years, even if the decline was quite moderate. Many politicians and academics simply claim that monetary easing Increasing Clamor for Beating Deflation | 191

was insufficient. Such a view is not altogether persuasive, b ­ ecause low inflation or even price declines w ­ ere observed in many developed economies other than Japan ­after the GFC, despite the fact that central banks aggressively eased monetary conditions, as is examined in chapter 18. While our understanding of a period of sustained price declines is l­ imited, the following interpretation seems to be convincing in the case of Japan. The most persuasive explanation for me is the flexibility of nominal wages, as noted before.26 Looking at the pace of consumer price inflation in Japan and in the United States, ­there is not much difference with regard to goods. Divergences are observed mainly in the prices of labor-­intensive ser­vices. The increase in unemployment was l­ imited in Japan even as the economy stagnated, ­because, as explained e­ arlier, regular workers accepted ­limited wage growth in return for employers preserving their jobs as much as pos­si­ble. Consequently, Japan avoided the significant jump in unemployment that was observed in other developed economies, but in return had to confront mildly declining prices, which was reflected in falling wages. Meanwhile, a number of economists attributed the appreciation of the yen to deflation in Japan. But the same economists tended to attribute the appreciation of the yen to deflation assuming the purchasing power parity. This argument was circular. Since exchange rates are asset prices trading in financial markets, and thus fluctuate more easily than prices of goods and ser­v ices in the short term, ­t here is no doubt that a rapid appreciation of the yen ­w ill tend to drag down the inflation rate. Accordingly, from the second ­ ere episodes of sharp yen appreciation—­ half of the 1990s onward, t­ here w for example, during the Asian financial crisis, the bursting of the dot-­com ­bubble, the collapse of Lehman B ­ rothers, and the Eu­ro­pean debt crisis—­ and this resulted in strong downward pressure on prices. Nevertheless, if one looks at the w ­ hole period of fifteen years beginning around 1998, t­ here ­were periods of both appreciating and depreciating yen, while in both cases prices continued to fall moderately. In any case, it is a circular argument if one attempts to explain the strength of the yen by the long-­term developments in the inflation rate and at the same time explain the fall in prices by the appreciation of the yen. As for other ­factors influencing prices, the compression of retail margins due to increased competition or falling prices of imported goods would also contribute to falling domestic prices. This is, to borrow the terminology of economists, positive supply shock, but this notion was brushed aside by many Japa­nese economists, who argued that ­these ­factors would only induce changes 192 | The Days as Governor

in relative prices and not the general rate of inflation. Admittedly, falling import prices would imply increases in real purchasing power, which would eventually push prices back up. In that sense, the fall in import prices could not have been the cause of mildly declining prices over extended periods of time. Meanwhile, it would also be a stretch to say that falling import prices do not affect inflation at all. In the short term, at least, fluctuations in such prices, be they upward or downward, should influence the inflation rate. The fluctuation of international commodity prices would have a large impact on the year-­on-­year inflation numbers, not only when they began to fall but also when they stay at the same level reached a­ fter a sharp increase. That indeed was an impor­tant ­factor in the widening of year-­on-­year price declines in the summer of 2009, but, with headline year-­on-­year figures attracting so much attention, deflation had an outsize influence on debates on monetary policy.

IS DEFLATION A MONETARY PHENOMENON? “Deflation is a monetary phenomenon” is a mantra often cited to explain deflation in the case of Japan. This was a variation of the dictum of Milton Friedman who in 1963 famously wrote, “Inflation is always and everywhere a monetary phenomenon.”27 Replacing “inflation” with “deflation,” the resulting notion, that deflation is a monetary phenomenon, was repeatedly turned against the Bank of Japan. More specifically, many politicians and academics argued that deflation was occurring b ­ ecause the supply of the monetary base 28 of the bank was too small. Indeed, in introductory economics textbooks, it is explained that a one-­unit increase in the monetary base ­causes an increase of the money supply as much as the money multiplier, which would accelerate inflation. Nevertheless, in ­actual data, such a relationship between the monetary base and prices is not observed. For example, while the CPI fell by 2.9 ­percent between March 1997 and March 2013, the monetary base increased by a staggering 166 ­percent over the same period (see fig. 9.5). The Bank of Japan thus became the target of much criticism that its supply of the monetary base was too small. But, in comparison with overseas central banks, the bank’s supply was not only large in terms of volume relative to GDP but also in terms of the rate of increase (see fig. 9.6). Many observers anchored their international comparison at the beginning of the GFC, which was actually comparing apples and oranges: central banks in Eu­rope and the United States had to rapidly increase the monetary base in response to increases in Increasing Clamor for Beating Deflation | 193

(Index, CY 1997 = 100) 240 Monetary base M2 Consumer Price Index (excluding fresh food)

220 200 180 160 140 120 100 80

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Figure 9.5 ​The monetary base, money stock, and the Consumer Price Index. Sources: Bank of Japan; Japa­nese Ministry of Internal Affairs and Communications.

(% of nominal gross domestic product) 30

25

Japan United States Euro area

20

15

10

5

0 1995

1997

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2011

Figure 9.6 ​The monetary bases of Japan, the euro area, and the United States. Source: Federal Reserve Economic Data, Federal Reserve Bank of St. Louis.

liquidity demand in an environment of domestic financial instability, whereas essentially no such prob­lem was observed in Japan. Why did prices practically stay put in spite of huge increases in the monetary base? In the case of the environment of severe financial instability following the collapse of Lehman ­Brothers, central banks around the world increased the supply of liquidity in response to acutely increasing demand from financial institutions. In this context, the a­ ctual increase in the monetary base corresponded to the increase in demand. Meanwhile, in the environment of zero interest rates a­ fter the crisis was over, the supply of the monetary base again corresponded to the increase in demand. This time, however, the increase in demand was due to the ZLB of interest rates. In a zero interest rate setting, since the opportunity cost of holding on to central bank money was zero, t­ here would be demand for such money even if the central bank attempted to significantly increase the supply of the monetary base. In both environments, abundant reserves, which ­were thought to stoke inflation, did not have powers to stimulate expenditure. It is the interest rate level, not the sheer size of the monetary base, that affects the spending decisions of economic agents. Unfortunately, this was not widely understood. To be sure, this misunderstanding was not unique to Japan. In the United States t­ here ­were frequent worries that the massive increases in the monetary base by the FRB would result in acute bouts of inflation. Against this, FRB chairman Ben Bernanke painstakingly repeated at press conferences that increases in the monetary base need not result in higher ­actual or expected inflation. At the same time, it is too much to say that the central bank does not need to worry about the increases in the monetary base at all. I was concerned by the risk that the Bank of Japan’s purchases of Japa­nese Government Bonds effecting increases in the monetary base could be regarded as “fiscal dominance,” which w ­ ill be discussed in chapter 15. Communication about monetary policy was all the more difficult.

THE DETERMINANTS OF THE EXPECTED INFLATION RATE The debate on the sources of deflation w ­ ill not be settled u ­ nless and u ­ ntil a persuasive answer is found for the question of what determines the inflation rate. Mainstream macroeconomics considers that the trend of inflation is determined by medium-­to long-­term expected inflation, and short-­term fluctuations around it are influenced by the output gap. The well-­k nown Phillips curve plots such a relation with the output gap on the horizontal axis and Increasing Clamor for Beating Deflation | 195

inflation rate on the vertical axis, resulting in an upward-­sloping curve. The observed curve and its theoretical interpretation initially seemed robust, but then the relationship became less vis­i­ble, and from the 1990s onward, the curve had almost flattened. Why has the Phillips curve become flatter? One view emphasizes that the expectation of stable prices has become much ingrained. As a result of achieving price stability, inflation expectations have stabilized at a low level, which in turn has forced firms to refrain from raising prices in fear of losing market share, even when faced with cost increases. Another view stresses the effects of increased competition due to globalization and advances in technology. In this view, markets have become more contestable, and firms have lost pricing power. Workers have to compete with foreign workers not only in manufacturing but also in ser­vices. Both of ­these explanations capture a facet of what was actually happening, but in any event, the influence of the output gap was becoming more minimal over time. As long as we stick with the aforementioned framework for inflation, the explanation about the inflation rate would not be complete without pinning down how inflation expectations are formed. In this regard, mainstream macroeconomics assumes that the expected inflation rate is determined by central bank monetary policy. Specifically, the expected inflation rate is assumed to converge with the target inflation rate set by the central bank. This simplifies the challenge of model building. But what is the plausible basis for assuming that the central bank has the ability to control the expected inflation rate at a par­tic­u­lar level? One must identify the ­actual determinant of the expected inflation rate—­both in the short and long terms. Short-­term expectations have been strongly influenced by concurrent developments, falling into negative territory between 2009 and 2010 (see fig. 9.7). Such expectation formations, where economic agents expect the continuation of past trends, are called adaptive expectations, and it has been recognized for some time that short-­term expectations in Japan show such tendencies.29 Having said this, the medium-­to long-­term expected inflation rate, which would have a stronger influence on the ­actual inflation rate, had not changed very much in Japan, and polling of economists consistently showed that the rate remained at around 1 ­percent through my tenure as governor. Janet Yellen noted in a speech that “survey mea­sures of longer-­term expected inflation in [Japan] remained positive and stable even as that country experienced many years of per­sis­tent, mild deflation,” and offered the observation that “economists’ understanding of the dynamics of inflation is far from perfect.”30 196 | The Days as Governor

Year-on-year, % change 2

1

0 6 to 10 years ahead (consensus forecasts) 2 to 6 years ahead (ESP forecast) –1 CY

2005

2006

2007

2008

2009

2010

2011

2012

2008

2009

2010

2011

2012

Year-on-year, % change 2 1 0 2 to 10 years ahead 1 to 2 years ahead 1 year ahead

–1 –2 CY

2005

2006

2007

Figure 9.7 ​Expected inflation, by economists. Note: ESP forecast is an average forecast of Japa­nese private-­sector economists. Source: Bank of Japan, Outlook Report, October 2012.

DOES THE CENTRAL BANK’S INFLATION TARGET ANCHOR INFLATION EXPECTATIONS? Mainstream macroeconomics posits that when the central bank sets an inflation target and strongly commits to achieving it, that would become an “anchor” to which both expected and a­ ctual rates of inflation would converge in the long term.31 This is ­because economic agents are assumed to behave in a forward-­looking manner. The target inflation rate is assumed to have a gravitational force. This assumption is r­ eally critical. The forecasts of overseas central banks regarding the rates of inflation usually converge with the target rates of inflation in three to five years b ­ ecause they are based on dynamic stochastic general equilibrium models incorporating such a mechanism from the beginning. The models are not as simplistic as the argument that increases in the Increasing Clamor for Beating Deflation | 197

monetary base would heighten inflation, but they have in common the idea that the central bank can set the expected inflation rate at what­ever level it desires as long as it is serious enough. The ­whole conceptual framework is vulnerable to a rather innocent question: Why can the central bank be the anchor of inflation? Admittedly, it is undeniable that monetary policy would influence the inflation rate. One ­example is a case in which the central bank faced with runaway inflation tightens it with an iron fist, and eventually succeeds in reining in inflation expectations. The central bank can prevent a collapse of the financial system—­ and, for that ­matter, deflation—by acting aggressively as the lender of last resort. Nevertheless, it is not easy to discern the reasoning ­behind the belief of academics that when the central bank maintains extremely accommodative policy, both expected and a­ ctual rates of inflation would converge to the inflation target set by the central bank in a relatively short period of time, even in a low-­inflation economy ravaged by a severe financial crisis and ­after interest rates had reached zero ­percent. Unfortunately, real­ity in Japan since the beginning of this ­century has not coincided with such a fairy-­tale framework.

THE PUBLIC PERCEPTION OF PRICES In addition to the conceptual vacuum with regard to how a central bank could achieve the desired inflation rate, ­there was another vexing issue: a society experiencing rapid aging, with a growing number of p ­ eople dependent on financial assets and pensions, may be increasingly predisposed to desiring lower inflation. In such an environment, even if the central bank might be able to raise the inflation rate through aggressive monetary policy, such acceleration of inflation could be only temporary and the resulting vacillations of the real value of income and asset values could impact the real economy, possibly ­leading to social unrest. In this regard, Jens Weidmann, the president of the Deutsche Bundesbank, once quoted Otmar Issing, who was the chief economist of the Eu­ro­pean Central Bank, noting that “­every society eventually gets the rate of inflation that it deserves—­a nd that it ultimately wanted. Demographic change, too, can play a role in this context.”32 While the medium-­to long-­term expected inflation rate is significantly influenced by central bank policies, such a mechanism is only part of the story. ­There seem to be other contributing ­factors, including the structure of the ­ eople. The Bank of Japan was well aware economy and the preferences of the p of this mechanism and called it the “public perception of prices.” This con198 | The Days as Governor

cept was quoted as one ­factor when the Bank of Japan published its “understanding of medium-­to long-­term price stability” at 1 ­percent in 2006. At the time, I was not a strong advocate of this notion. Even ­after I became governor, I was hesitant to make references to such a concept, since I interpreted such a notion as essentially another way to express the concept of medium-­to long-­ term expected inflation rate. I have, however, gradually come to think we cannot dismiss the argument of “the public perception of prices” lightly.

WHY TWO ­P ERCENT? Many observers always included in their argument a claim that a 2 ­percent inflation target was the “global standard,” which created the impression that the 2 ­percent figure was sacrosanct. ­There ­were usually two rationales ­behind their arguments. The first was the “upward bias” in the mea­sured inflation rate: the tendency the of published inflation rate to overstate a­ ctual inflation.33 The standard index of consumer prices is a Laspeyres index, which fixes a basket of goods and ser­vices purchased by a typical h ­ ouse­hold and calculates the index over time with outlays on that basket in the base year fixed at one hundred. The rate of change of that index is the rate of consumer price inflation. In the case of Japan, the basket of goods and ser­vices in the base year do not change for five years. Consequently, that would lead to overstating mea­sured inflation. One source is the so-­called weight effect. For example, the weight of goods and ser­vices whose relative prices fall should increase along with increased consumption, but that cannot happen with the basket fixed. The other source is the so-­called reset effect. This concerns mainly durable goods whose prices fall dramatically. As the levels of subindices of ­these goods fall significantly, their negative contribution to the year-­on-­year changes in the index would become smaller than they should be. Overstatement of inflation could also arise from changes in quality. In calculating the index, the basic princi­ple is to account for changes in quality—­ that is, conduct quality adjustment. Goods and ser­v ices whose quality has improved must be deemed to have fallen in price if their prices remain the same. For example, when a new personal computer comes out at the same price as an old one, it would be deemed to have fallen in price as much as the t­ here is an improvement in the pro­cessing power. Having said that, since an accurate adjustment in quality is not easy, ­there could be some bias in the mea­sured inflation rate. The study of such bias began in the United States in the 1990s, and most concluded that ­there was some “upward bias.” If the conclusions of Increasing Clamor for Beating Deflation | 199

t­ hese studies are correct, an inflation target of zero would actually result in targeting a negative inflation rate. The second rationale was to have a “buffer” against the ZLB of interest rates. Given that the effectiveness of monetary policy would be substantially impaired as the ZLB loomed, the argument went that it was impor­tant not to fall into such a trap. Accordingly, it could be necessary, in normal times, to have some extra room to lower interest rates in the case of shocks. In other words, it was desirable to set the inflation target at somewhat higher than zero, a sort of insurance against the ZLB in the conduct of monetary policy.

IS TWO ­P ERCENT SACROSANCT? I can fully understand the reasoning of ­these arguments. As a m ­ atter of fact, they w ­ ere basically accommodated as the Bank of Japan drew up its Understanding of Medium-­to Long-­term Price Stability in 2006. Nevertheless, I was against being strongly tied to one number, such as 2 ­percent, as the inflation target. As regards the bias in the construction of the CPI, one of the prob­lems was the difficulty of accurately assessing the bias. Whereas general attention is paid to “upward bias,” t­ here also exists “downward bias.” For example, in Japan, no quality adjustment is attempted for the price of housing ser­vices (rent and imputed rent), whose weight is close to 20 ­percent in the aggregated index, while in the United States, deterioration in quality arising from aging of the housing stock is accounted for. This treatment would result in downward bias of Japa­nese CPI compared with the United States.34 In some cases, it would be difficult to determine w ­ hether the bias was upward or downward. A case could be made for the price of medical or nursing care, whose importance in ­house­hold expenditures is expected to keep rising considerably. How confident could one be in mea­sur­ing the “quality” of ­these ser­vices? A more serious issue is the possibility of the bias being malleable. One could easily imagine the actions of firms concerned with price competition. A firm fearing a loss of market share resulting from increased prices might prefer to resort to lowering the quality of its products rather than mark up their prices. At the same time, a firm fearful of endless price competition resulting from price cuts might try to entice consumers by improving quality, effectively reducing prices. In other words, if firms effectively compete in prices without changing nominal price tags, and if such corporate be­hav­ior changes with the business cycle, any assessment of prices presupposing the existence of a fixed bias would be unac200 | The Days as Governor

ceptable.35 The Bank of Japan is very attentive to the technical details of the nation’s price indices, partly ­because it is actually involved in constructing some price indices, though not in a consumer price index. Turning to the issue of a “buffer” against the ZLB of interest rates, a 2 ­percent buffer was seen as fully justifiable before the GFC. Nevertheless, ­after the GFC, short-­term interest rates in many developed economies faced the ZLB. The insurance by having 2 ­percent turned out to be illusory. Consequently, following the GFC, Olivier Blanchard, then the chief economist of the IMF, floated the idea that a higher inflation target should be considered for more effective insurance.36 Given my experiences with the Japa­nese b ­ ubble economy and the debt burden of nonperforming loans that followed, I am sensitive to the fact that Blanchard’s approach ignores the need to constrain monetary policy from fostering credit ­bubbles. Considering that many ­bubbles originate in low-­inflation environments, if the central bank regards 2 ­percent or any other target rate of inflation as absolute, overriding other ­factors that need to be taken into account, the result would be much larger financial imbalances, including the formation of ­bubbles, which would harm the sustainable growth of the economy. With regard to the target inflation rate, the discussion is still ongoing. It could be 2 ­percent; some would like it lower, some higher. My sense is that it would be dangerous to be fixated on any one number. Admittedly, a­ ctual inflation readings are impor­tant, but more impor­tant is the unwavering pursuit of price stability in a sustainable manner from a medium-­to long-­term perspective.

FINAL THOUGHTS ON THE JAPA­N ESE DEBATE ON DEFLATION The debate on deflation in Japan raged on, perhaps becoming more vicious at times, ­until my final day as governor of the Bank of Japan in 2013. This debate, which has attracted much attention since the early 2000s, was most unfortunate for the Japa­nese economy, b ­ ecause the debate mistakenly deemed deflation as the cause of low growth. As a result, the fundamental challenges confronting the Japa­nese economy ­were not addressed, and this ­will be discussed in chapter 10. The debate on Japa­nese deflation was also unfortunate for the global economy in the sense that it produced an obsession with the perils of deflation and thus adversely affected the conducts of monetary policy in many developed economies. As governor I tried to persuade Japa­nese politicians, and the Japa­nese public, that the debate on deflation was misleading, but in this I was unsuccessful. Increasing Clamor for Beating Deflation | 201

The fundamental reason for the failure prob­ably reflects the amorphous nature of the term deflation. In the discourse between the Bank of Japan and academics and private-­sector economists, the bank discussed issues in terms of economics. In ­those circles, especially in the United States, deflation was what had to be avoided at all costs. In contrast, when noneconomists w ­ ere referring to deflation, they w ­ ere not making a fuss over falling prices per se. They had concerns for their own companies or their personal lives, which meant that they did not want to hear academic discussions on the inflation rate. In such a situation, any attempt by the bank to communicate would have been counterproductive. In addition, it also sank into my consciousness that debates on deflation in Japan would never change ­unless understanding about the under­lying mechanism of inflation changed among academics in the United States. From the 1990s onward, mainstream discussions w ­ ere founded on the output gap and the expected inflation rate, and, in my view, as the Phillips curve flattened, ­there was an increased emphasis on the role of the expected inflation rate and the central bank inflation target. Nonetheless, mainstream economics has not fully succeeded in spelling out the determinants of the expected rate of inflation. In press conferences and on other occasions, I remarked a few times that macroeconomic textbooks needed a few new and impor­tant chapters. While it ­will surely not be easy, we have to tackle this prob­lem, and I am hopeful that ­there ­will be pro­gress in the years ahead.

202 | The Days as Governor

| CHAPTER TEN |

Demographic Challenges and Raising Productivity The Japa­nese debate on deflation became noisier as the days passed. In the National Diet ­there was increasing po­liti­cal pressure on the Bank of Japan for more aggressive monetary easing. Economists and the press joined the chorus. The louder the voices became, however, the more I came to think that the frustration most ­people expressed with the word deflation was not with the fall in prices itself but rather with the gradually declining growth potential of the economy and the country’s deflating prospects. I also thought that t­ here would be no end to calls for aggressive monetary easing u ­ ntil the under­lying challenges confronting the Japa­nese economy ­were recognized and addressed. From 2010 onward, I increasingly spoke out about the issues of aging and falling birth rates, and also of productivity and the declining competitiveness of the Japa­nese industry.

DEBATES ON THE JAPA­N ESE ECONOMY The po­liti­cal sentiment of the times was reflected in comments by a Liberal Demo­cratic Party member of the House of Representatives, addressed to me during a parliamentary committee meeting. In my view, the most impor­tant issue facing the Japa­nese economy is deflation. As long as deflation continues, nothing can go well. . . . ​That is ­ ill the curse of the Japa­nese economy. When t­ here is deflation, firms w shrink, the yen ­will appreciate, factories ­will be offshored, unemployment ­will rise, wages ­will fall, and debtors’ burden ­will increase im­mensely. I believe that is the principal ­factor that raised in­equality and ravaged the regions. In order to beat deflation, only the Bank of Japan can banish deflation.1 203

The widely shared critique of the Bank of Japan’s monetary policy can be summarized in four points: 1. The most fundamental cause of prob­lems confronting the Japa­nese economy is the sustained fall in prices—­that is, deflation. 2. Deflation is a monetary phenomenon. All other ­factors cited, such as falling import prices, deregulation, technology change, or intensified competition only bring about changes in relative prices, not a general decline in prices. 3. The excessive appreciation of the yen is caused by timid monetary policy. The “hollowing out” of Japa­nese manufacturing is caused by such excessive appreciation of the yen. 4. The bank must conduct aggressive monetary policy. If that is achieved, Japan ­will extricate itself from the stagnation portrayed as the “lost de­ cades.” 5. In order for the bank to aggressively ease monetary policy, it must immediately set a target inflation rate and must achieve that target within a predetermined time frame of two years.

REFLATIONISTAS AND EXPECTATIONISTAS Many members of the National Diet, in both ruling parties and opposition parties, condemned the bank’s policy along ­these lines. The bank’s harshest critics came to be commonly called rifure-­ha (“reflationistas”) by the Japa­nese press. Their arguments ­were quite extreme, and they shared a relentless focus on quantity as mea­sured by the monetary base. According to ­these reflationistas, both falling prices and the appreciating yen w ­ ere simply the result of an insufficient supply of the monetary base. ­People making this argument—­ especially some members of the National Diet and media commentators and economists—­were quite combative. They banded together and their influence steadily increased. Outside Japan, t­ here was no corresponding school of reflationistas in the Japa­nese sense, focused so intently on a “crude monetarism.”2 I found it particularly difficult to respond to the claim from some that the bank had failed to change inflation expectations ­because it had not been bold enough. In their view, had expectations changed, the prob­lems confronting the Japa­nese economy would be easily solved. No term was coined to describe them at that time, but let me call them “expectationistas” in that they believed that the central bank had a complete power to manage the expectations of economic 204 | The Days as Governor

agents. From their perspective, the effectiveness of any central bank policy only depended on how it is presented. What was needed, in expectationistas’ view, was absolute resolution. My statements and public commitments ­were deemed too modest.

DISCOURSES ON DEFLATION While we can conceptually distinguish two schools, the differences are not significant. The “reflationistas” would be more vocal in their push for increases in the monetary base relying on the logic of crude monetarism, whereas the expectationistas would be more vocal in their push for effective expectations management, reflecting their more elaborate models. But both ­were calling for aggressive monetary easing, and they shared a belief that the central bank could raise the inflation rate on its own initiative. Their common mantra was “deflation is a monetary phenomenon.” They argued that deflation can be beaten if the central bank is bold enough. As explained in chapter 9, ­today’s mainstream macroeconomics has at its core a view that the central bank can provide an anchor for expected inflation. Accordingly, this established thesis was foremost in the minds of academics who called for aggressive monetary policy. As the low-­growth environment persisted, the views of corporate leaders and the public began to change with regard to monetary policy. Gradually, more and more ­people began to demand that the bank give any mea­sure a try, even if such mea­sure would not be appropriate in normal times, given the dismal economic environment. During our discussions at the bank’s Monetary Policy Meetings (MPMs), I tried to ­counter the arguments that the bank’s monetary policy was not sufficiently forceful. But with the public and corporate leaders worried about their livelihoods and corporate viability, rather than declining prices per se, I strug­ gled to attract public understanding through technical and academic explanations of the under­lying c­ auses of deflation and the l­imited capacity of monetary policy to provide a remedy. Try as I might, untangling the word de­ flation from the idea of low growth in the public mind proved too difficult for me at the time. Our efforts even fostered hostility t­ oward the bank, as many came to perceive it as oblivious to their real-­life concerns. The narrative of wide-­ranging and harmful deflation, though unfounded, was a power­ful opponent. An additional aspect that complicated the Bank of Japan’s responses was that it was impossible to refute, based on concrete data, the claim that the bank’s Demographic Challenges, Raising Productivity | 205

monetary policy was not forceful. Even when the increases in the monetary base did not seem to work as they w ­ ere supposed to, facts ­were brushed aside by arguments such as “the increase in the monetary base was not big enough,” “the bank failed to communicate effectively to influence expectations,” or “­things would have been worse if not for the increase in the monetary base.” Eventually I came to the conclusion that the bank needed to provide an alternative narrative to explain as plainly as pos­si­ble the fundamental c­ auses of low growth and the challenges facing the Japa­nese economy rather than engaging in a technical debate about the c­ auses of deflation. I asked Hideo Hayakawa, the executive director, and Kazuo Momma, the director general, of the Research and Statistics Department to put together the bank’s views on ­these issues. They ­were joined by other bank economists, who conducted research in vari­ous areas—­for example, in aging and the falling birth rate, sustainability of public finances, and the relation between banking and regional economies within a declining population. ­These efforts culminated in a series of working papers published by the bank. In re­spect to demographic issues, I de­ cided it was necessary to call them to the attention of overseas academics and policy makers and encourage further academic research, and devoted the May 2012 annual Bank of Japan Conference to “Demographic Changes and Macroeconomic Per­for­mance,” covering a wide range of related topics.

THE HEADWINDS OF RAPID AGING AND THE FALLING BIRTH RATE With regard to publicly explaining the views of the Bank of Japan, ­t here was an emphasis on laying out medium-­to long-­term challenges faced by the Japa­nese economy as thoroughly as pos­si­ble. Of ­t hose, the most impor­tant was rapid aging and the falling birth rate.3 The Japa­nese population peaked in 2008 at 128 million p ­ eople and has been declining ever since. In 2019, it stood at 126 million, which translates into an annual decline averaging 0.1 ­percent since 2008. At the same time, the peak in the working-­age population, ­t hose aged fifteen to sixty-­four, came fourteen years ­earlier, in 1995, at 87.3 million. It declined approximately 12 ­percent over a span of about twenty years, falling to 80.2 million in 2012 and to 75.2 million in 2019. That decline was also mild at first, but accelerated as the postwar Japa­nese baby-­boomers reached the retirement age of sixty-­five around 2012. An annual average decline in the absolute numbers of the working-­age population between 2010 and 206 | The Days as Governor

2015 was about 949,000 ­people, which corresponded to an annual decline of 1.2 ­percent. The most impor­tant channel through which demographics w ­ ill affect the economy is the change in the age composition of the population. It is more impor­tant than the decline in population itself. The key is the working-­age population, the cohort that is at the core of both production and consumption activities in an economy. When the proportion of that cohort is increasing, an economy ­will enjoy a demographic bonus. When that proportion is declining, an economy ­will suffer from demographic onus. Japan’s demographic bonus dis­appeared around the beginning of the 1990s. The proportion of the population over the age of sixty-­five to the working-­age population in 1970, at the end of Japan’s era of high growth, stood at 10.2 ­percent. It increased rapidly to 17.3 ­percent in 1990, to 25.5 ­percent in 2000, and to 40.4 ­percent in 2013. According to the estimate by the National Institute of Population and Social Security Research, that proportion is expected to rise further to 49.9 ­percent in 2022, and to 72.8 ­percent by 2050.4 This is ­really a staggering development and unpre­ce­dented in global economic history. ­There are two f­actors b ­ ehind this rapid aging. One is longevity, which reflects f­ actors such as advances in medicine, significant improvement of living standard during the high-­growth years, and the universal health insurance introduced in 1961, among ­others. The other was a precipitous fall in the birth rate, unseen in other developed economies. A ­ fter World War II t­ here w ­ ere baby booms in many developed economies, but the subsequent fall in the birth rate was especially large in Japan. Such existing trends in demographics, and especially the steep fall in the proportion of the working-­age population, must be taken as a given when one is thinking about the next few de­cades. In order to grasp the effects of the declining working-­age population at the time of my governorship at the Bank of Japan, it would be useful to compare real gross domestic product (GDP) growth and per capita growth and real GDP growth per working-­age persons among the G7 economies between 2000 and 2010 (see fig. 10.1). The figures show that in terms of real GDP growth, Japan is among the lowest growth economies. On the other hand, if real GDP growth per working-­age person is compared, Japan tops the league alongside Germany. Real GDP growth per capita shows Japan’s per­for­mance falling in about the ­middle of that of its peers. ­These patterns essentially hold even when the data set is extended to more recent years. Given that GDP growth over the long term ­will be mainly circumscribed by the growth in ­labor input and ­labor productivity, in Japan the headwind from the declining working-­age population has Demographic Challenges, Raising Productivity | 207

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Figure 10.1 ​An international comparison of growth per­for­mance. Source: Shirakawa (2012a).

been so strong as to push the overall GDP growth down since 2000. In this context, even if prices w ­ ere to increase and thus resulted in nominal income growth, real income levels or living standards would not improve. The fundamental issue facing the Japa­nese economy is not falling prices but building an economy that can sustainably secure per capita GDP growth against the background of a l­abor force that is shrinking. The prob­lem facing Japan is not about the past; the real prob­lem is sustainability. If nothing is done, potential growth would eventually have to decline. On this point, the Bank of Japan’s early estimate of potential growth rates ­were an overestimate, influenced by the high growth numbers during the global credit prior to the GFC.5 In fact, the bank’s estimate was gradually marked down from approximately 1 ­percent at the start of my governorship to around 0.5 ­percent in April 2010.6 Obviously, potential growth could increase if l­abor input and its productivity ­were to change. Accordingly, policy should be aimed at an increase of both. Having said that, it is also unlikely that ­these two f­ actors would change significantly in the short run. One has to be clearly mindful of the impacts of declining population rates. In this context, in order to explain the importance of increasing l­ abor participation, I often pointed out that if ­labor participation 208 | The Days as Governor

rate did not change for gender or age cohorts, the number of workers would decline annually by 0.6 ­percent during the 2010s and by 0.8 ­percent in the 2020s, which was an im­mense headwind.7 Given the sober fact that the speed of decline in the working-­age population was greater than that of the aggregate population, per capita GDP growth would undershoot aggregate GDP growth.

THE WORSENING TERMS OF TRADE The worsening of Japan’s terms of trade since 2000 was the most pronounced among the G7 economies. One reason was rising commodities prices, but deterioration in the case of Japan was more prominent than in the case of Germany, which was also a commodities importer (see fig. 10.2). The most notable feature with regard to Japan was that the worsening terms of trade resulted from declining export prices. The competitiveness of Japa­ nese exports was declining. Japa­nese firms ­were increasingly being forced to adopt business strategies that aimed at securing export and production volume through price cuts. A typical industry thus affected was electronics, whose competitive advantage against Chinese and Korean firms was eroded, resulting in it being forced to cut prices.8 In contrast, German firms succeeded in raising prices—in par­tic­u­lar, prices for their automobiles and capital goods exports. Similarly, Swiss firms, which faced a sharper appreciation of the domestic currency than Japa­nese firms, ­were also able to raise the prices of exports—­mainly precision machinery and phar­ma­ceu­t i­cals. Japa­nese firms ­were faced with the most acute prob­lem of declining competitiveness.

THE POWER OF NARRATIVE Unfortunately, ­these under­lying issues facing the Japa­nese economy ­were not widely recognized. Instead the national discourse focused on the claims that deflation was the biggest challenge facing the Japa­nese economy, that extricating Japan from deflation was the single most impor­tant imperative, and that this could be readily accomplished by increasing the quantity of money. Such a view was repeated on many occasions, including the prime ministers’ general policy speeches at the National Diet, formal speeches by corporate leaders in Japan, and newspaper editorials, and had an extremely big impact, becoming a narrative. The US academic Robert Schiller is quite right in emphasizing the role played by narrative.9 I agree with his observation that narratives cannot be ignored with re­spect to the spending decisions of h ­ ouse­holds and firms. Demographic Challenges, Raising Productivity | 209

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Figure 10.2 ​The export deflator and terms of trade. Sources: Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Japa­nese Cabinet Office.

I also believe that the influence of narratives can be most pronounced in economic policy making. As was explained in chapter 9, the deflation story in Japan was a perfect example of how narrative affected macroeconomic policy. One of the most often used descriptions of the Japa­nese economy over the last twenty years and even ­today has been the reference to the “lost de­cades,” which is again a typical narrative among p ­ eople in the Japa­nese government, corporate leaders, domestic and overseas economic commentators, and the press. Admittedly, the term may have a grain of truth if it ­were used to portray the ten years immediately following the bursting of the Japa­nese ­bubble. If the prob­lem of nonperforming loans had been tackled much more swiftly, growth would have been slightly higher during that de­cade. Having said that, it should also be borne in mind that t­ here was another reason for the downward inflection of growth: the growth rates seen during the b ­ ubble w ­ ere not sustainable in the first place. A weaker growth rate reflected a more or less inevitable pro­cess of shifting from an unsustainable path of growth to a more sustainable one. A dif­fer­ent misgiving strikes me when I hear the phrase “the lost two, even three de­cades” ­after the beginning of the 1990s. As noted e­ arlier, the overall real GDP growth was lackluster, but the defining f­actor b ­ ehind this was the shrinking l­abor force, which was an inexorable fact, and nothing had been “lost” by macroeconomic policy per se. If the ­people are bombarded with references to the “lost two de­cades,” that could give rise to groundless pessimism or, worse, to unfounded belief in an all-­powerful aggressive monetary policy. During my tenure as governor I seized on e­ very opportunity, including appearances before the National Diet, press conferences, and speeches, to emphasize the importance of identifying the under­lying forces holding back the Japa­nese economy and adopting appropriate policies in response. The prob­ lem was about the ­f uture. In this regard one should understand that ­t here would be two difficult issues in the years ahead. The first was the sustainability of high living standards. Per capita GDP growth would be likely to decline steadily, reflecting the more pronounced decline in the working-­age population more so than in the total population. In addition, the worsening fiscal balance resulting from increasing social security expenditures in an aging society could trigger, when coupled with low growth, a sudden loss of confidence in Japa­nese Government Bonds. The sustainability of government finances is the most impor­tant precondition for monetary and financial stability, something that w ­ ill be examined in chapter 15. Demographic Challenges, Raising Productivity | 211

The second pivotal issue is the declining competitiveness of Japa­nese industry. Obviously, if firms decide to reduce their prices in dollar terms, they might still be able to sell enough units, and consequently the level of GDP could be maintained. That, however, means that Japan’s terms of trade would worsen, resulting in diminished real purchasing power. For firms, worsening terms of trade mean that the ratio of export output prices to import input prices would decline, resulting in downward pressures on profits. For h ­ ouse­holds, it would mean that they would have to buy, for example, more expensive gasoline when their income is flat, and they would suffer a decline in their real income.

LOWER GROWTH EXPECTATIONS AND DECLINING PRICES The Bank of Japan started to emphasize that the central issue facing the Japa­ nese economy was not falling prices but falling potential growth in the context of a rapidly aging population and the declining competitiveness of Japa­nese industry. It was met with extreme hostility from p ­ eople who believed that deflation was the culprit of low growth and that the root cause was conservative monetary policy on the part of the bank. The bank responded by saying that low growth was not caused by deflation. One related fact is that, among the developed economies, ­there exists a clear correlation between per capita potential growth and the expected inflation rate (see fig. 10.3).10 Obviously, correlation does not mean causality. ­There are a ­couple of hypotheses for such correlation. The first of ­those points to the effects of declining population. When the working-­age population begins to decline, p ­ eople are likely to expect per capita income growth to stagnate, which in turn w ­ ill stifle expenditures and eventually result in lower inflation. With re­spect to this line of thought, one might ­counter that the correlation or causation should be negative: the declining working-­age population, through declining l­abor supply, should result in inflationary pressures. Each of ­these points of view reflect the difference in focus regarding the stages of population decline.11 At the phase where shrinking population is expected but the working-­age population has not actually declined significantly, one should see a stronger effect of lower aggregate expenditures reflecting lower income expectations. On the other hand, once the working-­age population begins to shrink sizably, the effect of supply-­side constraints should be greater. Japa­nese statistics seems to show that ­there was a turning point around 2012, when baby boomers started reaching the age of sixty-­five and exited the working-­age cohort. The effect of demographics on 212 | The Days as Governor

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2004

2006

2008

2010

0 2012

Figure 10.3 ​Inflation expectations and potential growth rates. Source: Bank of Japan (2013b).

prices seems to be turning to positive, though this effect is partially offset by labor-­saving capital investment. The second explanation points to the effects of the declining competitiveness of Japa­nese industry. As I have noted in chapter 9, Japa­nese firms tend to sustain employment against exogenous negative demand shocks. If shocks are only temporary, this practice would have the advantage of preserving firm-­ specific skills of employees. But if the shocks are of a permanent nature, the custom would become a liability b ­ ecause it would result in maintaining unprofitable business lines. This means that with such a norm in Japan, as potential growth rate drifts down due to per­sis­tent negative shocks, reduction of wages and output prices of unprofitable business became a way for retaining businesses and, for that m ­ atter, maintaining employment. The result was declining long-­term inflation expectations. Relevant per­sis­tent negative shocks include not only the direct destruction of demand by the bursting of economic ­bubbles but also the worsening terms of trade and rapid aging mentioned ­earlier. In my public speeches I often referred to the cost structure of the iPhone, which was first brought to the market in 2007. For example, at one point in 2011, of the five-­hundred-­dollar price tag of the iPhone the aggregate value of parts and components amounted to $173. With re­spect to assembly costs, they Demographic Challenges, Raising Productivity | 213

­were only six dollars. In contrast, gross margins of Apple w ­ ere as much as $321.12 This showed how large was the added value derived from conjuring up the basic product concept of the iPhone and from bringing it to the market. Japa­nese firms did supply many of the parts and components, but they had to confront stiff global competition, resulting in commoditization and incessant pressures for price cuts. Faced with declining nonprice competitiveness, Japa­ nese firms, bound by implicit long-­term employment commitments, had no option other than to cut costs by cutting wages. Lower growth reflecting declining competitiveness thus might have brought about lower wages and prices. ­Labor productivity is not the same as technical efficiency, considering that it is derived by dividing the value added—­that is, the sum of corporate profits and wages via l­abor input. One way to boost productivity is to realize cost ­savings through pro­cess innovations to production lines. The other way is through product innovation—­that is, to introduce products based on new ideas that satisfy the needs of consumers. As the cost structure of the iPhone showed, the lead of Japa­nese firms in this regard had been declining since the 1990s. I attempted to illustrate this fact in a speech in June 2012, employing the terms “red ocean” and “blue ocean,” which are often used in business strategies lit­ er­a­ture: “More concretely, it is necessary for firms to switch their fundamental strategy from the ‘Red Ocean Strategy,’ u ­ nder which they continue price competition in the shrinking markets, to the ‘Blue Ocean Strategy,’ ­u nder which they create new markets and provide high value-­added. If firms are successful in raising profitability not by cutting costs but by generating value-­ added, they can pay higher wages to their employees. Subsequently, consumers ­will have higher incentives to purchase value-­added goods and ser­vices; hence, a virtuous circle prevails.”13 ­There could be a number of reasons for the declining competitiveness of Japa­nese businesses since the 1990s. Japa­nese firms w ­ ere traditionally good at pro­cess innovation, but in the age of revolutionary advances in information technology, product innovation has become much more impor­tant. What became crucial in this new environment was “open innovation” and quick management decisions, which do not fit well with traditional Japa­nese practices. The long-­term commitment on employment deterred flexible reallocation of ­labor not only across companies and industry but within companies. Lack of diversity of management was not conducive to open innovation transcending firms and national borders. The social culture of punishing failure was so deeply ingrained that it tended to discourage pos­si­ble innovators. The demand for vari­ous standards, such as t­hose in safety and timeliness w ­ ere set so high that firms 214 | The Days as Governor

tended to be cautious in embracing experimental ideas. All in all, ­there was a bad fit between established Japa­nese “social contracts” and the new business environment characterized by information technology and globalization.

THE GROWTH-­S UPPORTING FUNDING FA­C IL­I­T Y When the public was clamoring for “beating deflation,” it was not ­really a call for increasing the inflation rate per se. Similarly, the term deflationary mind-­ set did not mean expectations of price declines but was shorthand for a pattern of cautious decision making and the resulting timidity of firms and ­house­holds. The idea of “banishing the deflationary mind-­set” actually was an expression of the desire to see an environment where firms could be more proactive. The question for the Bank of Japan was how it should behave. The first option was to refrain from making any comment or taking policy action aimed at potential growth, based on the understanding that it is outside the central bank’s competence to effect mea­sures aimed at enhancing potential growth. Growth-­enhancing policies, such as educating the young, supporting technological advances, and enhancing the skills of workers, are not directly associated with monetary policy. The second option was to continue advocating the necessity of enhancing potential growth as forcefully as pos­si­ble. Among overseas central banks, the position ­adopted by the Federal Reserve Board seems to be closer to the first option, while the Eu­ro­pean Central Bank’s position seems to be closer to the second. In fact, at the Eu­ro­pean Central Bank’s regular press conferences following its Governing Council meetings to deliberate monetary policy, the president always referred to the necessity of structural reform in the opening statement. The third option is to do what is feasible for the central bank, in addition to playing a role in advocating such changes in policy outside its remit. The Bank of Japan de­cided to adopt the third option. The first option was not attractive ­because nothing would have changed. It was easily i­magined that the result would be stronger demands on the bank to “beat deflation.” The second option would not find sympathetic ears if the bank was thought to be only preaching. Accordingly, the bank de­cided to implement its Fund-­Provisioning Mea­sure to Support Strengthening the Foundations for Economic Growth (or, in short, the Growth-­Supporting Funding Fa­cil­i­ty), whose outline was announced a­ fter the MPM at the end of April 2010. At the press conference following the meeting, I explained the aim of the mea­sure as follows: Demographic Challenges, Raising Productivity | 215

Currently, the Japa­nese economy is coming out from the global stagnation following the collapse of Lehman B ­ rothers, and is faced with the ­c yclical issue of returning to a sustainable growth path ­u nder price ­stability. At the same time, Japan is also confronted with a medium-­to long-­term issue. Its growth rate is trending lower reflecting declining population and productivity. Monetary policy of the central bank is aimed at the former, but it is also true that the latter issue, the decline of potential growth or growth expectations, has much impact on the prob­ lem of deflation. From this perspective, . . . ​the Bank of Japan must explore if ­t here is any contribution it could make, by employing central bank functions at its disposal. In that regard, the Bank must consider options taking into account the objectives vested to the Bank and monetary policy instruments available to the Bank.14 The details of the mea­sure w ­ ere approved at the June  2010 MPM, and the ­actual implementation followed in September. It was aimed at supporting the strengthening of the foundations for economic growth in Japan through supporting the funding of actions of banks and businesses. More specifically, banks ­were expected to draw up business plans to support the strengthening of the foundations for economic growth, and the bank would provide funding to banks’ lending or equity investment, which satisfied conditions set by the Bank of Japan, for a period of at least one and up to four years. The funding cap was initially set at 3 trillion yen. With the funding rate set at the policy rate of 0.1 ­percent, banks w ­ ere able to enjoy long-­ term funding at that low rate. This incentive-­based scheme to promote bank lending was the first of its kind among central banks in developed economies. The Funding for Lending Scheme introduced jointly by HM Trea­sury and the Bank of E ­ ngland, which followed in December 2012, was an analogous mea­sure. Incentives, or “subsidies,” to banks u ­ nder this Bank of Japan policy mea­ sure was not very large in view of the l­ imited room for the further lowering of interest rates. Even so, it had, at the margins, the effect of lowering bank lending rates. The mea­sure was not well received by banks, which believed that it would only exacerbate already fierce competition and not enlarge the lending pie. From the perspective of financial institutions, the weak borrowing demand was a reflection of the weak economy, not the level of interest rates. The bank was not unaware of this fact, but instead of just lecturing it hoped to play a catalytic role, though modest, in prompting financial institutions to make more 216 | The Days as Governor

serious to address the issue of productivity, through the bank’s lead in emphasizing growth enhancement.

REACTIONS TO THE BANK’S COMMUNICATION ON DECLINING GROWTH POTENTIAL ­ ere ­were mixed reactions to the Bank of Japan’s efforts. Economists and the Th media generally agreed that growth-­enhancing policies ­were necessary, but they viewed this as the job of the government, not the central bank, and even suggested that the bank was trying to divert attention from monetary policy to other issues. The more I spoke about the need to address the under­lying economic challenges facing Japan, the more I was criticized for not being aggressive enough with monetary easing. Quite a few economists w ­ ere relatively sanguine about the demographic challenge facing Japan, arguing that the effects of the shrinking l­abor force could be offset by enhanced productivity. This is not a new argument. During the b ­ ubble economy years, concerns had been already expressed over Japan’s prospects for a declining population. Initially, I shared the optimistic view that ­labor productivity could increase b ­ ecause of the substitution of capital for ­labor and attendant innovations and, therefore, that we need not worry too much about the effects of a shrinking population. It was some time before I realized that this reasoning only partially captured a more complex real­ity. The ­factor I had overlooked when I was young was the po­liti­cal, social, and economic dynamics brought about by rapid aging. When the electorate ages, fiscal outlays tend to f­ avor se­nior citizens, and working-­age p ­ eople tend to lose out, a problematic development described as gray-­hair democracy. In general, government tends to procrastinate in adopting policies conducive to raising productivity, which are often painful in the short term. I was also unaware of disparities among regions regarding the impact of population declines. Municipalities with increasing population, such as metropolitan Tokyo, ­were quite rare. In municipalities losing population, it becomes costly to maintain the quality of public infrastructure once the size of the population falls below a certain threshold level. The same is true for many types of ser­vices provided by the private sector. The market size of the location or its intensity of economic activity is one of the crucial ­factors affecting productivity in the ser­vice sector. In less populous areas we cannot count on the benefit of agglomeration. Smooth resource allocation across a region, which is a key for productivity, is Demographic Challenges, Raising Productivity | 217

often blocked by po­liti­cal and social forces. The result is a gradual decline in productivity growth. ­Those prob­lems caused by demographic change w ­ ere essentially due to delays in adjustment. In the very long term, when all adjustments w ­ ere completed, the size of the population might be neutral vis-­à-­vis per capita GDP growth. Nevertheless, this long adjustment pro­cess is painful. If it w ­ ere pos­si­ble to continuously tweak vari­ous systems and institutions in response to changing ­demographics without delay, the impact of aging could be manageable. Unfortunately, given the a­ ctual po­liti­cal and social dynamics, I was not optimistic in this re­spect. Compared with rapid aging, the declining birth rate in Japan was and is a more daunting prob­lem. As long as the birth rate is below the replacement level, the population ­will continue to decline. Some confidently say, “We do not have to worry about the shrinking population, as long as the growth of GDP per capita is maintained by increased productivity.” I am skeptical about this argument. As the growth theorist Charles Jones argues, “in many growth models based on the discovery of new ideas, the size of the population plays a crucial role” and [the models] “assume a constant or growing population.”15 What would happen to economic growth if population growth is negative? The issue is also of a po­liti­cal nature. It is pos­si­ble to partially offset the decline in population by receiving more foreign workers or immigrants. But in developed economies, including Japan, it seems difficult po­liti­cally and socially to receive immigrants on a scale that completely offsets adverse demographic trends. ­There is a lingering question about what is a ­really sustainable “equilibrium” and how we can achieve it. Declining population is projected to be a real­ity for many countries in the de­ cades to come, and is described by the expression “empty planet.”16 The implications of demographic change on macroeconomy and monetary policy are so profound that we have to think seriously. Rapid aging—­ compositional change of population—­means a decline in per capita income and thus the natu­ral rate of interest. This w ­ ill make monetary policy difficult, since monetary easing is an act of setting the interest rate below its natu­ral rate. The comfort is that this decline is transitional in nature, though its pro­cess is rather long, lasting ­until the fraction of the aged reach a peak. The other aspect of demographic change, population decline, could be more serious. If it means a decline in productivity due to the mechanism explained above, the implications for monetary policy is quite sobering. My impression is that ­these issues are not warranted sufficient attention by academics and policy makers, and I w ­ ill discuss them more systematically in chapter 20. 218 | The Days as Governor

­After all, the effects of demographics are somewhat like watching a slow-­ motion movie. While the scenes change only very slowly, it must not be forgotten that they are still moving from one scene to the next as time passes. It is dangerous to treat it lightly. To my regret, communications from the Bank of Japan regarding the impact of demographics during my governorship had only l­ imited impact on ­actual economic policy making in Japan. Since that time ­there has been much research on the relationship between demographic change and the macroeconomy, inflation, or the conduct of monetary policy in the growing body of work undertaken by international financial institutions and foreign central banks.17 ­After I left the Bank of Japan, I felt somewhat vindicated when I found out that overseas academics ­were noting that “Japan has been at the vanguard of research and policy discussions about the macroeconomic implications of demographic shifts” and that “we commend central banks that have already taken the lead on researching ­these issues, and urge continuing ­those efforts.”18 I cannot help feeling that it is difficult for even smart ­people to grasp issues u ­ nless they are actually exposed to the situation, be it related to a b ­ ubble or to demographic change, which Japan experienced much ­earlier than other developed economies.

Demographic Challenges, Raising Productivity | 219

| CHAPTER ELEVEN |

The Eu­ro­pean Debt Crisis

As 2009 unfolded, the Japa­nese economy continued its gradual recovery. This was made pos­si­ble by the overall improvement in the global economy, as financial markets regained an even keel starting in March of that year. But this benign environment was short-­lived. The Eu­ro­pean debt crisis, which began that autumn in Greece, arrived in a series of waves, each one larger than the one before, u ­ ntil the collapse of the euro seemed pos­si­ble.

THE BIRTH OF THE EURO The monetary u ­ nion that created the euro was rooted in the heroic po­liti­cal proj­ect to establish a peaceful Eu­rope, f­ ree from the devastating wars of the twentieth c­ entury. Within this po­liti­cal pro­cess it was often debated ­whether monetary ­u nion should come first or ­whether greater economic integration should come first, preceding monetary ­u nion. In the economic theory of an “optimal currency area,” the crucial conditions for having a common currency are thought to be the f­ ree movement of l­abor and the ability to effect fiscal transfers within the area.1 In this way of thinking, economic and po­liti­cal integration should be achieved before monetary ­u nion is attempted. A counterargument is that the pro­cess could work in the other direction: the launch of monetary ­u nion could help consolidate economic integration, which w ­ ill in turn prompt po­liti­cal integration. Eu­rope chose to introduce monetary ­u nion first as a means of encouraging a greater economic and po­liti­cal ­union. In 1992, with some hiccups along the way, the Maastricht Treaty was agreed upon, laying out the conditions for individual Eu­ro­pean countries to join the monetary u ­ nion, known as the Maastricht Criteria. Despite the skepticism of many observers, the euro was officially launched on January 1, 1999.

220

THE THREE STAGES OF THE EU­R O­P EAN DEBT CRISIS Ten years ­later the euro and the Eu­ro­pean Central Bank (ECB), which ­were created by the Maastricht Treaty, faced a series of existential threats. In October 2009 the government of Greece admitted that its prior fiscal statistics had been fabricated. This first stage of the Eu­ro­pean debt crisis came to a close in May 2010 with the announcement of a bailout of Greece by euro area governments and the International Monetary Fund (IMF). This period was noteworthy for the ECB’s introduction of a program to purchase government bonds called the Securities Market Programme (SMP). The second phase unfolded during 2011 and centered on heightened concerns about the solvency of Eu­ro­pean banks. During this period, the ECB introduced the Longer-­Term Refinancing Operation (LTRO), which enabled the bank to supply three-­year term funding to troubled banks. The third and final stage was the period between the spring and summer of 2012, when both Italy and Spain faced acute financial crises. An institutional development associated with this stage was the establishment of the Eu­ ro­pean Stability Mechanism (ESM) in October 2012, which granted life support to the Spanish banking system. At the same time, the ECB introduced a bond purchasing program, the Outright Monetary Transaction (OMT), linking it with reform efforts in the economies benefiting from the program. Excessive debt was the common thread ­r unning through the Eu­ro­pean economies hit by the crisis. The distressed borrowers ­were, however, dif­fer­ent from one another. In the case of Greece, the excessive debt was in the public sector. In Ireland and Spain, ­t here was excessive borrowing by the private sector—­particularly h ­ ouse­holds and financial institutions. Even if the borrowers w ­ ere dif­fer­ent at first, as the trou­bles deepened they all faced negative feedback loops among government finance, the financial system, and the real economy. Whereas the mechanism of the crisis was straightforward, the forces unleashed w ­ ere horrific. When the prices of bonds held by banks fell, bank capital was eroded. Banks with diminished capital would cut back on lending, which would negatively impact business conditions. This would then lead to lower tax receipts, exacerbating bud­get deficits and leading to a further fall in bond prices, starting the vicious cycle again. Consequently, unemployment in the euro area shot above 12  ­percent on average and above more than 25 ­percent in Greece and Spain. While the severity of the Eu­ro­pean debt crisis was broadly similar to what Japan experienced in the late 1990s, unlike Japan, Eu­rope experienced serious

The Eu­ro­pean Debt Crisis | 221

negative feedback between government finances and the financial system. This type of vicious feedback is often observed in emerging and developing economies, but it had not been observed in developed ones. Eu­rope experienced particularly severe ill effects ­because, unlike most emerging economies, the Eu­ro­pean countries hit by the crisis could not rely on currency devaluation to regain competitiveness through declines in prices and wages. The Eu­ro­pean debt crisis demonstrated that the negative feedback loop between sovereign credit and the financial system could be ferocious and that developed economies could also experience this. It also laid bare the complexity of conducting economic and monetary policies in an environment where monetary u ­ nion had run way ahead of po­liti­cal ­union.

THE FIRST PHASE OF THE CRISIS When the misleading Greek fiscal data first came to light, euro area policy makers took the view that Greece’s case was special. On February 5, 2010, the issue was first examined in detail at an international forum with repre­sen­ta­ tions from outside the euro area, when finance ministers and central bank governors of the G7 economies met in Iqaluit in northern Canada. It dawned on me then that something extremely serious was brewing, as I saw euro area representatives b ­ attle it out without any hint of trying to hide their differences before finance ministers and central bank governors from outside the euro area. The Japa­nese finance minister joining me at this meeting was Naoto Kan, who had assumed that role only a few weeks ­earlier. Looking back, I have wondered ­whether this G7 meeting may have left a strong impression on him regarding the necessity of fiscal reforms and ­whether this may have contributed to his rather impetuous proposal to raise the consumption tax during the Japa­ nese election campaign for the House of Councillors in July 2010 ­after he had become prime minister. Financial crises always manifest themselves as prob­lems in funding. In past financial crises in Latin Amer­i­ca and Southeast Asia, the IMF has provided funding as a part of support packages. W ­ hether the IMF should play a similar role in the case of Greece became a contentious issue. In the opening stages of the Eu­ro­pean debt crisis, the euro area policy makers w ­ ere focused on self-­help and did not welcome the IMF’s involvement. Another hotly debated issue was private-­sector involvement (PSI), which was shorthand for forcing private investors in Greek government debt to accept losses in order to lighten the debt burden of Greece. If PSI w ­ ere imposed on investors in Greek government debt, 222 | The Days as Governor

investors might fear the same happening for other euro area government paper, which might then lead to a run on the sovereign debt of other Eu­ro­pean countries. But the magnitude of Greek debt suggested that any resolution without PSI would not work. Conditions in financial markets rapidly deteriorated in the spring of 2010, and Greece was forced to go to both the Eu­ro­pean Union (EU) and the IMF. Agreement was reached on May 10 on a package to support for Greece by euro area governments and the IMF, and on financial system stabilization mea­sures including the establishment of an emergency lending mechanism, the Eu­ro­pean Financial Stability Mechanism, which had a firepower of 500 billion euros. At the same time, the ECB introduced the SMP, which was its first attempt to purchase government bonds, although not designed as quantitative easing (QE). The government bonds purchased ­under SMP w ­ ere only ­those of troubled countries, unlike the QE started in 2015.

THE SECOND PHASE OF THE CRISIS ­ ese stabilization mea­sures succeeded in buying some time, but not for long. Th By the ­middle of 2011, financial markets became unsettled again. The yields on other euro area government bonds had been relatively stable during the first phase of the crisis, with the exception of Greece, Ireland, and Portugal. But in the second half of 2011, yields on Italian and Spanish government bonds began to rise, and even the more highly rated French government bond faced negative pressures. Such disturbances in the ­middle of 2011 appeared against the backdrop of both heightened investor concerns about the event of PSI and the slowdown of the euro area economy. In the summer of 2011 a war of words broke out with policy makers from outside Eu­rope calling on euro area governments for actions to address the financial strains and with objections from Eu­ro­pean policy makers. The first instance was prob­ably at the annual Jackson Hole Economic Symposium at the end of August. At a panel discussion, the managing director of the IMF, Christine Lagarde, observed in a strong tone that immediate injection of capital was needed at Eu­ro­pean banks and warned that a serious liquidity crisis would happen if her call was ignored.2 Following this ­there ­were heated exchanges on capital injections into Eu­ro­pean banks at vari­ous international meetings. Eu­ro­pean policy makers w ­ ere now in the same shoes that their Japa­nese counter­parts had found themselves in during Japan’s financial crisis. Eu­ro­pean leaders ­were strongly criticized for the delay in their response in cleaning up prob­lems in the financial system. While I had some sympathies with them, The Eu­ro­pean Debt Crisis | 223

having faced a similar predicament, I encouraged my Eu­ro­pean colleagues to get on with the necessary reforms. The extreme tensions in the euro-­denominated financial markets eventually receded around the end of 2011. The main ­factor was the ECB’s execution of two monetary operations, both via the LTRO. Since euro area banks could then secure as much relatively long-­term funding as they wished, concerns over funding receded, and reduced tensions in financial markets.

THE THIRD PHASE OF THE CRISIS The relative calm was again short-­lived. The yields on government bonds of “peripheral” economies began to rise in March 2012. Investors ­were fixated on Spain, and their concerns about the Spanish financial system began to spill over into the Italian financial system. This in turn led to fears concerning the health of many Eu­ro­pean banks that had large exposures to Italian and Spanish banks. If such dominoes fell, the real economy and financial systems would suffer acute punishment. In the abstract, the crisis would dissipate if financial institutions had sufficient capital to weather the storm. Nontheless, the amount of fresh capital required would be more than the immediate capital shortfalls calculated by reviewing the current health of balance sheets b ­ ecause of the likelihood of strong negative feedback in a crisis phase among fiscal conditions, the financial system, and the real economy. Furthermore, with the prospect of im­mense losses arising from the demise of the euro looming on the horizon, however small the probability of that happening might be, investors would be loath to put up fresh capital. In the end the euro area governments had to have the ­will and capacity to defend the stability of the financial system. At the same time, investors had to be persuaded that such w ­ ill and capacity ­were fully backed by concrete institutional structures. In order to dispel investors’ concerns over the capital adequacy of the banks, Eu­ro­pean policy makers conducted three EU-­wide stress tests in 2009, 2010, and 2011. Unfortunately, ­these tests did not achieve their intended objectives. A successful stress test must—as the United States test had done in 2009—­assess capital requirements u ­ nder sufficiently severe scenarios and at the same time have a backstop, which investors find credible, in the form of capital injection by the government when banks fail to raise the necessary capital on their own. If investors do not have confidence in the pro­cess, simply conducting stress tests ­will not alleviate investors’ concerns. It was becoming evident that the Eu­ro­pean debt crisis would not abate u ­ nless policy makers succeeded in halt224 | The Days as Governor

ing the vicious feedback between the creditworthiness of the sovereign and the financial system. With regard to Eu­rope, the use of public funds, which was already unpop­u­lar in the domestic context, was loathed even more when the public saw it as bailing out profligate foreigners. Consequently, it was very difficult to agree on a price tag for the task, with diverging interests among northern euro area economies and southern euro area economies as well as among public-­sector and private-­sector creditors. The endgame began when, at the end of June 2012, Spain made a request to other euro area governments for assistance and capital injections to Spanish banks ­were endorsed on July 20, but the markets remained unsettled at that point. On July 26, 2012, Mario Draghi, the president of the ECB, made a famous remark in London: “Within our mandate, the ECB is ready to do what­ever it takes to preserve the euro. And believe me, it w ­ ill be enough.”3 Following that, on September 6, the details of OMT w ­ ere published, and at about the same time, an EU-­wide mechanism to enable capital injection using public funds was put in place. With the announcement of ­these mea­sures, financial markets fi­nally began to s­ ettle down, and the euro exchange rate reversed its decline. It was not immediately realized then, but in retrospect, the Eu­ro­pean debt crisis peaked in July 2012.

WHEN THE IDEAL OF THE EURO MET REAL­I TY Why did the Eu­ro­pean debt crisis happen? When the architects of the euro launched their ­g rand proj­ect, in which nations would renounce sovereignty with regard to issuing currencies and introduce a common currency, they must have thought through all conceivable eventualities, including the possibility of crises. The construct of the euro rested on three intellectual pillars. The first was the conduct of monetary policy focused on price stability. To achieve this, a strongly in­de­pen­dent central bank, the ECB, which was modeled on the Deutsche Bundesbank, was set up. Financial stability was treated as a separate goal assigned to supervisors and regulators. The second was a mechanism to maintain fiscal prudence. More specifically, euro area governments made specific commitments through the Stability and Growth Pact. In addition, market discipline was expected to encourage governments to pursue fiscal prudence. Given that transparency of financial markets would be enhanced as a result of eliminating exchange rate risk between economies, it was anticipated that profligate governments would be penalized by being forced to pay higher interest The Eu­ro­pean Debt Crisis | 225

rates on their bonds. The third was the frictionless flow of funds between financial markets within the euro area. With exchange rate risk eliminated a­ fter the launch of the euro, it was envisaged that optimal allocation of resources would be realized within the euro area and any resulting current account imbalances would be financed by capital flows from economies with low yields to t­ hose with high yields on a risk-­adjusted basis. Unfortunately, the a­ ctual functioning of such mechanisms left much to be desired. ­There ­were three reasons for the disappointment. First, ­there was ­little awareness of the possibility that the macroeconomy could be destabilized by growing financial imbalances, even if prices remained stable. Second, the Stability and Growth Pact was not always enforced to the letter. When two large euro area economies, France and Germany, faced a situation in which they could not abide by the pact in 2003, Germany, which usually called for strict enforcement of rules, aimed to stop the pact’s enforcement procedures. Accordingly, the Eu­ro­pean Commission de­cided not to pursue the case in 2004. Fi­nally, market discipline was not forthcoming as expected. Pricing in financial markets did not appropriately reflect risks and returns, with interest rates on Greek, Irish, Italian, Portuguese, and Spanish government bonds remaining at practically the same level as German bonds for almost ten years preceding the crisis. Consequently, both the governments and private-­sector economic agents ­were able to raise huge amounts of money at low interest rates, resulting in increased expenditure, wages, and inflation. Against such a backdrop the current account balances of peripheral economies went deeply into the red, reflecting increased domestic spending and loss of competitiveness. Current account imbalances within the euro area ­were getting bigger, but scant attention was paid to such a development masked by the balanced external position of the euro area as a w ­ hole. Reflecting on the intellectual pillars underpinning the euro and subsequent development, I am once again struck by the influence of power of ideas or the conventional wisdom of the day, as was the same with the Japa­nese ­bubble and the US housing ­bubble.

THE IMPACT ON THE JAPA­N ESE ECONOMY The Eu­ro­pean debt crisis had a strong impact on the Japa­nese economy through three channels. The first and the most prominent channel was the appreciation of the yen. The main reason for the appreciation was the increased demand for yen as a safe-­haven currency in an extremely uncertain environment where 226 | The Days as Governor

the disintegration of the euro area was no longer a hy­po­thet­i­cal question. Prob­ lems encountered in raising the US debt ceiling also heightened uncertainties. The movement of the yen exchange rate followed the so-­called risk-on / risk-­off be­hav­ior of investors. The yen appreciated when information that led to perceptions of heightened risk was published and depreciated with information suggesting receding risk. In terms of the nominal effective exchange rate of the yen, it hit a high in January 2012 and it remained around that level ­until July 2012, when it began to fall. That July was also when the euro effective exchange rate hit bottom and Mario Draghi made his famous remark. The second channel was the decline in exports reflecting the slowdown of the Eu­ro­pean economy. In 2011, Japa­nese exports destined for the euro area and the EU w ­ ere 9 ­percent and 12 ­percent of total exports, respectively, which ­were not very large numbers. ­There was, however, an additional indirect impact through China, to which almost 20 ­percent of Japa­nese exports ­were shipped, and which was more exposed to exports to the euro area and the EU (14 ­percent and 19 ­percent of the totals, respectively). The third channel was weakening business sentiment. As firms around the world became more aware of the worst-­case scenario involving the potentially extended economic stagnation in Eu­rope interacting with the Eu­ro­pean debt prob­lem, they became more cautious in making investments. That resulted in a substantial drag on Japa­nese exports, where capital goods had a large share.

THE BANK OF JAPAN’S RESPONSES The Eu­ro­pean debt crisis had also impacted the conduct of monetary policy on the part of the Bank of Japan, whose initial reaction was to guard against strains in the US dollar funding market. The swap lines among central banks, which ­were quite effective in dissipating the extreme tensions following the collapse of Lehman ­Brothers, w ­ ere terminated as of February 1, 2010, against a backdrop of stability returning to global financial markets. Yet as the Eu­ro­ pean debt crisis deepened they w ­ ere reactivated by major central banks on May 10. Considering that the crisis was essentially confined to Eu­ro­pean financial institutions and sovereigns, initial discussions pointed ­toward a ­limited reinstatement aimed at economies experiencing severe market turmoil. It was not ­until the very end of negotiations, on the urging of the Bank of Japan, that all parties to the previous swap lines ­were again allowed to participate so as to prevent the crisis from spilling outside Eu­rope. The formalities of reinstating the swap lines w ­ ere then conducted in haste at the participating central banks. The Eu­ro­pean Debt Crisis | 227

The second step by the Bank of Japan was the introduction of a new monetary policy program, called Comprehensive Monetary Easing. It was an attempt, as the Eu­ro­pean debt crisis deepened and the Federal Reserve Board embarked on QE, to enhance monetary easing further, as is explained in more detail in chapter 12. The most vexing issue was formulating the Bank of Japan’s responses against the worst-­case scenario of the euro area breaking up. At the beginning that possibility was hardly on anyone’s mind, but markets gradually began to price in the possibility of Greece leaving the euro area, dubbed “Grexit,” as the crisis intensified. An issue that was initially mentioned as an afterthought increasingly commanded attention. ­There was a real possibility that the exit of Greece from the euro area was only the first domino to fall. If other economies in the euro area ­were to follow Greece, the financial system of the ­whole area could face a meltdown. The Bank of Japan had to initiate contingency planning against such an eventuality, evaluating the pos­si­ble impact of Greece falling out of the euro area on Japa­nese financial markets and institutions.

COMPARISON WITH THE JAPA­N ESE EXPERIENCE The deepening of the Eu­ro­pean debt crisis provoked a lively debate in Japan regarding the lessons that Japan should learn from it. Advocates of fiscal prudence, seeing that the crisis began with a fiscal crisis in Greece, usually called for fiscal reforms in Japan, warning not to follow the path taken by Greece. ­Others held that the crisis was not about fiscal deficits per se but about the danger of embarking on a monetary ­union without po­liti­cal ­union. In other words, if an economy had its own currency and central bank, it would be able to attempt recovery from a fiscal crisis through lower interest rates or currency depreciation. Moreover, t­ here would also be room for central banks to perform the “lender of last resort” function. ­These options for the country’s economy would be lost in a monetary ­union. While I believed in the necessity of fiscal reforms in Japan, I also believed that it was rather misleading to attempt a direct comparison of the Japa­nese situation with the events in Greece or in Eu­rope as a ­whole. Having said that, I must admit ­there ­were common under­lying issues. The common theme between Japan’s financial crisis in the 1990s and the Eu­ro­pean debt crisis was the negative feedback loop between the financial system and the real economy, as well as the failure to act quickly and decisively. The latter point overlaps my experiences attending international meetings in 228 | The Days as Governor

the second half of the 1990s. Discussions evolved similarly with regard to the Eu­ro­pean and Japa­nese crises, with representatives of economies hit by crisis attempting to defend their actions as they took a lot of flack from other participants. For my part, reflecting on the experiences of the Japa­nese financial crisis, I emphasized in the international meetings the necessity of taking actions to prop up the financial system, including prompt capital injections. At the same time, I was conscious that my remarks might ring hollow, coming from an irresponsible commentator, remembering the difficulty of driving through comprehensive solutions in Japan. Any expert could easily figure out what needed to be done. The difficult part was building up the po­liti­cal support to put the most desirable policies in place. From that perspective, in the case of the euro area, ­there existed negative feedback and reverberation between the creditworthiness of sovereigns and banks, which ­were not observed in the case of Japan. Given that Eu­ro­pean policy makers had to deal with such a serious prob­lem without the benefit of a Europe-­wide government, their task was prob­ably much more difficult. In that sense, the Japa­nese financial crisis had ­little to offer Eu­rope in terms of lessons. At the same time, the deepening of the crisis was brought about by an ele­ ment that had also been observed in Japan: the difficulty of forging the necessary consensus for resolving the crisis. In the case of the euro area, the greatest obstacle was the conflicting interests and the diverging fundamental viewpoints among the member economies. Whereas Japan, being a currency area confined to one economy, does not share the same issues as the euro area, ­there still are acute differences in views among the population—­for example, between retirees and workers, and between metropolitan area residents and residents in the regions losing population—­that result in delays to necessary fiscal and structural reforms. If one puts aside the specific ­factors that made consensus building difficult, it could be said that t­ here was not much difference between Eu­rope and Japan a­ fter all in the near term; the resulting deferral of necessary reforms was bringing about an increasing the reliance on central bank policies to avert disruptions.

PURCHASES OF GOVERNMENT BONDS BY THE EU­R O­P EAN CENTRAL BANK ­ fter the Eu­ro­pean debt crisis broke out, the ECB introduced two schemes by A 2012 for the purchase of government bonds.4 One was the SMP, which was ­adopted in May 2010, and the other was the OMT, the adoption of which was The Eu­ro­pean Debt Crisis | 229

announced in September 2012. When the central bank utilizes government bonds in its funds-­supplying operations, it may ­either lend against government bond collateral or make outright purchases. In the case of the Bank of Japan, both methods had been employed for many years, making them “conventional” instruments of monetary policy. In contrast, the ECB followed the Deutsche Bundesbank’s practice, which only made use of government bonds as collateral. This was based on a past ­mistake, where hyperinflation was brought about by direct central bank purchases of bonds from the government. Given the unfavorable views of the ECB regarding the purchase of government bonds, it must have been a difficult decision for the bank to start buying for the first time. The prob­lem must have been exacerbated by the fact that in the euro area ­there was no single-­name government bond, as in Japan or the United States, making it necessary for the ECB to work out the condition of allocating the purchases among the then seventeen member states.5 Observing how the ECB had reached its decisions on the bond purchase program, I felt a strong sense of commonality among central banks. To a central bank the greatest concern with regard to purchases of government bonds is to ensure that the scheme does not become an automatic instrument to finance the government. In fact, it is ­because of such concerns that many economies prohibit direct purchases at the time of the issuance of government bonds. Nevertheless, even when the central bank buys government bonds in the secondary market, if the central bank must purchase the bonds, ­there would be ­little difference with the direct purchase of new issues. A difficult prob­lem for a central bank is to avoid falling into such a trap. From such a perspective, the logic used b ­ ehind the introduction of a government bond purchasing program was extremely impor­tant. In the case of the SMP, the ECB explained its motivation and objective as “to address the malfunctioning of securities markets and restore an appropriate monetary policy ­ ere cynical views that such a justification transmission mechanism.”6 ­There w was merely an intellectual statement without much practical substance, but I could not disagree more. Without such logic t­ here was a significant risk that the central bank would be forced to purchase unlimited amounts of bonds— in other words, to be trapped in a situation of “fiscal dominance.” With re­spect to the OMT, conditionality was the main focus of the debates. While central bank purchases of government bonds can buy time by alleviating acute liquidity concerns or nudging government bond yields lower, they are merely “bridging a gap” ­until necessary policies are put in place. Such purchases w ­ ill never fundamentally solve the under­lying prob­lems. In the case of 230 | The Days as Governor

the euro area, the policies required w ­ ere fiscal consolidation in economies ­running large government deficits, structural reforms to enhance competitiveness, injection of capital to financial institutions, and—­overarchingly—­a further integration of the euro area economies. Obviously, all of them w ­ ere outside the competence of the central bank. Considering that the momentum to adopt fundamental solutions could wane and the essential reforms could falter as the immediate crisis was staved off through central bank liquidity provision, it was impor­tant to ensure that governments would commit themselves to implementing appropriate policies when the central bank was purchasing government bonds.

LENDER OF LAST RESORT TO THE GOVERNMENT? The short history of ECB programs above well illustrates the utmost care taken by the central bank in the design and a­ ctual implementation of government bond purchases, but t­ here are other more make-­or-­break situations in which the central bank is confronted with the stark choice of supplying or not supplying liquidity. During the Eu­ro­pean debt crisis I observed with acute interest decision making by the central bank when the po­liti­cal system was dysfunctional, drawing parallels with the situation in Japan. If the central bank has simply looked on while governments could not move, the euro area would have disintegrated. At the same time, if the central bank provided liquidity, it would prevent or hold off the disastrous breakup of the euro for a while, but trou­bles ­were sure to return. In such an environment surrounding the euro, one began to hear arguments that the ECB should play the role of the lender of last resort to governments. I cannot recall the exact occasion at which I first heard about this concept, but I do remember my befuddlement that such a view or concept could actually emerge. Obviously, it is not always easy to draw a line between central bank purchases of government bonds in the secondary market and direct financing of the government. Nevertheless, the modern thinking on central bank in­de­ pen­dence starts from denying direct lending by the central bank to the government. In addition, the lender of last resort function of the central bank outlined the princi­ple of central bank action to prevent systemic events by lending to banks facing temporary liquidity shortfalls, while the prob­lems faced by governments during the Eu­ro­pean debt crisis ­were not temporary liquidity shortages. Moreover, unlimited liquidity provision by the central bank is not an intrinsic ability. It is only made pos­si­ble by the confidence in the government The Eu­ro­pean Debt Crisis | 231

that its finances are sustainable. In other words, it is highly unlikely for the public at large to accept currency issued by the central bank when government bonds on the bank’s balance sheet are in default. Monetary stability ultimately rests on public confidence regarding fiscal sustainability, as I ­w ill explain in chapter 15. I do not have any information on the behind-­the-­scenes po­liti­cal maneuvering b ­ ehind Draghi’s famous remark on July 26, 2012, as the Eu­ro­pean debt crisis reached its climax. Fortunately for the ECB, the ESM was created by October of that year, and the bank was able to introduce the specifics of the OMT together with the discussion leading up to the establishment of the ESM. The ESM did not solve e­ very prob­lem, but it was at least one of the impor­tant pieces of a crisis-­fighting framework. I believe that Eu­rope was fortunate in finding a happy ending, with the necessary government policies put in place and the ECB following up with a supportive policy.

THE IMPORTANCE OF SOCIAL INTEGRATION When the euro was facing its existential crisis, I bluntly asked my Eu­ro­pean colleagues in private on the possibility of a breakup. Their typical answers went like this: “Given the im­mense cost of the collapse of the euro, solutions of sorts would be found before the clock fi­nally ran out.” From the viewpoint of an outsider, it was frustrating to see the slow pace at which solutions ­were taking shape. Nevertheless, developments leading up to the establishment of the ESM or the Single Supervisory Mechanism seemed to verify the visions of Jean Monet, the French business leader and politician who is counted among the founding ­fathers of Eu­ro­pean integration, that “Eu­rope w ­ ill be forged in crises and w ­ ill be the sum of the solutions a­ dopted for t­ hose crises.”7 Against the backdrop of the strong po­liti­cal commitment of founding a united Eu­rope and launching a single currency, the euro, I can see no alternatives for Eu­rope other than further deepening its integration. At the same time, I feel that ­there is a yawning gap between Monet’s visions and facts on the ground when observing the developments that surfaced ­after my term as governor of the Bank of Japan, such as migration flows, terrorist attacks from Islamist residents, and rising pop­u­lism. For economic policies to yield satisfactory results, politics and society need to have a sufficiently shared identity. In the case of Eu­rope, the issue was internal differences over the objective of Eu­ro­pean integration. In the case of Japan, ­there are also ominous divisions. ­There are diverging interests, for exam232 | The Days as Governor

ple, between retirees and workers and between large metropolitan areas and regions losing population. Such rifts often manifest themselves as fiscal deficits. When confidence in the sustainability of government finances is eroded, monetary stability w ­ ill also be shaken. In that sense, the Eu­ro­pean debt crisis illustrated an issue that was common to any country, including Japan. We should not forget that the key to monetary, price, and financial stability is to maintain a social contract that more or less reasonably satisfies the population.

The Eu­ro­pean Debt Crisis | 233

| CHAPTER TWELVE |

The Comprehensive Monetary Easing Policy Beginning in the spring of 2009, the developed economies experienced a very gradual recovery, much like the slow recovery that Japan experienced ­a fter the bursting of its ­bubble in the 1990s. But during the recovery from the global financial crisis (GFC) of 2007–9, the Japa­nese economy faced the challenge of a sharp appreciation of the yen, particularly brought on by monetary easing in the United States. This prob­lem became most acute in mid-2010 when the Federal Reserve ­adopted its second round of quantitative easing “QE2.” To address the weakness in Japa­nese business sentiment and in prices caused by the strong yen, at the Bank of Japan we felt that we had no option other than to try to lower both short-­and longer-­term interest rates. But with interest rates already so low we had only ­limited room for further reductions. To address this challenge, in October 2010 the bank a­ dopted a new and exceptional framework called Comprehensive Monetary Easing, in which the bank would purchase not only long-­term Japa­nese Government Bonds (JGBs) but also begin purchasing risk assets such as exchange-­traded funds (ETFs) invested in corporate equity securities—at that time an extremely unusual action for a central bank.

THE APPRECIATION OF THE YEN During the lackluster recovery in both Eu­rope and the United States in 2009 ­there w ­ ere hopes for a brighter f­ uture. But by the spring of 2010, with the economy still sputtering, the Federal Reserve revised down its projections for growth and inflation for both 2011 and 2012. Slow growth was most evident in Eu­rope, which was in the midst of the Eu­ro­pean debt crisis. Expectation of immediate recovery in the developed economies dis­appeared, which became an annual rite a­ fter the GFC, repeating the “false dawn” phenomenon that Japan 234

(%) 6 Japan United States United Kingdom Germany

5 4 3 2 1 0

–1 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Figure 12.1 ​Ten-­year trea­sury yields. Sources: Bank of E ­ ngland; Deutsche Bundesbank; Japa­nese Ministry of Finance; US Trea­sury.

had lived through a­ fter the bursting of our b ­ ubble. With the rates of inflation falling around the world, “global deflation risk” became the talk of the day. Against this background the yield on ten-­year US Trea­sury notes dropped from 4.0 ­percent in April 2010 to 2.5 ­percent in August, while Japa­nese long-­ term interest rates also fell from 1.4 ­percent to below 1.0 ­percent (see fig. 12.1). The abrupt narrowing of interest rate differentials between Japan and the United States, reducing the extent of the interest rate benefit of holding dollars rather than yen, contributed to a rapid appreciation of the yen. The exchange rate of the yen against the US dollar, which had hovered around ninety-­three to ninety-­ four yen to one dollar in the spring of 2010, broke through the ninety-­yen level in June and reached eighty-­five yen by early August. The yen’s appreciation against the euro was starker, rising from 127 yen to one euro at the beginning of April to 111 yen in the ­middle of July. Between April and August of 2010, the nominal effective exchange rate of the yen appreciated by 10.6 ­percent.

ENHANCING MONETARY EASING In order to demonstrate clearly that the Bank of Japan was aware of deleterious effects of the yen’s rapid appreciation, in a statement a­ fter a Monetary The Comprehensive Monetary Easing Policy | 235

Policy Meeting (MPM) on August 10, we included language explic­itly referencing the risk of negative impacts on economic activity resulting from changing conditions in international financial and capital markets. Meanwhile, po­liti­cal attention in Japan abruptly shifted to the need for policies to confront the appreciation of the yen directly, dominating the domestic discourse on economic policy. The most vis­i­ble means of responding to the yen’s rise would have been foreign exchange market intervention, to sell yen and buy dollars or euros. ­Whether this would have been effective is an entirely dif­fer­ent question. While the Ministry of Finance repeatedly conducted “verbal interventions,” expressing concern over the appreciating yen, it was not ­eager to conduct ­actual market interventions. This was understandable given the likely l­ imited effectiveness of unilateral interventions by Japan and the remote prospect that our Eu­ro­ pean and US counter­parts would cooperate in conducting coordinated market interventions to strengthen their own currencies. The leaders of Japan’s po­liti­cally potent export industries ­were becoming extremely frustrated. So when the dollar-­to-­yen exchange rate reached 84 yen on August 12, 2010, the Bank of Japan released a statement ­under the name of the bank’s governor that read, “­There are substantial fluctuations in the foreign exchange and stock markets mainly against the backdrop of growing uncertainty about the outlook for the US economy. The Bank of Japan ­will carefully monitor such developments and their effects on Japan’s economy.”1 This was only the fourth time since the turn of the ­century that the Bank of Japan had released a statement by the governor. Previous instances followed the September 11, 2001, terrorist attacks in the United States, the co­a li­tion air strikes against Iraq in March 2003, and the collapse of Lehman B ­ rothers in September 2008. Rare though it was, I was ­under no illusion that this statement would halt the yen’s appreciation. Both the government and the bank ­were increasingly berated for our “incompetence” in responding to the strength of the yen. Initially, Prime Minister Naoto Kan, Finance Minister Yoshihiko Noda, and other government leaders took a posture of carefully monitoring developments. In fact, leaders of major domestic business lobbies, who likely considered more than the interest of the exporting industries alone, ­were privately critical of press articles that overly emphasized the effects of the stronger yen or the complaints of man­ag­ers of the export industries attempting to shift the blame for their lackluster profits to the exchange rate. Eventually, however, demands from both members of the National Diet and the export industries became stron236 | The Days as Governor

ger by the day, and the government eventually gave in, calling on the bank to do something about the appreciation of the yen. As the clamor in Japan continued into the summer, the annual Jackson Hole Economic Symposium hosted by the Kansas City Federal Reserve in late August was quickly approaching. As this seemed a good opportunity to exchange views in confidence with the heads of other central banks, I de­cided to attend the event myself. The theme of the conference was “Macroeconomic Challenges: The De­cade Ahead.” On August 27, in the opening speech, the chair of the FRB, Ben Bernanke, veered off the theme of the conference and discussed the benefits and costs of two monetary policy options: asset purchases and forward guidance. As he ­later revealed in his memoir, it was an intentional act, changing his speech shortly before the conference in the light of the changing outlook on the US economy and inflation. Bernanke implied the possibility of further easing by stating that the FRB was “prepared to provide additional accommodation if needed.”2 His speech threatened a further appreciation of the yen. I received a number of telephone calls from a Bank of Japan deputy governor, Hirohide Yamaguchi, who reported on the noisy public reaction in Japan and shared the views of other Policy Board members. ­I de­cided to cut short my stay at the Jackson Hole Symposium and to call an extra MPM so that we could announce additional monetary easing. At the MPM, held on August 30, we de­cided to introduce a new six-­month term to the bank’s fixed-­rate fund-­supplying operations, in addition to the existing three-­month term. We also announced that the bank was ready to spend 10 trillion yen for the six-­month operations, enlarging the eventual total of fixed-­rate operations to 30 trillion yen. The initial press reporting on the bank’s decision was within expectations, but newspaper headlines the next morning ­were sensational and scathing: “Not Enough Done by the Government and BOJ” (Nihon Keizai Shinbun,August 31, 2010). Politicians from all parties w ­ ere up in arms, calling for more aggressive mea­sures to halt the yen’s rise. A cross-­party group of members of the National Diet held a symposium, advocating amendments to the Bank of Japan Act and a joint commitment by the government and the Bank of Japan to a specific inflation target.

INTERVENING IN THE FOREIGN EXCHANGE MARKET The Japa­nese business community, and especially the export industries, argued vehemently for intervention in the foreign exchange market to suppress the yen’s rise. They argued that if interventions by Japan alone would not be effective, The Comprehensive Monetary Easing Policy | 237

the government should persuade other countries to join in coordinated interventions, and that if an agreement on coordinated interventions could not be reached, the government should at least try unilateral intervention. For the business community, inaction was unacceptable: the government and the Bank of Japan appeared to be totally incompetent, sitting on their hands. While in most countries the appreciation of the currency would lead to grumbling from exporters, such strong expectations for government intervention in the exchange market may be uniquely Japa­nese, at least among the developed economies. Most developed economies conduct foreign exchange intervention only in exceptional circumstances—­usually to address very rapid movements, regardless of direction. The last time the US authorities intervened was in 2000, and the Eu­ro­pean Central Bank (ECB) has only intervened once, in 2000, since it opened its doors in 1999. By comparison, Japa­nese interventions have been much more numerous and have almost uniformly been only on one side of the market: buying dollars and selling yen. Both the US Trea­sury, which has primary responsibility for the exchange market operations of the United States, and the ECB, which has that responsibility for the euro, w ­ ere opposed to foreign exchange interventions in 2010, even when conducted solely by Japan. The Americans and Eu­ro­pe­ans conveyed their opposition both to the Ministry of Finance and the Bank of Japan. Policy makers outside Japan believed that any currency market interventions should be coordinated by the countries involved. So I received phone calls from overseas colleagues telling me that they ­were opposed to unilateral intervention by Japan in their currency. Japan faced a dilemma. If we de­cided to intervene on our own, the effects ­were likely to be l­imited and perhaps would appear in­effec­tive. But if the government and the bank did not try to intervene, domestic criticism of inaction and incompetence would grow louder. On September 15, 2010, the Ministry of Finance entered the market for the first time since March 2004, selling 2.1 trillion yen for US dollars in a single day. The bank supported the ministry’s action by releasing a statement of the governor that read, “The Bank of Japan strongly expects that the action taken by the Ministry of Finance in the foreign exchange market ­will contribute to a stable foreign exchange rate formation.”3

INFLUENCING LONGER-­T ERM INTEREST RATES During this period the members of the bank’s Policy Board came to the conclusion that the bank needed a more “sustainable” and “scalable” framework 238 | The Days as Governor

for actions to ease monetary policy in response to adverse developments. This conclusion reflected our recognition that the baseline scenario for the global economy would be an extended period of low growth. In such an environment we could expect narrowing interest rate differentials and upward pressure on the yen to persist and that calls for the bank to ease further would never cease. But w ­ ere t­ here meaningful options for a further easing monetary policy? For the “reflationistas” the answer was obvious and s­ imple: just print money and massively expand the monetary base. For “expectationistas” it was also ­simple: the bank only needed to show sufficient resolve in targeting a higher rate of inflation. But no one on the Policy Board thought that an increase in the quantity of the monetary base would, by itself, boost economic activity or raise the inflation rate. We all believed that any stimulus effect of monetary policy would, at its core, be realized through lower interest rates and their influence on both economic activity and the exchange rate. At the end of September 2010, interest rates in Japan ­were already at historic lows, with the overnight rate at 0.1 ­percent, the ten-­year JGB rate just above 0.9  ­percent, and both long-­and short-­term bank lending rates between 1.2 ­percent and 1.3 ­percent. Even so, the board was united in its view that if we wanted to ease policy further, the already low level of interest rates had to fall even more. With this intention, on October 5, 2010, the Policy Board a­ dopted its Comprehensive Monetary Easing policy package, which both realigned the easing mea­sures that had been a­ dopted piecemeal since the collapse of Lehman ­Brothers and also included new methods to bring down the general level of interest rates. As short-­term interest rates ­were already effectively at zero, the bank’s new policy aimed to lower interest rates beyond the short term. As our post-MPM statement explained, “The Bank w ­ ill encourage the decline in longer-­term interest rates and vari­ous risk premiums to further enhance monetary easing.” 4 Private sector borrowing costs have two components. Th ­ ere is the risk-­free rate that is represented by the government’s borrowing costs reflected in JGB yields, and on top of the risk-­free rate, ­there are also the risk premiums that individual borrowers pay, which principally reflects the credit risk of their higher likelihood of default as well as other idiosyncratic risks not included in the risk-­free rate. Lowering the general level of interest rates faced by private borrowers required a two-­pronged approach of mea­sures to lower the longer-­ term risk-­free rate and mea­sures to compress vari­ous risk premiums. “Longer-­ term” was a relative concept, and in the initial stages of Comprehensive Monetary Easing, the bank viewed it as the interest rates of up to two-­to three-­year The Comprehensive Monetary Easing Policy | 239

maturities. We focused on this time frame b ­ ecause most borrowing by non­ financial firms in Japan was for terms shorter than three years. It also appeared that, in the foreign exchange market, the dollar-­to-­yen exchange rate was influenced by interest rates differentials at t­ hese maturities.

MEA­S URES TO LOWER THE LONGER-­T ERM RISK-­F REE RATE The Bank of Japan introduced two mea­sures to lower the longer-­term risk-­ free rate. First, we extended the purchases of JGBs to include ­those with remaining maturities of one to two years. While the purchase of long-­term government bonds has often been portrayed as unconventional, the Bank of Japan had been buying JGBs continuously since the 1960s and it was a part of the conventional tool kit. A ­ fter the collapse of Lehman B ­ rothers, the bank increased the pace of its annual purchases from 14.4 trillion yen to 21.6 trillion yen in two stages in December 2008 and March 2009. The March 2009 mea­sures included two other changes: the introduction of the purchase of thirty-­year bonds as well as a mechanism to control the duration of JGBs on the bank’s balance sheet. The duration for bonds purchased for the bank’s portfolio during the 2009 fiscal year was 3.9 years, which resulted in an overall duration of 5.2 years at the end of March 2010. The preexisting rationale for the bank purchasing JGBs was to provide sufficient central bank reserves in the face of rising demand for cash in a growing economy. By contrast, ­under the Comprehensive Monetary Easing program, the bank now explic­itly targeted lowering the level of the risk-­ free interest rate. This was the first time that the bank purchased JGBs with a clearly stated intent to lower interest rates. Second, we explic­itly a­ dopted forward guidance by making clear our intention of maintaining the bank’s short-­term policy rate at effectively zero. Specifically, we confirmed that the bank would maintain the virtually zero interest rate policy u ­ ntil it judged that price stability was in sight and that this judgment would reflect our Understanding of Medium-­to Long-­term Price Stability. Given that most market participants ­were already expecting an extended period of a zero interest rate, the forward guidance effect alone might not have been a particularly power­ful easing mea­sure in the near term. But if and when overseas interest rates began to rise alongside improvements in the economy, the forward guidance we ­adopted would be likely to stimulate the economy through a weaker yen arising from a widening of interest rate differentials. This policy was like a sail unfurled to catch any favorable winds. Fi­nally, we also 240 | The Days as Governor

lowered the target level of the interest rate to what the bank deemed to be effectively zero. This had been 0.1 ­percent, consistent with the interest rate the bank paid on excess reserves. The overnight rate was instead allowed to dip temporarily below 0.1 ­percent in order to make this clear, and the guideline for money market operations was amended from “at around 0.1 ­percent” to “at around 0 to 0.1 ­percent.”5

LOWERING RISK PREMIA In order to lower the vari­ous risk premiums reflected in private borrowing costs, ­under the new policy the Bank of Japan began to purchase financial assets issued by the private sector. Specifically, the bank now set out to purchase commercial paper (CP), corporate bonds, ETFs that held corporate stocks, and real estate investment trusts (REITs). Whereas central bank purchases of private credit instruments such as CP and corporate bonds w ­ ere not unheard of during the GFC, the Bank of Japan was then unique among developed countries by including ­these among our monetary policy instruments. The inclusion of ETFs and REITs in the list of assets to be purchased was then completely novel in the context of monetary policy.6 Our decision to buy stocks was not new. The bank had purchased stocks held by financial institutions in 2002, but the aim of that mea­sure had been to sustain financial stability (see chapter 5). Now, however, the purchase of stocks from the market, held by ETFs (themselves “stocks” traded on exchanges), became a component of the bank’s routine monetary operations. Our reasons for breaking this new ground was straightforward: the Policy Board came to the conclusion that a decline in risk premiums for equity investments would be one of the very few remaining channels for lowering business funding costs. ETFs and REITs w ­ ere not on the list of assets the bank was permitted to purchase ­under the Bank Act, but the bank could buy nonlisted assets if it deemed it necessary to achieve its objectives and received authorization from the minister of finance, which was forthcoming.

THE ESTABLISHMENT OF AN ASSET PURCHASE PROGRAM When the Bank of Japan embarked on Comprehensive Monetary Easing, it established, as a temporary mea­sure, an entry on its balance sheet titled the Asset Purchase Program. The purpose of this separate entry was to clearly reveal to market participants and the general public the entire extent of the The Comprehensive Monetary Easing Policy | 241

unconventional policy actions taken by the bank. When the program was implemented in October 2010, the aggregate amount of purchased assets initially brought together totaled 35 trillion yen. Of that, the largest component was fixed-­rate funds-­supplying operations against the pooled collateral, at 30 trillion yen. Vari­ous other asset purchase programs made up the remaining 5 trillion yen, the largest being the purchases of securities issued by the government at 3.5 trillion yen (1.5 trillion yen of long-term bonds and 2 trillion yen of short-­term bills), followed by CPs and corporate bonds at 500 billion yen each, ETFs at 450 billion yen, and REITs at 50 billion yen. Given the extraordinary mea­sures included in the Comprehensive Monetary Easing program, the Policy Board carefully considered the design of an “exit strategy” before embarking on such a novel enterprise. When a central bank acts as “the lender of last resort” during a financial crisis, financial institutions short of liquidity are likely to be willing to borrow from the central bank at somewhat higher interest rates than would normally prevail given the lack of alternatives. ­These somewhat higher interest rates create an incentive for borrowing financial institutions to repay the loans as soon as the crisis abates and less expensive sources of funds reemerge. In this way, lender of last resort programs have a built-in, automatic exit mechanism. In contrast, unconventional monetary policy mea­sures, such as the bank’s Comprehensive Monetary Easing, do not have such automatic exit mechanisms, and the timing of the exit must be judged by weighing the benefits and costs of keeping the unconventional mea­sures in place. Th ­ ese judgments w ­ ill, inevitably, be difficult, subjective, and subject to hindsight bias. When adopting extraordinary mea­sures, it would be easy to be complacent about the ability to reverse the policy at the appropriate time. Even a well-­thought-­out decision to exit from easing might be criticized in hindsight if the economy weakens. By contrast, the costs of keeping unconventional monetary policies in place for too long may be less tangible, at least at the time. Accordingly, we thought it would be impor­tant to design a framework where the “costs” of monetary policy could be readily assessed. A particularly difficult cost to assess is the threat to the central bank’s own credibility if it is perceived to overstep the bound­aries of its authority and legitimacy in a demo­cratic society. If the Bank of Japan ­were to begin purchases of JGBs with relatively short remaining maturities of one to two years, it could be easy to imagine that po­liti­cal pressures on the bank would mount further, with criticism particularly from the reflationistas to both increase the

242 | The Days as Governor

amounts of purchase and to extend the maturities so as to lower even longer-­ term interest rates. Starting down this path creates the risk of falling into a position of fiscal dominance whereby the central bank simply becomes a support for government borrowing and loses its ability to pursue its own mandate. The purchases of ETFs and REITs implicitly involve the allocation of funds within the economy and, thus, are more akin to the choices normally made by governments and legislators. Purchasing greater amounts of JGBs, unrelated to society’s need for cash, as well as purchasing risk assets, would also expose the bank to the risk losses, which would ultimately be borne by the Japa­nese taxpayers. In all of ­t hese ways the extraordinary policies we ­were contemplating can be seen as quasi-­fiscal in nature and only masquerading as monetary policy. Adopting ­these policies might well be justified, but one could make a strong argument that they should not be implemented via the monetary policy of the central bank but should be treated explic­itly as fiscal policy and implemented by the government with approval from the National Diet. With all of this in mind, when we introduced the Comprehensive Monetary Easing program, the Policy Board stated, “The Bank intends to ensure its financial soundness by managing risks stemming from the purchases of vari­ ous financial assets u ­ nder the Program and by properly recording loss provisions and appropriately treating losses if they are incurred. The Bank seeks for the government’s understanding in this regard.”7 In addition, to facilitate public understanding we de­cided to or­ga­nize communications by putting all of the vari­ous mea­sures we had ­adopted ­under the single umbrella of the Asset Purchase Program. In this way we thought the bank could pursue effective policy while at the same time maintaining the accountability of the central bank in a demo­cratic society. When the Policy Board de­cided to adopt Comprehensive Monetary Easing, I was conscious of the carefully designed asset purchase program implemented by the Bank of E ­ ngland in 2009. The Bank of E ­ ngland had bought both gilts and corporate bonds through its wholly owned subsidiary, the Bank of ­England Asset Purchase Fa­cil­i­t y Fund, which was able to borrow money from the bank to purchase assets while an agreement was reached to have any losses borne by HM Trea­sury. In contrast, the Bank of Japan’s Asset Purchase Program did not have a separate ­legal entity, and the bank was to bear any resulting losses. But both asset purchase programs ­were similar in that they encompassed a ­whole set of operations and had quasi-­fiscal policy overtones.

The Comprehensive Monetary Easing Policy | 243

REACTIONS TO THE NEW POLICY PACKAGE How to portray the mea­sures we a­ dopted was extensively discussed within the Policy Board. Although t­ here would be increases in the quantity of bank reserves as a consequence, we did not want to refer to what we w ­ ere d ­ oing as quantitative easing. All members thought it would be misleading to call it that ­because the aim was not to ease policy by increasing the bank’s liabilities. The novelty of ­these new mea­sures was their foremost objective to lower yields on longer-term JGBs and narrow risk premiums through purchases of risk assets. We thought t­hese mea­sures w ­ ere essentially easing in terms of quality. The name Comprehensive Monetary Easing was ­adopted in the hope that the public would see the bank’s broader purpose. Comprehensive Monetary Easing initially provoked strong reactions. For ­ ere completely market participants and Bank of Japan observers, the mea­sures w unexpected. The next day’s newspaper headlines, such as “Additional BOJ Easing Surprises, Shocking Market” (Asahi Shimbun, October 6, 2010) and “Markets Welcome ‘Surprise’ BOJ Move” (Yomiuri Shimbun, October  6, 2010) seemed to describe both surprise and amazement. Headlines such as “Policy Enters Unknown Territory” (Yomiuri Shimbun, October 6, 2010) also reflected an understanding that the new mea­sures ­were exceptional. Even economists who had been advocating that the bank should buy ETFs and REITs appeared not to have expected that it would actually happen. But the Policy Board had no intention of trying to pull a rabbit out of a hat. Our aim was to adopt policy mea­sures, however modest in their effectiveness, whose transmission channels could be clearly understood. As expected, not all the reactions of academics and private-­sector economists w ­ ere positive. Many economists called for the bank to purchase more and longer-­term JGBs. They thought that the amount to be purchased ­under the Asset Purchase Program, which was 3.5 trillion yen, was too small. From the bank’s perspective, t­ hese purchases w ­ ere on top of the annual 21.6 trillion yen purchases through the traditional bond purchase operations, whose stated rationale was to satisfying the secular demand for cash in a growing economy. But the amount of ­these traditional purchases was already much greater than the annual increase in cash demand. If quantity was to be at the center of the debate, this annual purchasing program should also be taken into account. Even so, we refrained from trying to quash criticism by combining the amounts of operations and showing off a large number. That might have been effective if the aim was to just rebuke the too-­little-­quantity argument. But we also 244 | The Days as Governor

(%) 6 Japan United States Europe

5

4

3

2

1

0 2007

2008

2009

2010

Figure 12.2 ​Yields spread between corporate (AA) bonds and government bonds. Note: Three and one-­half year maturities. Source: Bloomberg.

thought we might risk the bank being forced into unlimited JGB buying if we completely removed the rationale of satisfying the long-­term increase in cash demand. The Policy Board hoped that the effectiveness of monetary policy would be judged by its impact on the level of interest rates and not just the sheer size of the bank’s operations or balance sheet. In fact, yields on long-­term JGBs ­were lower and credit spreads of corporate bonds ­were narrower in Japan, compared with the levels in Eu­rope or the United States (see figs 12.1 and 12.2). Even then, ­those economists who thought the Bank of Japan’s monetary policy was not forceful enough pointed out that Japa­nese interest rates ­were still too high in terms of real interest rates—­t hat is, nominal rates adjusted by expected inflation. This line was also ­adopted by the naysayers in the National Diet. Many of ­t hese arguments assumed that the bank could act directly upon expected inflation—­which, in my view, was magical thinking. The Policy Board ­adopted the view that inflation expectation would only rise when ­actual inflation picked up as a consequence of increased spending in response to the lower nominal interest rates brought on by the bank’s new operations. The Comprehensive Monetary Easing Policy | 245

With re­spect to the argument that the Bank of Japan should be purchasing longer-­term JGBs, our thinking was that the purchases should be directed ­toward the maturity term most likely to stimulate economic activity. In the United States, with a substantial amount of mortgages with terms as long as thirty years and much corporate borrowing via the bond market with ten-­to fifteen-­year maturities, lowering the level of super-­long-­term interest rates can strongly influence the economy. By contrast, in Japan, credit to businesses and ­house­holds is overwhelmingly extended by banks with an average term of about three years. To be effective, we felt that the focus of the bank’s asset purchases should aim to bring down two-­to three-­year interest rates.

CONCERNS ABOUT THE EXIT The Comprehensive Monetary Easing program did not change the views of the Bank of Japan’s critics ­a fter their initial surprise. What was new was that the bank faced a completely dif­fer­ent sort of criticism. One critical argument was that the bank risked its autonomy over the control of interest rates by targeting long-­term rates, which could jeopardize its exit from the unconventional policy framework. To be sure, all members of the Policy Board shared the view that the bank should judiciously avoid being mired in a never-­ending easing cycle, though we did not see this as a reason to preclude a more aggressive easing policy. Generally speaking, academics and private-­sector economists tended to view that any prob­lem arising from too abundant a monetary base could be avoided as long as the central bank would promptly raise interest rates whenever it was necessary. This is a superficial argument. By saying that all w ­ ill be fine when the central bank acts correctly in a timely manner, the analy­sis rules out the prob­lem from the outset. In the real world, the central bank is likely to face difficult choices and trade-­offs. For example, it might be the right time to raise the interest rate to prevent a rise in inflation, but action might negatively affect the fiscal balance and destabilize the financial system through a fall in the price of government bonds held by financial institutions. Another tricky situation would be a period of subdued inflation while financial imbalances, leading to a ­bubble, could be accumulating. To retain control of interest rates in the f­ uture, the central bank needs to take into account not only economic theory in a narrow sense but also keen insight into developments in the po­liti­ cal establishment and the society at large.

246 | The Days as Governor

While my decision to support Comprehensive Monetary Easing reflected my own weighing of ­these many ­factors, I did not expect ­every member of the Policy Board to arrive at the same judgment. In fact, one member of the board, Miyako Suda, dissented, opposing the inclusion of JGBs in the list of assets to be purchased. As governor I had a desire to send a strong public message with a unan­i­mous decision, though as chairman of the board I also appreciated the value of dissenting views both in sharpening our deliberations and in maintaining the legitimacy of the central bank decisions.

THE CENTRAL BANK IN A DEMO­C RATIC SOCIETY Discussions about Comprehensive Monetary Easing among economists tended to focus on the likely effectiveness of our mea­sures. In my mind, a more fundamental and difficult issue was how far the central bank could venture into unconventional territory while sustaining its legitimacy in a demo­cratic society. My long-­standing view was, and remains, that the toleration of the power given to central banks in a demo­cratic society rests upon its willingness to assess and expose both the pros and the cons of the policy options the banks consider and the actions they take. Central banks have special powers to issue the national currency that are accepted by every­one. Th ­ ese powers, however, make it pos­si­ble for central banks to purchase an effectively unlimited quantity of assets. Even if the policies ­adopted by a central bank are quasi-­fiscal in nature, prob­lems are unlikely if the outcomes are good and within expectations. But if the policies backfire and result in losses, all of the costs w ­ ill ultimately be borne by the citizens as taxpayers, who can then fairly complain that they never intended to grant the central bank so much power. The possibility of ­actual financial loses by the central bank, or of the bank having negative equity, brings t­ hese issues to a point. Should a central bank be forced to recognize large losses? Would negative equity compromise a central bank’s ability to implement policy? A number of economists believe that losses or negative equity are irrelevant to the conduct of policy by a central bank, viewing both profits and losses of the bank as a mere sideshow or a by-­ product of monetary policy that aims for macroeconomic stability. This is a shortsighted view. We need, I think, to take a step back and reflect upon the relations between the central bank and the economy, the national legislative body, and society and then think this through from both an accounting perspective and a policy perspective.

The Comprehensive Monetary Easing Policy | 247

NEGATIVE EQUITY AT THE CENTRAL BANK The central bank may fall into negative equity depending on the magnitude of losses it suffers and the ampleness of its equity capital buffer to absorb losses. With re­spect to the Bank of Japan, on the liability side of its balance sheet, non-­ interest-­bearing banknotes once occupied the lion’s share. This changed, however, when it a­ dopted unconventional policies that substantially increased the share of current account deposits of financial institutions with the bank. While banknotes do not earn interest, current account deposits, which previously ­were non-­interest-­bearing, began to earn interest at 0.1 ­percent for excess reserves beginning in the autumn of 2008.8 On the asset side of its balance sheet, the bank held mostly government bills and bonds and loans to banks. The shares of each asset class changed with the times, particularly as the proportion of government paper increased when the bank moved deeper into unconventional territory. In terms of generating revenue, the central bank enjoys a balance sheet structure that almost guarantees profits. Even if the bank pays a 0.1 ­percent interest rate on current account deposits, the overall level of interest paid on all of its liabilities is low ­because banknotes do not earn interest. Interest earned on the bank’s assets is somewhat higher b ­ ecause assets, be they government paper or loans to banks, have longer maturities and thus tend to earn higher premiums. If long-­term assets remain on the bank’s balance sheet, they can be earning the higher interest that prevailed in days gone by. In normal times central banks ­will turn a profit.9 The profits resulting from the power to issue currency is called seigniorage, and most central banks, including the Bank of Japan, pass this income on to the government ­after deducting operational costs and staff wages. Having noted that the central bank enjoys a balance sheet structure that almost guarantees profits I should also note that the Bank of Japan’s profits steadily declined as interest rates came down. Profits fell as the margins between assets and liabilities narrowed, reflecting the gradual lowering of interest earned on assets while the interest paid on liabilities could not fall much farther. With this balance sheet structure, the bank might eventually face the risk of losses from a rise in interest rates. In this event, the bank could be forced to curtail payments to the government or even report negative equity and technical insolvency.

248 | The Days as Governor

THE ACCOUNTING ISSUES RELATED TO THE EXIT Many central banks hold capital. The level differs among the banks; t­ here are capital-­rich ones like the ECB and thinly capitalized ones like the Bank of ­ iddle of that worldwide spectrum.10 ­England. The Bank of Japan lies in the m Such a level for the Bank of Japan’s capital reflects a benchmark established by the bank itself. Specifically, it set the rule to maintain the capital adequacy ratio at around 10 ­percent, within the range of about two percentage points above or below that level relative to banknotes issued. This decision was made by the bank’s Policy Board ­after the new Bank Act came into force in 1998. By the end of March 2010, the end of the accounting year before embarking on Comprehensive Monetary Easing, the bank had equity of about 3 trillion yen and provisions for bond and foreign exchange transactions of about the same amount. The bank’s buffer for losses was, thus, approximately 6 trillion yen before it could fall into a position of negative equity. Private enterprises can build up buffers for foreseeable losses by selling new shares of equity capital, but central banks cannot follow such a course. For the Bank of Japan, equity can be built up through legally mandated accumulation to its reserve fund at a rate of 5 ­percent of the bank’s profits and also through additional payments to the reserve fund as authorized by the minister of finance. The reserve fund can only be used to cover losses incurred by the Bank of Japan or to be appropriated for dividends. The capital adequacy ratio drifted lower in the second half of the 1990s, from over 9 ­percent to around as low as 7.5 ­percent. While this was lower than a literal application of the rule for the bank’s capital to be “at around 10 ­percent, within the range of about two percentage points above or below that level,” it was tolerated as “generally within” the prescribed range. Rising interest rates that would be expected following the exit from the extraordinary easing policies would inevitably result in lower prices for JGBs. In ­those circumstances, if the bank ­were to sell its JGB holdings ­there would be losses equal to the difference between the sale price and the book value. But if the bank ­were not to sell JGBs and instead ­were to hold them ­until maturity, it would not suffer from huge capital losses. Rather, it would experience a narrowing of its margins as it paid rising interest expenses on its interest-­bearing liabilities, like excess reserves, while yields on assets increased only gradually. The share of the bank’s liabilities represented by banknotes, on which the bank pays no interest but “earns” the seigniorage, would strongly influence the resulting profit or loss. The banknote issuance is relevant ­because rising interest rates would be likely to prompt ­house­holds and firms to deposit cash in private The Comprehensive Monetary Easing Policy | 249

banks; this would, in turn, cause non-­interest-­bearing banknotes to be returned to the bank and the level of interest-­bearing excess reserves to rise. The possibility of falling into negative equity would hinge on accounting conventions. ­Under the provisions of the Bank of Japan Act, the bank’s accounting rules are determined by the Policy Board. Whereas the bank is not required to follow private practices, the conventions actually ­adopted at pre­sent are in line with ­those of the private sector. In the case of private financial institutions, three dif­fer­ent options are available for JGB holdings, depending on their purposes. The first option is that JGBs held for trading purposes are required to be marked to market; profits and capital could thus fluctuate substantially depending on market conditions. The second option is that JGBs held to maturity would be subject to cost amortization. ­Under this treatment, when a financial institution buys JGBs above face value, losses that would manifest themselves at redemption are amortized over the holding period. The amortized losses would be recognized as costs in each accounting period, and any hit to profits in each accounting period would be smaller, while the effects on capital would only slowly become evident over time. The third option applies to JGBs held neither for trading nor to maturity, which would be subject to the so-­called full capital inclusion method, requiring financial institutions to reflect capital gains or losses directly in their capital account. In this case, the impact on profits or losses would be small but the impact on capital could be significant. Given that the Bank of Japan does not hold JBGs for trading, the most suitable accounting convention to be followed should be the amortized cost or the full capital inclusion method. Holdings of government bonds by the central bank is a consequence of its monetary policy decisions, and the bank usually holds them ­u ntil maturity. In par­tic­u ­lar, if bonds are purchased in response to increasing banknote demand, reflecting economic growth, it is highly unlikely that the bank would have to sell the bonds. In fact, very few central banks sell bonds from their balance sheets. In the case of the Bank of Japan, the overall picture conforms to holding to maturity. While sales before maturity could not be ruled out, especially following periods of large-­scale purchases, the bank would be more likely to take a slower route of allowing its holdings to shrink gradually through redemption at maturity and thereby avoid the possibility of the potentially disruptive impact of direct sales on financial markets. In light of ­these considerations, the bank ­adopted the cost amortization method for its holdings at its Policy Board meeting in May 2003. 250 | The Days as Governor

THE ROLE OF CENTRAL BANK CAPITAL FROM AN ECONOMICS PERSPECTIVE Would negative equity compromise a central bank’s ability to conduct monetary policy? Th ­ ere are dif­fer­ent views on this issue. One camp holds that ­because of its power to issue currency, the central bank’s ability to conduct policy would never be compromised. In this view, the levels of central bank capital are irrelevant; central banks can be technically insolvent and still be effective. Moreover, ­because the central bank can issue currency without paying interest, over time the ability to earn seigniorage ­will eventually stabilize its financial position. In accounting terms, if the net pre­ sent value of such an “intangible asset” of f­ uture seigniorage w ­ ere recognized on the asset side of its balance sheet, the central bank should never fall into negative equity. Most academics and private-­sector economists tend to support this line of thinking. This argument is understandable as a description of how ­things would stand ­under normal economic and social conditions. But my own sense is that this is too simplistic and that we should not confine our analy­sis of the consequences of unconventional monetary policy to “normal economic conditions.” ­There are several issues to discuss at this juncture. First, one cannot confidently and precisely anticipate the pos­si­ble reactions of citizens or financial firms to a central bank that has negative equity. When it is understood that negative equity is unusual and should thus be avoided, the central bank would be likely to ask the government to replenish its capital, creating the possibility of greater central bank dependence on the government—­and perhaps even a position of fiscal dominance with a loss of public trust in the central bank to pursue its policy objectives in­de­pen­dently of the government. Second, even if the central bank does not fall into negative equity, confidence in the bank could be shaken depending on the source of the losses. Negative equity, or even just large losses, could be regarded as symptomatic of failure on the part of the central bank or the government. For example, if losses arose from defaults on the private securities purchased by the central bank, criticism might be leveled that the bank had provided unfair support to some businesses or that its risk management was lax.11 Losses could also conceivably result when the central bank increases the interest paid on current account balances held by private banks at the central bank. Even if that was essential from the perspective of maintaining macroeconomic stability, one could envisage the central bank being criticized for unduly supporting financial The Comprehensive Monetary Easing Policy | 251

institutions. Realized losses or negative equity might well ignite arguments about the central bank’s quasi-­fiscal monetary policy, which could undermine the po­liti­cal accountability for distinct fiscal and monetary policies. Fi­nally, given that the expectations regarding the “intangible asset” of the ­future seigniorage stream can soften the concerns on negative equity in central bank accounts, and that such an asset is ultimately dependent on the confidence in the government, any loss of confidence in the government ­will result in the losses based on the decline of the ­future seigniorage stream. The credibility of the central bank is the most impor­tant foundation of policy effectiveness. Overall, I do not believe that ­there is a universally applicable princi­ple, f­ ree of geo­graph­i­cal and historical context, that can explain the level of capital or the significance of negative equity for a central bank. Any answer is a function of not only economics and finance but also of po­liti­cal and social developments to central bank policies. Since the GFC, I have been amazed by the dif­fer­ent po­liti­cal responses in dif­fer­ent countries. In the United States, large-­ scale asset purchases by the FRB brought on strong criticism from segments of the Republican Party. In contrast, in Japan ­there ­were virtually no harsh words from ­either the ruling co­a li­t ion or the opposition. The considerable ­flexibility we had in Japan in the timely deployment of central bank policies helped in fighting crises. But perhaps in a democracy only ­those elected directly by the ­people should have the power to choose policies that may ultimately impose costs on the electorate and, thus, the central bank should not be allowed to exercise broad discretionary powers that allocate significant losses within a society. I was concerned that ­going down this path might eventually erode confidence in the Bank of Japan and make it difficult in the ­future to conduct in­de­pen­dent monetary policy. Comprehensive Monetary Easing was designed and implemented with ­these concerns in mind.

THE BANK OF JAPAN’S VIEWS How should the central bank plan for the possibility of losses and negative equity? I still admire the thoughtfulness of what Toshihiko Fukui, my pre­de­ces­ sor as the Bank of Japan’s governor, explained in a speech he gave at the meeting of the Japan Society of Monetary Economics in June 2003: Central banks’ concern with the soundness of their capital base might not be grounded purely in economic theory but may be motivated rather by the po­liti­cal economic instincts of central bankers. In other words, 252 | The Days as Governor

once the restriction that “the central bank should only take risks consistent with the level of its self-­imposed capital base” is v­ iolated, the boundary between the functions of the central bank and ­those of the government may become difficult to discern. Consider a case where, for what­ever reason, a central bank’s capital becomes depleted, and the bank requires financial support from the government. The central bank might e­ ither run into difficulties in conducting its policy and other business operations or might cause the view to spread that it ­will, and eventually it w ­ ill become difficult to maintain public confidence in the currency.12 During my tenure as governor, I approached t­ hese issues from a similar perspective. First, we worked closely with the Ministry of Finance, which had the powers to authorize the bank’s provisioning, to convince it that a policy of maintaining a certain level of positive equity capital was appropriate and, thus, that it was necessary to set aside adequate provisions. This was no easy task ­because of ongoing strains in government finances and b ­ ecause increased provisioning would reduce the bank’s payments to the government. Second, I instructed staff to review e­ very facet of risks in the bank’s asset portfolio, employing a range of methodologies, including both value at risk and stress tests, and to report their results regularly to the Policy Board. Fi­nally, through communication with the public, we tried to raise awareness about the possibility of losses and the need to maintain the soundness of the bank’s finances while recognizing the role of the central bank in a democracy. Our approach was not widely understood by other central banks u ­ ntil the time of the GFC, when the issue began to attract more attention. But the situation has changed somewhat. In April 2013, the Bank for International Settlements (BIS) published a review of central bank finances in which Jaime Caruana, the BIS general man­ag­er, wrote, “Central banks should . . . ​ideally be equipped with the financial resources and financial mechanisms they need to keep performing their socially useful functions even during crisis periods. Avoiding ­these risks prob­ably requires sufficient resources and mechanisms to keep equity positive in the face of losses caused by socially beneficial actions. In short, central bank financial in­de­pen­dence is impor­tant.”13 The importance of this subject is perhaps best explained by another quote from Toshihiko Fukui’s 2003 remarks: “If the public allows the central bank to take on a certain level of risk within the context of flexible monetary policy, then it would be appropriate for the public to support the risk-­taking be­hav­ior of the central bank by restoring its capital base should the latter be damaged The Comprehensive Monetary Easing Policy | 253

as a result of taking risks. In such a way, the balance between democracy and a central bank’s flexibility in conducting its monetary policy could be maintained.”14 When Comprehensive Monetary Easing was ­adopted in the autumn of 2010, I had the opportunity to reflect on the appropriate role of the central bank in a democracy. ­These thoughts w ­ ere also in my mind on subsequent days when we confronted the ­Great East Japan Earthquake and prepared the Joint Statement of the Government and the Bank of Japan.

254 | The Days as Governor

| CHAPTER THIRTEEN |

The G­ reat East Japan Earthquake At 2:46 p.m. on March 11, 2011, a huge earthquake, of unpre­ce­dented size in the history of observed earthquakes, struck Japan. The ­Great East Japan Earthquake, with its epicenter just off the coast of northeast Japan; the tsunami that the quake engendered; and the meltdown of the Fukushima Daiichi Nuclear Power Plant together plunged Japan into its worst crisis since the end of World War II. Over the years Japan has repeatedly been struck by large earthquakes. When I assumed governorship of the Bank of Japan, I had a foreboding that the moment of truth would come from a major earthquake. So I was conscious of the need for the bank to maintain preparedness against such a disaster. But the magnitude of the calamity caused by the a­ ctual earthquake, tsunami, and nuclear accident was beyond anyone’s imagination. We deployed ­every resource of the bank to maintain the stability of financial markets and the functioning of Japan’s financial system, which is the most impor­tant contribution a central bank could do for the economy and society at large.

THE EARTHQUAKE STRIKES It was a Friday after­noon. At the moment the earthquake struck, I was in my office holding a meeting with staff to prepare for the Monetary Policy Meeting (MPM) that would begin on Monday. A ­ fter the floor sharply heaved vertically, in a manner that I had never experienced, the building then shook violently from side to side for an extended period. The earthquake registered a magnitude of 9.0 on the Richter Scale, and 7 on the Japa­nese Meteorological Society’s seismic scale.1 Shortly a­ fter the quake, a massive tsunami washed the Pacific coast of Japan, and especially the eastern shore of the country. From my office on the eighth floor of the Bank of Japan headquarters I saw a construction crane on top of a half-­built high-­rise slowly swaying left and right, adding to my anxiety. When the first wave of shocks had passed, I adjourned the meeting and instructed the staff to return to their desks and 255

implement disaster response. My immediate action was to establish a disaster management team, headed by myself, with deputy governor Hirohide Yamaguchi as the next in charge, and Kenzo Yamamoto, the executive director overseeing the Payments and Settlement Systems Department, as the lead man­ag­er of the command center. It was now 3:00 p.m.2 First we sought to determine if the bank’s payment network system, BOJ-­NET, was still functioning. E ­ very payment in Japan is ultimately settled through BOJ-­NET, as are all Japa­nese Government Bond (JGB) transactions. Thus, economic activity in Japan would be severely impaired if BOJ-­NET s­topped functioning and payments and JGB transactions ground to a halt. Fortunately, within a few moments, we found that BOJ-­NET was functioning normally and we then issued the following statement: 1. On March 11, at 2:46 p.m., an earthquake of a maximum scale of 7 occurred, whose seismic center was at the offshore of Sanriku.3 ­There was no substantial damage to the buildings of the Head Office or the branches of the Bank of Japan, and the Bank’s business operations, including operations at the win­dows, are carried out as usual. The BOJ-­NET is functioning normally. 2. The Bank has set up a disaster management team at its Head Office headed by the Governor, immediately ­after the outbreak of the earthquake, to assess the impact of the earthquake on financial markets as well as on financial institutions’ business operations and to respond as necessary. 3. The Bank ­will do its utmost, including the provision of liquidity, to ensure the stability in financial markets and to secure the smooth settlement of funds.4 At 3:55 p.m., I made a phone call to Prime Minister Naoto Kan to report that BOJ-­NET was operating normally. L ­ ater, as night fell, a “special financial mea­sure” was issued in the name of the minister in charge of financial affairs and myself, which asked financial institutions to redeem deposits even if the depositors had lost their deposit certificates or passbooks. The bank also announced that the MPM on Monday, March 14, would begin one hour ­earlier; would be completed in one, not two, days; and that we would publish any decision immediately. I also sent emails to the governors of overseas central banks to inform them of the situation in Japan ­after the earthquake. Many of the staff at the Bank of Japan headquarters, like other workers in Tokyo, had to spend that night in the building ­because of disruptions to transportation. As my apartment was relatively close by, I was able to get home by 2:30 a.m. 256 | The Days as Governor

MAINTAINING THE PROVISION OF FINANCIAL SER­V ICES The importance of rapid and appropriate responses ­after an im­mense natu­ral disaster is always in the back of the minds of the staff at the Bank of Japan. Particularly a­ fter the ­Great Hanshin Earthquake, which struck Japan in 1995, the bank spent considerable resources on planning and having the necessary infrastructure for business continuity. Thanks to t­ hese preparations, the bank ­ ere unwas able to respond fairly well to many of the challenges. But t­ here w expected events as well. The most surprising was the meltdown at the Fukushima Daiichi Nuclear Power Plant and its aftermath. The first hydrogen explosion occurred on March 12. Immediately a­ fter the earthquake, of the roughly 2,700 offices of the 72 financial institutions with headquarters in the most acutely affected area, 280 had to be shut down. Like the Bank of Japan, private financial institutions faced considerable difficulties keeping their doors open for business, as they faced commuting prob­lems for their staff and blackouts, necessitating the use of in-­ house power generators that faced a scarcity of fuel ­because fuel deliveries suffered due to severed expressways. Against all odds, many firms ­were able to sustain or promptly recover their ability to provide financial ser­vices. Especially as Japan is highly dependent on cash transactions, compared with other developed economies, it was doubly impor­tant to maintain the availability of cash for the purchase of day-­to-­day essentials. This is why the minister in charge of financial affairs and I had immediately asked financial institutions to redeem deposits, even if depositors had lost deposit certificates or passbooks. In addition, over that first weekend, we kept the Bank of Japan’s cash win­dows open at our Tokyo Headquarters; at the Aomori, Fukushima, and Sendai Branches; and at the Morioka local office, which would normally be closed on Saturdays and Sundays, to ensure a timely and ample supply of cash to the stricken areas.

MONETARY POLICY MEA­S URES TAKEN Prior to the earthquake we had not anticipated any further easing mea­sures to support the Japa­nese economy. Immediately a­ fter the earthquake, my initial thought was that our main response should be to state clearly the Bank of Japan’s readiness to supply liquidity to the financial system. ­These thoughts ­were quickly superseded as events unfolded at the Fukushima Daiichi Nuclear Power Plant over the weekend. The ­Great East Japan Earthquake | 257

On the eve­ning of Sunday, March 13, I was in the bank’s guest­house near the prime minister’s offices—we call it the Kantei in Japan, like the White House in the United States—­waiting to be summoned to discuss economic policy responses. No one had an accurate picture of what was happening at the nuclear plant. Tele­vi­sion news feeds, which I was following closely, w ­ ere drip-­ feeding the dire developments at the plant. I began to fear the negative economic consequences of widening risk premiums in financial markets, arising from the deteriorating business outlook and by the increasing risk aversion of investors triggered by the extraordinary tragic events. The Bank of Japan de­cided to put up two lines of defense: supplying liquidity and enhancing monetary easing. The earthquake, tsunami, and nuclear ­accident together posed extreme uncertainties, incapable of probabilistic analy­sis as described by the g­ reat economist Frank Knight. When uncertainties of this nature heightened, financial markets, anticipating the worst, see increasing demand for liquidity as investors rush to the comfort of holding cash. If precautionary liquidity demand goes unmet, financial markets ­will be destabilized, eventually impairing economic activity. To avoid this we de­cided that the bank should supply a massive liquidity injection to dispel any concerns over funding. Coming out of the meeting at the Kantei at midnight, I told the reporters, who w ­ ere ­there to inquire as to the bank’s response, that the bank would intentionally flood the market with liquidity the next morning. Confirming t­ hese words, the bank aggressively supplied liquidity on Monday, March  14, offering 21.8 trillion yen in its fund-­supplying operation, of which 15.1 trillion yen was taken up, including 8.9 trillion yen in same-­day funds. This amount was more than three times greater than the largest single-­ day liquidity injection the bank made following the collapse of Lehman ­Brothers in 2008 and the largest on rec­ord at the time. With re­spect to monetary easing, effective options ­were ­limited. We undertook an increase by about 5 trillion yen to the bank’s Asset Purchase Program, aimed principally at risk assets, which had been introduced ­earlier in 2010 as part of the Comprehensive Monetary Easing framework. The aim was to prevent any widening of risk premiums by the bank by purchasing an additional 500 billion yen in long-­term JGBs, one trillion yen in short-­term government bills, 1.5 trillion yen each in commercial papers and corporate bonds, 450 billion yen in exchange-­traded funds, and 50 billion yen in real estate investment trusts. We deliberately increased the purchase of private assets as part of the overall effort which, in the end, resulted in aggregate purchases of 40 trillion yen. 258 | The Days as Governor

BUSINESS CONTINUITY IN THE FACE OF THE NUCLEAR ACCIDENT ­ fter the initial massive earthquake on March 11, ­there ­were a series of strong afA tershocks, not only in the six prefectures in the northeast Tohoku region but also, ­ ese more generally, in eastern Japan, including the Tokyo metropolitan area. Th Japa­ n ese population, and the situation became even quakes unsettled the ­whole 5 worse with a series of explosions at the nuclear plant. The building that ­housed Reactor Number 1 exploded at 3:36 p.m. on March 12. The next day Reactor Number 3 also experienced a meltdown, followed by an explosion of its reactor housing at 11:01 a.m. on March 14. March 15 saw white smoke coming out of the building housing Reactor Number 2 and also a fire at Reactor Number 4. The Nuclear and Industrial Safety Agency declared that the severity of the accident was at level 7, which was the worst level that the world had ever seen—as bad as the Chernobyl disaster in Ukraine in 1986. The number of nearby residents that ­were evacuated on Japa­nese government ­orders topped 140,000 by August 29, 2011. The Bank of Japan sought to gather information through all available channels. As rumors circulated, many staff posted to foreign diplomatic missions in Japan and their dependents began to leave the country, following instructions from their home countries. Overseas firms, including financial institutions, began to relocate staff and their ­family members out of Tokyo, and some ­ ere ­were even closing down operations. For the business of the bank, t­ here w two overarching issues. The first prob­lem was securing the supply of electricity. The computing center of the Bank of Japan was ­housed in a building in suburban Tokyo. Unfortunately, the area around the center was subject to rolling blackouts due to the reduced generating capacity at the Tokyo Electric Power Com­pany (TEPCO). ­These blackouts could have ­stopped the Japa­nese system for pro­cessing and settling payments in yen and government securities transactions. The center did have some in-­house power generating capacity; this could avert a shutdown for a few days, but it left the center quite vulnerable. The reliance of the core Japa­nese payment and settlement system on in-­house power generation would likely have appeared most unusual to overseas market participants, and could have unsettled them and brought about knock-on effects. Yamaguchi explained the potentially serious implications to the Kantei; the Ministry of Economy, Trade and Industry; and TEPCO, and requested an exemption from the rolling blackouts for the bank’s computing center. I had already made a direct plea to Prime Minister Kan ­after the late-­night meeting at the Kantei on March 11 The ­Great East Japan Earthquake | 259

and had also called the chairman of TEPCO in the early hours of Monday, March 12. Through t­ hese efforts we w ­ ere able to have the computer center exempted from rolling blackouts. The second prob­lem was to keep the doors open at the Bank of Japan’s Fukushima Branch. While the branch was about sixty kilo­meters away as the crow flies from the Fukushima Daiichi Power Plant, if the evacuation area for preventing radioactive contamination had been enlarged beyond the initial twenty-­k ilometer perimeter, the branch might have to had to be evacuated.

THE NER­V OUS REACTIONS OF FINANCIAL MARKETS Global investors’ views on Japan increasingly turned negative. On March 14 the Nikkei Index fell by 633 yen (6.2 ­percent), and on March 15 fell even farther, by 1,015 yen (10.6 ­percent). In such an environment the task before the Bank of Japan was to prevent fear from spreading within financial markets. The bank supplied vast amounts of funds day ­after day, and as a result, current account balances at the bank totaled 42.6 trillion yen on March 24, which was a level never before seen. Consequently, the short-­term money markets remained stable. Stability was also maintained in the government bond market, where the yield on ten-­year JGBs was 1.30 ­percent just before the earthquake and remained within a relatively narrow range of 1.20 to 1.25 ­percent through the m ­ iddle of March. In the foreign exchange market, the dollar-­to-­yen exchange rate, just u ­ nder 82 yen prior to the earthquake, threatened on March 17 to break through the 79-­yen level on the back of rumors that the earthquake would force Japa­nese financial institutions to repatriate their foreign currency assets and convert them into yen. Against this backdrop both the Ministry of Finance and the Bank of Japan approached our respective overseas counter­parts, urging them to join a coordinated intervention in the foreign exchange market to stabilize the yen. This effort bore fruit on March 18 when G7 monetary authorities conducted coordinated interventions for the first time since September 2000. Before then, intervention to c­ ounter an appreciation of the yen had been opposed by both the Eu­ro­pean and US authorities. But a­ fter the earthquake t­ here was sympathy for the special circumstances faced by Japan, and our counter­parts agreed to coordinated intervention. On March 18, I went over to the Finance Ministry early in the morning, and a­ fter participating with Finance Minister Yoshihiko Noda in a conference call with G7 counter­parts, Noda and I appeared before reporters. From then on ­there was a reversal of trends in the 260 | The Days as Governor

foreign exchange market and the dollar-­to-­yen rate was pushed back up over 85 yen. In my view, ­these coordinated interventions ­were quite effective in preventing negative feedback from the natu­ral disaster spreading to other financial markets, and particularly the Japa­nese stock market

CALLS FOR THE BANK OF JAPAN TO DIRECTLY FINANCE THE GOVERNMENT The ­Great East Japan Earthquake also required an immediate fiscal response. Of course, no outlays had been planned for the calamity in the government’s fiscal year 2011 bud­get. Three successive supplementary bud­gets w ­ ere assembled. The first supplementary bud­get, approved by the National Diet on May 2, amounted to 4 trillion yen. The second, approved on July 25, amounted to 1.9 trillion yen, and the third, approved on November 21, amounted to 9.2 trillion yen. Legislation for the next fiscal year’s bud­get was prepared by the cabinet on December 24, including a special account for reconstruction efforts, with an additional 3.8 trillion yen earmarked for earthquake responses. All in all, total fiscal spending plans related to the natu­ral disaster came to 18.9 trillion yen, not including outlays related to compensations for the nuclear accident. Soon ­after the earthquake, t­ here was a clamor within the ruling Demo­cratic Party of Japan for the Bank of Japan to directly finance reconstruction efforts. On March  18 the front page of one national newspaper (Sankei Shimbun) ­carried the headline “­Great East Japan Earthquake, ¥10+ Trillion Emergency Reconstruction Bond Issue, All to Be Purchased by BOJ.” The government continued to resist calls for direct financing by the bank, but many members of the Diet from both the ruling co­ali­tion and the opposition parties demanded that the government change its thinking. A cross-­party group of members of the Diet, calling themselves the Group Advocating Reconstruction Financing without Tax Hikes, released a manifesto that called for the bank to fund the reconstruction efforts by purchasing all JGBs with market operations. To my surprise, out of about seven hundred members of the Diet, 211 members from both sides of the aisle signed this document. The unpre­ce­dented scale of the reconstruction efforts profoundly changed the po­liti­cal climate. Many of ­those urging direct financing by the bank ­were simply repeating the arguments for further monetary easing and using the earthquake opportunistically. They connected the national emergency to the necessity of taking more exceptional actions in terms of monetary policy. ­These arguments ­were heard from parts of the business community as well. JGB yields had remained The ­Great East Japan Earthquake | 261

quite stable following the quake, and the government was not experiencing any difficulties in meeting its borrowing requirements. With JGB yields remaining stable at low levels, I was concerned that for the Bank of Japan to directly finance the government would have sent the wrong message to overseas investors and observers. Any suggestion that the Japa­nese authorities w ­ ere losing their own confidence in the country’s ability to absorb the cost of reconstruction could have jeopardized the stability in financial markets that we then had. I was determined to clearly and forcefully ­counter t­ hese calls for direct financing. Public opinion showed l­ittle tolerance for the idea that Japan faced “completely unforeseeable developments” in the magnitude of the tsunami and the inadequacy of safety systems at nuclear power plants. By contrast, I thought that the likely consequences of direct financing of the government by the Bank of Japan ­were completely foreseeable. To ­counter the calls for direct financing, I chose to raise public awareness of the vital importance of sound money as a part of Japan’s financial and economic infrastructure. Consequently, the policy debate on direct financing died down in the context of earthquake responses temporarily but would eventually raise its ugly head once again in debates about deflation and yen appreciation.

GATHERING AND COMMUNICATING ACCURATE INFORMATION One of the most taxing exercises for the Bank of Japan was overseas communication. The dearth of information underscored the uncertainty and exacerbated fears about the consequences of the power plant accident for the Japa­nese economy, finance, and society at large. Overseas investors w ­ ere particularly jittery. Over the first weekend ­after the earthquake, a rumor circulated among overseas financial institutions that the Tokyo Stock Exchange would not open its doors the following Monday. Th ­ ere was also baseless speculation that both the bank’s computing center and some executive functions ­were to be transferred to Osaka. The heads of major overseas financial institutions called my office seeking to confirm the veracity of ­these rumors. To avoid self-­reinforcing negative market dynamics, in a special conference call with overseas central bank governors I made a detailed pre­sen­ta­tion on the situation in Japan. On the occasion of my trip in April to the United States for the spring meetings of the International Monetary Fund (IMF) and the World Bank, I followed this up with a speech at the Council on Foreign Relations in New York—­“­Great East Japan Earthquake: Resilience of Society and Determination to Rebuild”—to 262 | The Days as Governor

help dispel the excessive pessimism about the Japa­nese economy caused by inaccurate information.6 Direct information about what was happening in the disaster-­stricken regions was hard to come by. As I could not find time to leave my Tokyo office, I asked my deputy governor, Yamaguchi, to visit the affected regions and the bank’s branches and report back to me. Yamaguchi arrived in the area on March 31 and gave me a detailed briefing on what he saw and heard from branch staff, thanks to which I was able to obtain a much more concrete feel for the situation in the affected areas. Macroeconomic and financial conditions in Japan changed significantly. The nation had never experienced anything like the combined consequences of the huge earthquake, tsunami, and nuclear accident, and thus uncertainties about the f­ uture had never been greater. U ­ nder t­ hese circumstances I de­ cided that I should hear directly from business and financial experts, and I scheduled as many face-­to-­face meetings as pos­si­ble. Their stories ­were candid and gave me insights I would not other­wise have had. In addition, Bank of Japan staff gathered in my office ­every eve­ning so as to effect timely and efficient exchanges of information. It was obvious in a situation like the ­Great East Japan Earthquake that the value of macroeconomic data was ­limited, not only ­ ecause it was actually not pos­si­ble to compile ­because of the time lags but b statistics accurately from the affected areas. In such an environment, the key to making sound assessments was firsthand information from businesses at the fulcrum of supply chains, often from individual factories. We w ­ ere fortunate in that business leaders ­were willing to provide us with so much information. Notably, Bank of Japan staff ­were able to foresee with considerable accuracy the timing of the recovery of corporate supply chains, in contrast to the less informed and more pessimistic forecasts of private-­sector economists. This was due, I believe, to the mutual trust built up over many years between many companies and the bank.

A HUGE DECLINE IN ECONOMIC ACTIVITY In 2010, the year before the earthquake, Japan registered the highest growth among the G7 economies, at 4.2 ­percent, and this favorable trend should have continued into 2011 had the disaster not struck. The quake knocked the Japa­ nese economy off course, and growth for 2011 dipped to −0.2 ­percent.7 As of 2018 the death toll from the disaster stood at around sixteen thousand, with around twenty-­five hundred still missing. In terms of physical damage, the sea The ­Great East Japan Earthquake | 263

­ ater inundation of 561 square kilo­meters caused by the tsunami was the most w notable. The falloff in economic activity from the earthquake was both rapid and huge. The Industrial Production Index for March 2011 showed a month-­ to-­month decline of 15.5 ­percent on a seasonally adjusted basis, which was the largest monthly decline ever recorded. The quarterly real gross domestic product (GDP) growth rate before annualization was −0.7 ­percent in the first quarter and −0.2  ­percent in the second quarter. This sharp decline in economic activity was comparable to that experienced ­a fter the collapse of Lehman ­Brothers, but the nature of the shock was clearly dif­fer­ent. In the days ­after the collapse of Lehman, demand literally dis­appeared. By contrast, the earthquake abruptly shocked and constrained the supply side of the economy. The supply shocks came from three directions. First, the extensive earthquake and tsunami caused damage to the capital stock in the Tohoku and adjoining northern Kanto regions, both to public infrastructure, such as roads and port facilities, and to private capital, such as factories and commercial buildings. Second, t­ here was a huge decline in electric power generation capacity. Japan’s nuclear power plants, which had supplied 23 ­percent of Japan’s electricity before the earthquake, ­were shut down one by one. Consequently, the loss of generation capacity at TEPCO and the Tohoku Electric Power Com­ pany amounted to 23 ­percent and 33 ­percent, respectively, constraining the supply of electricity to the Kanto and Tohoku regions.8 Third, ­there was the disruption to supply chains for parts and industrial inputs that spread of the effects of the earthquake beyond the disaster-­struck areas. With regard to many consumer goods, for example, China, Japan, and the United States are dependent on each other, as the United States designs the goods, Japan supplies the parts and components, and China assem­bles the finished products. In this way the disruption to supply chains reached beyond the Japa­nese economy. While the initial decline in economic activity was largely caused by supply-­ side ­factors, ­there ­were also downward pressures on the demand side. The nuclear accident and power shortages depressed economic activity both through the deterioration of business and consumer sentiment and a decline in tourism. To save electricity, streetlights and building lights ­were turned off. Moreover, immediately following the earthquake, t­ here arose a nationwide desire to restrain from holding get-­togethers where food and drinks ­were served, which led to the cancellation of many public and private events. This had a chilling effect on consumption, especially in the ser­vice industries for travel and entertainment. Even though the four most affected prefectures occupied a mere 11 ­percent of the Japa­nese landmass and directly contributed only 264 | The Days as Governor

6 ­percent of GDP, the r­ ipple effects combined to depress economic activity across all of Japan, out of proportion to the relative importance of the stricken area.9 But as most of the decline in business activity came from supply constraints, a recovery could be anticipated if and when supply chains ­were up and ­running again.

THE STRUG­G LE TO RESTORE PRODUCTION On the front lines of manufacturing, t­ here w ­ ere frantic efforts to repair production lines. One of the key businesses in terms of restoring global supply chains was the factory of Renesas Electronics, located in Hitachinaka, Ibaraki Prefecture, which produced microcontrollers—­a crucial component for automobile engines and transmissions. Production stoppage at the plant significantly affected the operations of not only Japa­nese but also overseas auto manufacturers; all eyes ­were on the recovery efforts at this one factory. Fortunately, with help from business partners, production resumed e­ arlier than expected, and the supply chain was repaired much more quickly than some of the initial pessimistic forecasts had indicated. Looking at the components of GDP, contribution from domestic private demand dropped significantly at −0.6 ­percent in the first quarter. It then gradually began to reverse the fall, with the second quarter number being −0.2 ­percent. By contrast, contribution from external demand registered −0.2 ­percent in the first quarter and widened to −0.8 ­percent in the second, reflecting the disruptions in supply chains. In the meantime, the contribution from public demand was 0.1 ­percent and 0.3 ­percent in the first and second quarters, respectively, as outlays from the reconstruction supplementary bud­gets kicked in, helping to sustain demand. Even as the supply chain issues ­were being solved relatively quickly, the stoppage of nuclear power plants raised serious concerns for the Japa­nese economy. Putting aside the more fundamental question of the role of atomic energy ­ atter of increasing in Japan’s electric power generation, ­there was the urgent m imports of liquefied natu­ral gas, reflecting the increasing reliance on gas-­fired generators. Consequently, the monthly seasonally adjusted trade balance turned to a deficit in April 2011, the month a­ fter the earthquake. Whereas the average monthly trade balance had stood at a surplus of 674.5 billion yen in the twelve months preceding the earthquake, the figure turned to a deficit of 203.8 billion yen in the first twelve months a­ fter it (March 2011–­February 2012), widening further to 437.8 billion yen and 891.7 billion yen in the second and The ­Great East Japan Earthquake | 265

third twelve-­month periods. The peak deficit was registered in March 2014 at 1.568 trillion yen.

THE TEPCO QUESTION AND THE JAPA­N ESE CORPORATE BOND MARKET During many of my conversations with business and financial leaders, they raised the serious “TEPCO question.” TEPCO was a huge business; it had revenues of 5 trillion yen, net profits of 133.7 billion yen, and gross and net assets of 13.2 trillion yen and 2.5 trillion yen, respectively, according to its financial reports for the fiscal year ending March 2011. It was the largest issuer of corporate bonds in Japan, with 4.7 trillion yen worth of bonds outstanding. Its annual financing needs, consisting of long-­term corporate bonds falling due and short-­term borrowings amounted to 1.1 trillion yen. Immediately ­after the accident at its nuclear power plant, attention focused on how to value TEPCO’s financial obligations. ­Because of the significant compensation that the com­ pany was expected to have to pay, TEPCO likely had negative equity and was technically insolvent. The immediate question was ­whether the com­pany was to be put into corporate reor­ga­ni­za­tion, which was the most obvious choice, or to take a dif­fer­ent path.10 Many issues had to be considered, beginning with the appropriate allocation of liabilities arising from the nuclear accident between TEPCO and the government. The most impor­tant issue was the possibility that the start of any formal reor­ga­ni­za­tion would lead to systemic events. Some argued that electric power companies w ­ ere dif­fer­ent from financial institutions: t­ here should be no chain reaction analogous to a bank run that would impair the operation of other electric power companies. ­There ­were opposing views that reor­ga­ni­za­tion proceedings should be avoided for fear of causing systemic events for electric power companies and, in the end, this view prevailed. Although I was not privy to what the decision makers at the Kantei and the Ministry of Economy, Trade and Industry ­were thinking, I believe that they ­were worried about financial issues. Electric power companies ­were significant borrowers in the corporate bond market. At the end of March 2011, the nine major electric power companies that supplied most of electricity in Japan collectively had issued 13 trillion yen in bonds, which amounted to 21 ­percent of all Japa­nese corporate bonds outstanding. Moreover, ­u nder the Electricity Business Act, the holders of electric com­pany bonds had a special right to receive payment in preference to other creditors, including even claims for dam266 | The Days as Governor

age compensation caused by a nuclear disaster. B ­ ecause of this, electric com­pany bonds w ­ ere regarded as “quasi-­government” bonds and w ­ ere used as the benchmarks for yields on all Japa­nese corporate bonds, reflecting investors’ belief that electric power companies would never fail. Even if such beliefs ­were not desirable as a ­matter of a public policy, the fact that they had persisted for so long raised the stakes for applying corporate reor­ga­ni­za­tion to one of the power companies. Creating the pre­ce­dent of a corporate reor­ga­ni­za­tion by contradicting the supposed safety of the bonds would likely have caused the w ­ holesale downward revision to the creditworthiness of all electric power companies, even though the existing TEPCO bondholder would not have suffered any losses ­because of his or her preferential creditor status. That would have in turn made investors fundamentally reassess the credit quality of electric power com­pany bonds and made funding difficult for ­those companies, leading to a systemic event. I suspect this was the government’s concern. Against this backdrop ­there ­were heightened uncertainties in the Japa­nese corporate bond market. Consequently, it became difficult for investors and issuers to concur on the terms of new issues, and issuers had to halt their fund­ rais­ing for a while.

THE DEDICATION OF THE BANK OF JAPAN STAFF The ­Great East Japan Earthquake caused ­great suffering, but ­there ­were many moving moments during Japan’s response to the disaster. Some involved my firsthand experience of the dedication of the Bank of Japan staff. The areas around the bank’s Aomori, Fukushima, and Sendai Branches, and around local offices in Mito and Morioka, ­were the most badly hit. The Fukushima and Sendai Branches faced the severest difficulties, particularly in the challenges of staff to reach them. ­There was also the emotional stress among staff of the Fukushima Branch, which was only sixty kilo­meters away from the Fukushima Daiichi Nuclear Power Plant. Even so, the bank managed to carry out its duties. My first visit to the disaster-­stricken area was in the beginning of June. Standing before a wide expanse of land devoid of structures, which had all been swept away by the tsunami, I found myself completely at a loss. At that time the local staff ­were quietly and resolutely g­ oing about the seemingly routine task of examining damaged banknotes and exchanging them for new ones. Watching the staff calmly ­handle the huge volume of tsunami-­damaged notes and coins, I was deeply moved. Such dedication was not confined to the bank. I found it everywhere I visited in the affected areas. The ­Great East Japan Earthquake | 267

CONDOLENCES FROM ABROAD I was also heartened by the kind messages of condolences and support that I received from my overseas central bank colleagues. Within minutes of the earthquake, emails from foreign central bank governors and presidents flashed on the screen of the computer in my office. I was most inspired by ­those messages. The Bank for International Settlements and the Bank of Thailand collected donations from their staff and also made donations as institutions. Kim Choongsoo, the governor of the Bank of ­Korea, visited the Japa­nese embassy in Seoul to express his condolences. At the G20 Finance Ministers and Central Bank Governors meeting held in Washington, DC, on April 15, barely one month a­ fter the earthquake, t­ here was a message of solidarity and support via a communiqué. Immediately ­a fter the earthquake, as fears mounted over nuclear fallout, ­there was a sharp decline in the number of overseas visitors to Japan, and many international gatherings ­were canceled. In such an environment I was happy to see William Dudley, the president of the New York Fed, attend a conference in Tokyo as previously scheduled. Having urged Dudley to attend when he phoned in to inquire about the situation on the ground in Tokyo before the meeting, I was especially thankful to see him waiting for the conference to begin with a smile—­even as an aftershock shook the conference venue.

ISSUES HIGHLIGHTED BY THE ­G REAT EAST JAPAN EARTHQUAKE ­ uman civilizations have coped with the risks posed by natu­ral disasters since H the dawn of time. No economy in the world can completely avoid them. Having said that, according to the study by one Japa­nese research institute, of all the earthquakes larger or equal to magnitude 6.0 that struck the world between 2000 and 2009, more than one-­fifth happened in the vicinity of Japan.11 While typhoon-­related events causing disastrous wind and rain damage are much more common, consequences are, of course, much more severe when an earthquake, a tsunami and a nuclear accident all occur at once, as they did during the ­Great East Japan Earthquake. This huge earthquake highlights the challenge of thinking clearly about the severe consequences of rare “tail events” brought on by natu­ral disasters.12 Perhaps the most impor­tant issue would be the appropriateness of nuclear power generation in an earthquake-­prone country like Japan. This subject is beyond my expertise, but I would like to focus on two issues more closely related to central banking. 268 | The Days as Governor

What should the corporate strategy be to avoid or mitigate large-­scale disruption of production in the face of a natu­r al disaster? Japa ­nese businesses spent many years enhancing their competitiveness through the ­continuous reduction of intermediate goods inventory via sophisticated manufacturing routines known as “just-­in-­t ime” inventory management. As admirable as ­these are, when any link in ­these chains is severed by a natu­ral disaster, businesses are forced to sharply curtail production constrained by the minimal inventory of intermediate inputs on hand. The ­Great East Japan Earthquake, by breaking the supply chains into pieces, laid bare such risks of not holding inventory. More impor­tant, the earthquake highlighted the risk of concentration: every­one sourcing from one business located in a single area, which was illustrated by the supply chain network prob­lems centered on the Hitachinaka plant of Renesas Electronics. Mitigation of ­t hese risks through increasing inventory or sourcing from dif­fer­ent suppliers is costly. Relocation of production overseas by Japa­nese firms, which had been increasing even before the earthquake, seemed to have accelerated further in the context of risk mitigation. Th ­ ese concentration risks are also impor­tant at the economy-­w ide level. For example, concentration of economic activity in just one area is dangerous, but in a competitive environment, t­ hese social costs are often not sufficiently internalized by businesses and thus increase tail risks. The other issue was ensuring the continuity of financial ser­vices provision. The ability of companies and ­house­holds to make and receive payments, to convert short-­term investments into cash, and to draw on available credit lines make up the critical infrastructure of an economy—as impor­tant as electricity, ­water supply, and road transport. Enhancing readiness against disruptions, including natu­ral disasters, is known as business continuity planning (BCP). ­After the G ­ reat East Japan Earthquake, the Japa­nese government drew up basic plans for the promotion of countermea­sures against prospective earthquakes, and the Bank of Japan enhanced its BCP to an even greater extent. Private financial institutions and financial exchanges have since followed suit, but individual efforts may not lead to an economy-­wide efficient outcome. A catalytic role needs to be played by some public organ­ization so as to improve economy-­ wide BCP. Many central banks, including the Bank of Japan, have promoted BCP and improvements in payment and settlement systems through vari­ous channels. Such efforts, perhaps l­ittle known to the public, are ingrained in the banking function of the central bank, and are impor­tant activities entrusted to the central bank. The ­Great East Japan Earthquake | 269

THE READINESS OF SOCIETY AS REGARDS TAIL EVENTS The ­Great East Japan Earthquake reminded Japan that society ­will ultimately make choices that determine its level of readiness to meet tail events—­the small likelihood of extreme consequences. Responses ­will differ according to the type of events anticipated, with dif­fer­ent responses to earthquakes, tsunamis, or nuclear accidents. ­There are innumerable types of tail events to be considered. Even with a narrow focus on natu­ral disasters, it is necessary to think about typhoons and volcanic activities, among ­others. In recent years, we have become aware of the prospect of cyberincidents. ­There are also tail events to be considered in the conduct of macroeconomic policy. As has been noted in previous chapters, large-­scale disruptions to the economy as typified by the Japa­ nese financial crisis of the second half of the 1990s or the global financial crisis in 2007–9 ­were such tail events. Financial crises do not occur frequently, but they ­will happen, and when they do the costs to the economy and society are enormous. An exclusive fixation on ­bubbles and the risks of financial crises could lead to more restrained conduct of monetary policy that could nip the buds of both innovation and more robust economic growth. A balancing act in economic policy is analogous to the debates on tail event readiness for natu­ral disasters like earthquakes. The degree of acceptable tail risks—be they earthquakes, tsunamis, nuclear accidents, or financial crises and macroeconomic shock—is ultimately a choice made by a society. ­There is no single right answer, and responses ­will differ from one country to another. The defenses that can be put in place ­will likely differ according to the affluence of a society. Reflecting on my own experience, I am troubled by the lack of a balanced public discourse on the benefits and costs of erecting defenses against the tail events that I have lived through. More specifically, I do not believe that the tail risks in the macroeconomy and the financial system have attracted the same level of careful attention as t­ hose events whose damage can be more easily discerned. Earthquakes, tsunamis, typhoons, or nuclear accidents usually result in observed physical damage, which enable ­there to be debates based on relatively concrete cost assessments. Views tend to diverge quite sharply, but at least the debates balance the costs and benefits. In contrast, it is more difficult to imagine what could happen if tail risks materialize ­because of macroeconomic policy. With the exception of the central bank, t­ here are few who have sufficient incentive to internalize t­ hese risks and envision a wider horizon. As noted e­ arlier, ­there was a sudden outburst of calls for the Bank of Japan to directly finance the government follow270 | The Days as Governor

ing the ­Great East Japan Earthquake, even when ­people lashed out violently at both TEPCO and the government on the grounds they had failed to be prepared to manage the extreme consequences of the seemingly remote likelihood of ­t hese events. Given the nebulous nature of tail events in macroeconomic policy, it is the central bank, which by its nature is attentive to tail risks, that has the responsibility to think clearly about such risks and explain them to the public.

The ­Great East Japan Earthquake | 271

| CHAPTER FOURTEEN |

Sixfold Suffering and the Currency War The appreciation of the yen dominated economic policy debates throughout my tenure as governor of the Bank of Japan. The bank faced continual calls to beat deflation, but the voices demanding a halt to the appreciation of the yen ­were even louder. “Beating deflation” was simply shorthand for “improving economic conditions,” and many business leaders instinctively understood that monetary policy alone was not an adequate remedy. But many thought that aggressive monetary easing could halt the appreciation of the yen’s exchange rate. The relationship between exchange rates and monetary policy—­ particularly in the so-­called currency war—­a lso became the focus of international policy debates among central bankers. While periods of yen appreciation ­after 2000 have been described in chapters 5, 8, and 12, this chapter provides a structured and comprehensive description of the debates about the yen’s appreciation that occurred during my five-­year tenure as governor.

THE SIXFOLD SUFFERING The term sixfold suffering (rokujuku in Japa­nese) entered the popu­lar vocabulary around 2010. It was a cliché used by many business leaders to express their frustration with economic forces beyond their control that handicapped Japa­nese businesses in international competition. The appreciating yen, high corporate tax rates, high prices and unreliable supply for electricity, delays in concluding free-­trade pacts, stringent ­labor regulation, and ever-­tightening environmental regulation together made up the sixfold suffering that business leaders claimed held them back. In par­tic­u­lar, between 2011 and 2012, as worries mounted over the supply of electricity as nuclear power plants ­were turned off a­ fter the G ­ reat East Japan Earthquake and, at the same time, the yen appreciated during the Eu­ro­pean debt crisis, leaders of the export-­focused automotive, electronics, and electric machinery industries became even more vocal. To my ears, the term sixfold suffering reflected private-­sector leaders’ 272

sentiment that despite r­ unning their businesses to the best of their abilities, they had to cope with difficulties beyond their control b ­ ecause of m ­ istakes of the government and the central bank. The term was a con­ve­nient way to express indignation and frustration and to deflect responsibility. Sixfold suffering is ­today no longer heard from Japa­nese business leaders, even though ­little has changed in the five ­factors other than the exchange rate of the yen. In my view, this suggests the magnitude of business discontent at the time of the appreciating yen.

EXCHANGE RATE DEVELOPMENTS SINCE 2000 The bulk of transactions in the foreign exchange markets ­today reflect capital transactions and investment flows. Financial institutions and investors are continuously making their choices about the currency composition of their assets and liabilities by comparing the yields and prospective volatility both of the under­lying investments and of the exchange rates. Thus, as financial markets have become more global, exchange rate movements have come to be dominated by financial flows rather than by currency trades reflecting the flows of goods and ser­vices. The movement in exchange rates for any currency is comprehensively captured by its nominal effective exchange rate, which is calculated by weighting the movements of vari­ous bilateral exchange rates via trade flows between relevant jurisdictions.1 According to the monthly nominal effective exchange rate calculated by the Bank for International Settlements, since 2000 the trough in the yen’s exchange rate was in July 2007, at which point the currency had depreciated 22.5 ­percent from January 2000.2 The peak in the effective exchange rate was registered in January 2012, and the rate stayed more or less at the same level ­until July of that year. With a trough-­to-­peak appreciation of the yen of 54 ­percent, which was dubbed the superstrong yen, one can fully understand the frustration of Japa­nese business leaders. But this was also just the mirror image of the superweak yen of prior years. Comparing the level of July 2012 with that of January 2000, the yen appreciated about 19 ­percent. During this same period, the Swiss franc registered a 59 ­percent gain. The franc appreciated b ­ ecause it was regarded as a “safe-­haven asset,” just like the yen. The Australian dollar appreciated during this period by 36 ­percent. It was a commodity currency, buoyed by the rapid growth of China, which was a feature of the global economy in t­hose years. The euro appreciated 31 ­percent during the same period. In short, looking at the overall Sixfold Suffering and the Currency War | 273

percentage appreciation, the yen’s appreciation in the first two de­cades of the twenty-­first c­ entury was by no means the largest among developed economy currencies (see fig. 14.1). Moreover, in terms of price competitiveness of industries, the real exchange rate, which takes account of the dif­fer­ent rates of inflation in each country, is much more impor­tant than changes in nominal exchange rates. In terms of the real effective exchange rate, the yen’s appreciation fell well short of that following the Plaza Accord (see fig. 14.2) and also did not stand out in comparison with its peers. The elevated levels of the yen exchange rate over the five years starting in July 2007 was largely brought on by the global financial crisis (GFC) of 2007–9 and the Eu­ro­pean debt crisis and reflected the yen’s status as a safe-­haven currency. July 2007 was just one month before trou­bles surfaced at the French bank BNP Paribas, and July  2012 was when the Eu­ro­pean debt crisis reached its climax. It is striking to see the correspondence of the timing between ebb and flow of crises on the one hand and the yen’s exchange rate on the other.

THE YEN AS A SAFE-­H AVEN CURRENCY That foreigners would buy the yen as a safe-­haven currency was a puzzling phenomenon for Japa­nese business leaders and for the public at large. One of the most common questions that I fielded during my tenure as governor was “Why is the yen purchased as a safe-­haven currency when in Japan the government’s finances are in tatters and both potential growth and the population are declining?” Foreign capital, however, does not expect absolute safety in any currency. Rather, investors are interested in relative safety compared with other currencies and that relative safety is not necessarily based on a long-­term perspective. Investors are actually looking for both assets and a currency that offers “good enough” shelter in the near term. As the exchange rate is the relative price of two currencies, any changes in perception regarding safety show up as fluctuations in the exchange rate. During the GFC, one of the most impor­tant f­ actors affecting the perceived safety of a currency was the ease of external funding. In this dimension, Japan was an almost impenetrable fortress. Japan’s current account per­sis­tently registered surpluses ­every year before the ­Great East Japan Earthquake. The aggregate of ­t hese cumulative flows—­Japan’s net international investment position—­a mounted to 251.5 trillion yen, or 52.5 ­percent of gross domestic product (GDP), at the end of 2010. China also had a large net international investment position, second only to Japan’s, but its currency could not serve as 274 | The Days as Governor

(Index, January 2000 = 100) 160 Japanese yen UK pound Australian dollar US dollar Swiss franc

150 140 130

Appreciation

Euro Korean won

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120 110 100 90 80 70 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Figure 14.1 ​Nominal effective exchange rates (narrow index). Source: Bank for International Settlements.

(Index, CY 2010 = 100) 160 150

Appreciation Japanese yen

140 130

Depreciation

120 110 100 90 80 70 1980

1983

1986

1989

1992

1995

1998

2001

2004

Figure 14.2 ​Real effective exchange rates. Source: Bank of Japan.

2007

2010

2013

a safe haven both ­because it was not freely convertible and ­because of lingering investor concerns over the rule of law in that country. The position of the Chinese yuan also directly, if subtly, contributed to the yen’s strengthening. The yuan exchange rate came to be pegged to a basket of currencies from July 2005, but China also continued to intervene in the currency market to mitigate the yuan’s appreciation against the US dollar. Market participants entered so-­called proxy hedges against f­ uture appreciation of the nonconvertible yuan by buying the convertible yen ­under the assumption that ­there would be some correlation between the two currencies in the long term. This contributed to the strengthening of the yen. The third largest holder of net external asset was Germany, but the euro could not serve as a safe haven ­because the euro area was the epicenter of its own debt crisis. The fourth largest was Switzerland. ­Factors that investors looked for in a safe-­haven currency would include convertibility, sufficiently large financial markets, rule of law in resolving private disputes, and the ease of external funding. The Swiss franc happened to fit the bill, along with the Japa­nese yen. If the German mark ­were still in existence, the increase in demand for safe-­haven currencies during the GFC would likely have been absorbed by the mark, and the pressures on the yen would have been weaker.3

INTEREST RATE DIFFERENTIALS Narrowing interest rate differentials also contributed to the appreciation of the yen, as was described in chapter 8. In summary, when growth stagnated in Eu­ rope and the United States ­after the GFC and the Eu­ro­pean debt crisis, the Eu­ro­pean Central Bank (ECB) and the Federal Reserve Board (FRB) aggressively eased monetary policy, bringing down the level of their interest rates. ­After two financial crises and stagnant growth, the Bank of Japan had already lowered interest rates and was facing the zero lower bound in the short end of the yield curve. ­There was, thus, much less room for interest rates to be lowered in Japan. Even if long-­term interest rates w ­ ere higher than short-­term rates, their levels ­were already the lowest globally, and ­there was ­little room for them to decline any further. In short, interest rate differentials could narrow further, but Japa­nese monetary policy could not widen them on its own (see fig. 14.3). To induce a decline in the yen exchange rate, a Monetary Policy Meeting (MPM) at the Bank of Japan debated the adoption of negative interest rates paid on current account balances with the bank in spring and summer 276 | The Days as Governor

Yield curves as of August 29, 2008

(%) 6

Japan Germany Switzerland

5

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4 3 2 1 0 –1

Overnight 1

2

3

4

5

6

7

8

9

10

20

30 years

10

20

30 years

Yield curves as of July 31, 2012

(%) 6

Japan Germany Switzerland

5 4

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3 2 1 0 –1

Overnight 1

2

3

4

5

6

7

8

9

Figure 14.3 ​Yield curves of developed economies. Source: Bloomberg.

of 2012, a policy that had already been ­adopted by the Danish and Swedish central banks. While interest rates on deposits could be negative, ­there was no way to impose negative interest rates on the cash balances held by the general public in paper currency. Given the prevalent use of currency in Japan, this would have ­limited how far negative interest rates could go, ­because if interest rates on deposits went deeper into negative territory, depositors would take cash out of bank accounts and keep it ­under their mattresses. I was highly skeptical that negative interest rates could widen interest rate differentials to a meaningful degree and, for that m ­ atter, influence the exchange rate. In pricing both interest rates and exchange rates, the attention of market participants is acutely focused on the influence of each central bank’s monetary policy on the f­ uture path of short-­term interest rates. The Bank of Japan had clearly explained that it would continue with zero interest rates. But even if the bank had not expressed any forward guidance on f­ uture short-­term interest rates, given the state of the economy in Japan and abroad the prevalent view would have been that Japan’s zero interest rates would continue for some time and ­these expectations w ­ ere already reflected in the low long-­term interest rates in Japan. Interest rates in the United States w ­ ere higher and, thus, the FRB had the latitude to lower both short-­term interest rates and the level of the entire yield curve by purchasing long-­term Trea­sury bonds, and also to encourage a shift in market expectations that interest rates would remain at effectively zero for longer. In this way the FRB’s actions induced the US dollar to depreciate through monetary easing while the Bank of Japan lacked the means to offset the narrowing of interest rate differentials. The appreciation of the yen was all but inevitable. ­These under­lying forces ­were not widely understood in the debates inside Japan on the exchange rate. Along with the Bank of Japan, the Swiss National Bank (SNB) faced a similar predicament, and I frequently exchanged views with Philipp Hildebrand, the bank’s head, on the appreciation of our currencies. The Swiss franc and the yen ­were both regarded as safe-­haven currencies ­because both w ­ ere supported by large net external assets, both ­were facing the zero lower bound, and both had interest rates that ­were the lowest in the world.

THE DOUBLE WHAMMY ARGUMENT OF AN EXPENSIVE YEN AND DEFLATION With re­spect to the ­causes of the expensive yen, I often heard and read of analysts placing the blame on deflation. To be sure, the princi­ple of purchasing power parity suggests that movements in the exchange rate should compen278 | The Days as Governor

sate for inflation differentials. But ­people often also claimed, “We are hurt by both the rising yen exchange rate and deflation,” producing a “double whammy.” But the idea of purchasing power parity holds that exchange rates ­will tend to move so as to offset inflation differentials over time. ­There was no double whammy (see chapter 9). But the feelings ­behind this idea ­were another reflection of the general feeling of unsatisfactory economic conditions that many Japa­nese associated with deflation. In a similar vein, ­there ­were ­others who argued that the target inflation rate ­adopted by the Bank of Japan was too low and that this, in turn, caused the appreciation of the yen. But even in the extreme and unlikely case that purchasing power parity would prevail immediately, a 1 percentage point increase in the expected inflation rate would only cause the dollar-­to-­yen exchange rate to move from 100 yen to 101 yen. Such a small implied appreciation in the exchange rate was unlikely to bring much benefit to the Japa­nese economy. As a ­matter of fact, during my tenure as governor, the Australian dollar experienced among the steepest appreciations while, at the same time, the Reserve Bank of Australia maintained the highest target inflation rate among the developed economies, at 2–3 ­percent.

THE FEAR OF HOLLOWING OUT At the Bank of Japan we routinely heard both cries of suffering from business contacts about the appreciation of the yen and their complaints about the bank’s policies. In my own private meetings with business leaders and regular exchanges with the heads of business lobbies, I heard directly about their unhappiness with the yen and with the bank’s policies. The strongest voices ­were ­those in the automobile and electronics industries, the backbone of Japa­nese exports. At the National Diet, the bank was condemned by both the ruling co­ ali­tion and opposition parties. While one can understand that Japa­nese businesses would be displeased with the pressures on their profits from the appreciation of the yen, the claim that the yen’s strength at this time would “hollow out” the Japa­nese economy seemed to me to be misplaced. Worries that Japa­nese businesses would be forced to shift production facilities from Japan to abroad, resulting in lost domestic employment, rang hollow to my ears. In fact, outward foreign direct investment had already increased from 4.9 trillion yen in 2000 to 11.5 trillion yen in 2008.4 ­There ­were two further reasons why I was not convinced of the exchange-­ rate-­induced “hollowing out” argument. First, in a globalized world, the decisions Sixfold Suffering and the Currency War | 279

by businesses to locate production facilities in a specific location depended mainly on ­factors such as local production costs and the size of markets. As to the former, it is costly to maintain labor-­intensive production pro­cesses at home. As to the latter, the size of the Japa­nese domestic market was not expected to grow due to our adverse demographics, while emerging market economies like China ­were expected to grow much more rapidly. It was a quite rational judgment to set up manufacturing factories in countries where wages are relatively low and final demand is relatively high. Exchange rates, of course, are not irrelevant to foreign direct investment and such investment increased as the yen appreciated sharply. While the appreciation of the yen did negatively affect the profitability of exports and encourage businesses to make outward direct investments, was the rising yen the principal reason for shifting production abroad? Sharp fluctuations in exchange rates—in e­ ither direction—­can, of course, affect business investment decisions at the margin and can impose irreversible costs. But my own assessment of a­ ctual Japa­nese foreign direct investment over the past de­cade is that the yen’s rise was merely accelerating the inevitable, nudging the timing of decisions to shift production, and was not the principal driver of the under­lying trend of Japa­nese foreign direct investment. Second, the overseas expansion of Japa­nese businesses needs to be understood from the perspective of comparative advantage. Over time, the location for the production of goods and ser­vices w ­ ill reflect dif­fer­ent countries’ comparative advantages, particularly conditions such as demographics and technological endowment. During its high-­g rowth era in the 1960s, 1970s, and 1980s, Japan won a significant share of global markets in textiles, shipbuilding, steelmaking, electronics, and automobiles. As emerging market economies have caught up, we should expect t­ hese shifts in basic manufacturing pro­cesses to reflect shifts in comparative advantage. In the evolving supply chains covering the ­whole of East Asia, Japan’s comparative advantage was not found in the basic assembly lines but in higher value-­added production and ser­vices. At the same time, the aging population of Japan created increased demand for workers in labor-­intensive sectors such as health care and social care. With a declining ­labor force, the share of employment in t­ hese ser­v ices industries would have to increase in Japan. ­There could be cases where decision induced by exchange rate fluctuations brought about irreversible costs. A case in point is a painful lesson about “reshoring” in the automobile and electronics industries during 2004–7 (see chapter 6). The significant depreciation of the yen at that time was mainly brought about by differences in the conduct of monetary policy between Japan and 280 | The Days as Governor

other economies, when the Bank of Japan maintained zero interest or close to zero interest rates as overseas central banks raised rates. The yen’s depreciation temporarily improved the profitability of domestic manufacturing and of exports, which prompted some large-­scale domestic capital investments. This backfired following the GFC, when overseas central banks cut their rates ­aggressively all at once and the yen appreciated sharply, hammering export profitability. In retrospect, the low exchange rate had only increased export profitability in the short term. In the longer term, reshoring against the undercurrents of changing comparative advantages made the ultimate adjustment all the more onerous in the subsequent normalization and appreciation of the yen. The adjustment burdens in the electronics industries, however, did not arise solely from fluctuations in the exchange rate. Another serious strategic misstep, prominently seen in the production of flat-­screen tele­vi­sions, was made by Japa­nese firms that continued to pursue vertically integrated manufacturing while foreign rivals shifted ­toward “fabless” manufacturing, where both inputs and final products ­were manufactured in factories owned by ­others located outside Japan.5 ­After I left the Bank of Japan in 2013, during a period of relative yen weakness the export competitiveness of the Japa­nese electronics industry was not restored. Outward foreign direct investment did increase even ­under the lower yen exchange rates a­ fter 2013, but t­ here was ­little talk of the hollowing out of Japan, nor any evidence of reshoring. Perhaps even Japa­nese business leaders had come to peace with the inevitability of the shift to overseas manufacturing and the ­factors ­behind this trend.

GROWING FRUSTRATIONS AMONG MANUFACTURING BUSINESSES During my governorship, I was well aware of the Japa­nese export industries’ discontent and frustration with the higher yen. I had also long admired the leaders of ­these industries, who had so consistently pursued improvements in their own competitiveness. But I could also identify a tone of self-­importance when they used the term sixfold suffering. I particularly recall my surprise at a formal luncheon with local business leaders in Nagoya, in November 2011, when I heard an executive officer of a global enterprise say: “I know that it is unconventional in the extreme, but given the extreme appreciation of the yen, the time might be ripe for the Bank of Japan to directly finance the government.” I sensed his frustration that the appreciation of the yen was the result of speculation in the foreign exchange market and that good corporate citizens Sixfold Suffering and the Currency War | 281

toiling in factories w ­ ere victims of such money games. But shocks to the economy, like fluctuations of the currency, create both winners and losers, and ­t hose conducting economic policy must consider the impact on the overall Japa­nese economy. No ­matter which way the exchange rate might move, policy makers have to consider not only their short-­term effects but also the long-­ term influences on the supply side and on the allocation of resources within the economy. In par­tic­u­lar, when assessing the impact on demand it is necessary to assess the positive effects on Japa­nese real incomes due to improvements in the terms of trade, not just the more immediate and vis­i­ble negative impacts on exporters. Why are so many objections raised against a stronger domestic currency in Japan as compared with other major economies? In most economies ­t here are a relatively small number of exporters, concentrated in larger businesses, and a larger number of importers more widely dispersed often among small-­ and medium-­size enterprises. Moreover, the main direct beneficiaries of a stronger domestic currency are consumers. This structure tends to give more prominence to views that welcome a weaker domestic currency and this tendency is especially con­spic­u­ous in Japan, where the leadership of the main business lobbies, such as the Japan Business Federation, is traditionally populated by the principals of export-­oriented manufacturing firms. Th ­ ese are the p ­ eople most often sought out by the media for comments about the exchange rate. The dominance of the view of exporters may also result from the tendency of Japa­nese employees to identify their interests with t­ hose of their employers against the backdrop of lifetime employment, which remains the norm at large firms in Japan.

THE MOOD OF THE POPULATION REGARDING THE STRONG YEN ­ ere ­were loud complaints about the sixfold suffering and perceived hollowTh ing out of the economy from some quarters, but this was not the w ­ hole picture. When I had the opportunity to speak with business leaders in private I often heard other views on the fundamental ­causes of the loss of competitiveness, emphasizing f­ actors such as the decreasing attractiveness of their product line rather than just the appreciating yen. In par­tic­u­lar, the broader decline of the competitiveness of the Japa­nese electronics industry was understood by many ­people as not primarily caused by the appreciation of the yen. ­There was also a shared recognition that increases in Japa­nese outward foreign direct investment reflected the broader economic realities of the shrinking do282 | The Days as Governor

mestic market due to declining population, the more rapid growth rates of emerging market economies, and wage differentials. But even t­ hese business leaders railed against the strong yen when they spoke publicly in their official capacities as principals of businesses and industry lobbies. Perhaps they feared the blame that would be heaped upon them if their comments w ­ ere taken as accepting yen appreciation and as inviting a stronger yen. I should acknowledge that I also chose my words in public carefully so as not to be seen as tolerant of a strong yen. I did not, for example, explain that the real effective exchange rate had remained relatively low even if the nominal exchange rate had appreciated. Importers whose profitability improved with a strong yen kept quiet for obvious reasons. And no words ­were heard from exporters whose products enjoyed non-­price-­competitive advantages. For all of ­these reasons, public discussion about the exchange rate was overwhelmingly one-­sided. This was not the first time that I observed that many say one t­ hing in public while expressing completely dif­fer­ent opinions in private; this is a fact of life. But the conduct of economic policy w ­ ill be compromised if the tendency is completely unchecked and no one is willing to question the orthodoxy of the crowd. Indeed, in my lifetime, most of the big m ­ istakes in Japa­nese economic policy making have resulted from acquiescence to public opinion anxious about an appreciating yen. Both the “runaway inflation” of 1973–74 and the b ­ ubble economy of the late 1980s particularly come to mind. Given the massive cross-­border capital flows of our globalized financial system, policy makers simply cannot do as they wish with the exchange rate. Conceptually, if a country wished to avoid fluctuations of the exchange rate, this could be achieved by restricting the f­ ree movement of capital. But for a developed economy like Japan, aiming to thrive within the globalized economy of significant trade and capital flows, this option would be counterproductive at best and more likely completely impractical. One could imagine that a country could choose to have a fixed exchange rate. For Japan this would effectively mean abandoning a monetary policy tailored to domestic economic stability and would, instead, force the nation to piggyback on US monetary policy, which would, in fact, be neither pos­si­ble nor appropriate. This prob­lem is subsequently dubbed the “trilemma of an open economy.” As long as Japan wants to choose the path of globalization and have its own monetary policy, it must also accept the constraint of a floating exchange rate. The Japa­nese public and politicians have been slow to reconcile to this real­ity. Sixfold Suffering and the Currency War | 283

THE CURRENCY WAR While public opinion in Japan was fixated on the strong yen, an inauspicious debate broke out in the international arena over the so-­called currency war among central banks. The phrase was coined by Guido Mantega, the finance minister of Brazil, who was quoted in the Financial Times on September 27, 2010, while drawing attention to the phenomenon of developed economy central banks trying to depreciate their currencies by using this rather sensational expression.6 This seemed especially to be triggered by the weakening of the US dollar a­ fter the FRB’s further monetary easing. Mantega’s comment came ­after a Jackson Hole Economic Symposium speech by the FRB chair Ben Bernanke—­ which suggested additional monetary easing was forthcoming and accelerated the fall of the US dollar—­and the formal launch of the second round of quantitative easing (QE2) by the FRB.7 During this same period, Japan had intervened in the foreign exchange market for the first time in more than six years. Many developed economy policy makers deeply regretted the term currency war, but it had already captured the attention of the financial press. At international meetings I heard many policy makers object to the suggestion that the global economy was undergoing such a war. Cross-­border trade and capital flows not only benefit the economies directly concerned but also contribute to advances in the entire global economy. It seemed grossly inappropriate to liken the fluctuations in currencies that result from such flows as analogous to a war. Mantega’s remarks also appeared to be an attempt to deflect criticism for ­Brazil’s policy failures by shifting the focus to the policies of other countries. I felt uncomfortable both with t­ hose who simplistically dismissed Mantega’s remarks and also with the emerging economies’ one-­sided and equally simplistic condemnation of the easing policies ­adopted by the developed economies. Putting aside the appropriateness of Mantega’s choice of words, I thought that ­there was a need to reflect deeply on the global implications of nationally based monetary policies at the zero lower bound of interest rates. The basic thinking of developed economy policy makers was that each economy was pursuing domestic stability and that their individual efforts should eventually result in the stability of the global economy. The key was assessing the global spillover of monetary easing by developed economies, and especially the United States. On this point ­there ­were two conflicting views. One was that aggressive ­easing, particularly near the zero lower bound, amounted to a “beggar-­thy-­ neighbor” policy that triggered a race of competitive currency devaluations. 284 | The Days as Governor

This is the zero-­sum game view. In the alternative view, monetary easing aimed at stimulating domestic demand would eventually lead to stability of the global economy. This view was expressed by the top officers of the FRB, including Bernanke, at vari­ous international forums, countering critics from emerging market economies. According to Bernanke’s speech in March 2013, monetary easing in each economy was an “enrich-­t hy-­neighbor” policy reflecting the “plus-­sum game” view.8

VIEWS FROM EMERGING AND DEVELOPING ECONOMIES A number of emerging and developing economies expressed unhappiness with the huge capital inflows they received a­ fter the United States eased monetary policy. Their immediate concerns w ­ ere focused on the appreciation of their ­currencies and the resulting loss of export competitiveness. They w ­ ere also likely—­and rightly—­concerned with the potential destabilizing impact on their economies if and when ­these capital flows reversed direction. If the affected central banks resorted to foreign exchange market intervention to stop their currencies’ appreciation, domestic monetary conditions would be eased further, stimulating economic activities. At the same time, the appreciation of the domestic currency that did occur would contain inflation and perhaps allow opportunities to ease monetary policy further. Unfortunately, this was not the ­ ecause increases in foreign exchange reserves resulting from end of the story, b currency interventions ­were inevitably invested in US Trea­sury securities, which had the effect of further lowering US long-­term interest rates. This would then come full circle, with further capital outflows from the United States and corresponding inflows into emerging and developing economies. The lower interest rates in developed economies resulting from aggressive monetary easing also accentuated the “search for yield” by international investors, bringing yet more capital flows in the form of carry trades. Against protests voiced by the leaders of emerging and developing economies, developed economy authorities responded that if capital inflows ­were causing domestic prob­lems, each economy should then take what­ever steps ­were needed to mitigate ­these inflows. One ave­nue was to let the domestic currency appreciate and then, once it had strengthened sufficiently, market participants would be more likely to expect the currency to weaken, which could put a brake on capital inflows. Another approach would be to strengthen the regulation and supervision of domestic financial institutions. From the perspective of developed economies, emerging and developing nations ­were shirking Sixfold Suffering and the Currency War | 285

responsibility for their own financial systems and making unreasonable demands on the conduct of monetary policy in developed economies. This back-­and-­forth debate echoed the early discussion in the United States about the impact of the “global savings glut” of excessive savings from emerging economies causing large current account surpluses and the buildup of US dollar foreign exchange reserves, which in turn contributed to the decline in long-­term US interest rates and the US housing b ­ ubble.9 This argument seemed to me to assume that the United States could not take offsetting actions on its own to raise interest rates. In any case, the differences in views ­were not bridged and we had repeated lively and sometimes acrimonious exchanges at international meetings. Representatives of the FRB w ­ ere careful in choosing their words but ­were sometimes unable to hide their frustrations.10 The discourse, in my view, was strikingly similar to how Asian central banks complained to the Bank of Japan and how the bank responded when it was conducting very accommodative monetary policy, including quantitative easing, especially in 2004–7. Thus, I well understood the logic of the FRB’s arguments b ­ ecause I had been saying fundamentally the same t­ hings. But a­ fter the tumultuous experience of the GFC, I became more sympathetic to the pleas made by emerging market economies for greater consideration of the economic and policy implications of massive flows coming from developed and ­going ­toward emerging and developing economies, being as they w ­ ere influenced by both push and pull f­ actors. During my five years as governor I participated in repeated international discussions on the spillover from the conduct of monetary policy by one country onto the economies of ­others. Invariably t­ hese discussions focused on the effects of monetary policy in developed economies—­and the United States, in particular—on emerging and developing economies. I tried several times to generalize the discussions to reflect a recognition of spillover across all economies in the form of carry trades and inflows to save-­haven currencies like the Japa­nese yen. But I was unsuccessful in my aim for a broader recognition of ­these challenges; perhaps I should have been more forceful.

THE POLICY RHE­T ORIC IN DEVELOPED ECONOMIES Just as emerging market countries conducted foreign exchange market interventions along with monetary easing in response to the appreciation of their currencies, the developed economies had frequently intervened in the currency markets in prior de­cades, particularly following the Plaza and Louvre Accords 286 | The Days as Governor

(Billions of yen) 90 80 70 60 50 40 30 20 10 0 1991

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Figure 14.4 ​Foreign exchange intervention. Source: Japa­nese Ministry of Finance.

of 1985 and 1987, respectively. Only in the late 1990s, a­ fter the abject failure of the crisis involving the departure of the pound sterling from the Eu­ro­pean Exchange Rate Mechanism in 1992, did the more developed nations begin to refrain from foreign exchange intervention. Minimizing currency market interventions became the norm for developed economies, with the notable exceptions of Japan and Switzerland. The Eu­ro­pean and US authorities always conveyed strong dis­plea­sure when Japan intervened in the foreign exchange market (see fig. 14.4). In Japan the authority to intervene is vested in the minister of finance rather than the central bank. While the Bank of Japan monitors daily developments in the currency market and advises the Finance Ministry on the practical issues of intervention, the finance minister is responsible for decisions to conduct interventions. But both the Ministry of Finance and the Bank of Japan are part of the extensive exchanges of views and information with other national authorities. In the course of global discussions, I always had a nagging feeling that authorities of other developed economies ­were inconsistent, and not ­entirely honest, in their reasoning. Sixfold Suffering and the Currency War | 287

When Japan conducted unilateral intervention, Eu­ro­pean policy makers often publicly expressed concerns and disagreement. I was often frustrated with their characterization of the influence of monetary easing on exchange rates. Both Eu­ro­pean and US central bankers maintained that they w ­ ere easing monetary policy for the purpose of domestic economic stabilization—to promote domestic demand and stable prices—­and not at all for the purpose of influencing their exchange rates. Of course they intended to stimulate their domestic economies with monetary easing, but I was suspicious that they w ­ ere not also hoping to weaken—at least to contain any appreciation of—­their currencies. Their silence on the subject of their own currencies’ movements appeared to be deliberate. They condemned foreign exchange market intervention by other countries while, at the same time, lecturing t­ hose countries to engage in self-­help in response to the impact of their own monetary easing on exchange rates. This posture was only available to central banks that could lower interest rates and narrow interest rate differentials—an option not open to the Bank of Japan.11

THE UNPRE­C E­D ENTED EXPERIMENT BY THE SWISS NATIONAL BANK In this context, the responses by the Swiss authorities are worthy of further examination. Switzerland was similar to Japan in that it had a safe-­haven currency, and the level of Swiss interest rates ­were among the lowest in the world. But the Swiss authorities made very clear their intention to check the appreciation of their currency.12 This was most evident during the second stage of the Eu­ro­pean debt crisis, beginning in the summer of 2011, when the Swiss franc appreciated sharply and briefly broke through the level of 1.2 francs to one euro. The SNB conducted aggressive quantitative easing in August 2011, and also undertook interventions that had the effect of expanding, in just one month, current account balances at the bank by an amount of almost 40 ­percent of nominal Swiss GDP. But this was in vain. Eventually the bank surprised the world on September 6 by embarking on unlimited foreign exchange market intervention, to maintain a ceiling on the exchange of 1.2 Swiss francs to one euro.13 Could Japan have ­adopted the same approach as Switzerland? If so, would it have worked for Japan? I was doubtful on both counts. Japan was still the third largest economy in the world, while Switzerland was a small, open econ-

288 | The Days as Governor

omy with nominal GDP just one-­tenth that of Japan. The scale of intervention that would have been necessary for Japan was completely dif­fer­ent. Moreover, Japan was a member of the G7 group of developed economies. The po­liti­cal costs would likely have been prohibitive had Japan tried to get away with such massive foreign exchange market interventions at the same time that the G7 was pressing China to show more flexibility in the management of its foreign exchange rate regime. As for the effectiveness of foreign exchange intervention, ­there is an argument that t­ here is an asymmetry between interventions by a central bank that aim to support the value of its currency and ­those that aim to weaken its currency. When trying to support a currency, a bank’s defenses are ­limited by the extent of its holdings of foreign currency reserves, which market participants can easily recognize. But when that bank wishes to put a brake on the appreciation of its currency t­here is no natu­ral limit to the availability of domestic currency that it can create and sell, and thus it is much more likely that the currency’s appreciation can be halted if monetary authorities show their determination to pull out all the stops. Even so, the SNB was able to hold the line for only a few years. The bank suddenly abandoned the franc’s peg against the euro in January 2015, shortly before the ECB ­adopted quantitative easing and the Swiss franc appreciated sharply. The bank’s reasoning for ending the peg was as follows: Had the SNB delayed the discontinuation of the minimum exchange rate, this would only have been at the expense of an uncontrollable expansion of the SNB balance sheet by hundreds of billions of Swiss francs, and potentially by several times Swiss GDP. Such an expansion would have severely impaired the SNB’s ­future ability to conduct monetary policy and jeopardized the fulfillment of its mandate in the long term. Moreover, given the fact that the minimum exchange rate was no longer sustainable, further intervention would have been pointless, and the enormous loss arising from it could not have been justified.14 This experience of the SNB seems to underscore the fact that it is difficult for a central bank to go on expanding the balance sheet to deter appreciation ­unless it is convinced that the rate is close to an equilibrium rate and flows ­will subside. This difficulty is not merely an accounting m ­ atter; it stems from

Sixfold Suffering and the Currency War | 289

broader po­liti­cal and even social considerations. Foreign exchange losses at the central bank imply that the taxpayer is incurring losses while profits are reaped by overseas and domestic financial market participants who have sold foreign currencies to the central bank. In a demo­cratic society, the central bank ­will not be able to continue to generate such losses on an open-­ended basis. If interventions have been conducted directly for the government’s account, the losses ­will immediately accrue to the taxpayer. Thus, even though foreign exchange intervention that attempts to weaken the domestic currency may be more effective than interventions in the other direction, the central bank’s actions can reach the limit of society’s tolerance.

COMMUNICATIONS REGARDING THE EXCHANGE RATE I was an advocate of neither a strong nor a weak yen. In the long term I thought that the exchange rate would tend to reflect the economic fundamentals. But in the short term the exchange rate would fluctuate, reflecting a myriad of ­factors, and from time to time could overshoot its fundamental value. But we have no way to discern w ­ hether the a­ ctual exchange rate is consistent with fundamentals in real time. So I was of the view that, as a rule, it was not ­appropriate for the central bank to offer its views on the par­tic­u ­lar level of the yen’s exchange rate. Th ­ ere w ­ ere, however, instances where exchange rate movements ­were sharp and where silence from the bank seemed likely to ­accelerate the appreciation of the yen with abrupt negative consequences for the outlook for economic activity and prices. In ­t hese exceptional cases, the bank expressed concerns through the governor’s statements—­four such statements during my tenure, on August 12 and September 15, 2010, and on March 18 and August 4, 2011. ­There is a striking institutional prob­lem in Japan with communication about exchange rates in the lack of clarity about who is the official spokesperson on the exchange rate within the government. The power to intervene is legally vested in the finance minister and it should be clear that the minister has the final word. But especially when the yen is rising, other government ministers freely and frequently engage in their own verbal interventions, particularly at press conferences following cabinet meetings, often resulting in mixed messages to the markets. Japan should follow the lead of the United States and the euro area, where ­there is a wide understanding that external communications about the exchange rate are solely to be undertaken by the officials with ­legal

290 | The Days as Governor

powers over market interventions—­the Trea­sury secretary in the United States and the president of the ECB in the euro area.15

VARI­O US POLICY PROPOSALS FOR HALTING THE APPRECIATION OF THE YEN The Bank of Japan’s general view on exchange rates is a conventional one, mostly in line with ­those of other developed economies’ central banks. The exchange rate is seen as one of the impor­tant variables that influence economic conditions and price dynamics and should be carefully monitored as one ­factor that affects the conduct of monetary policy. Looking back on monetary easing decisions during my tenure as governor, given that the yen was appreciating throughout the period (and significantly weighed on the outlook) the exchange rate was often at the center of our deliberations and one of the impor­ tant f­ actors in our decisions. But this is not what business leaders, the government and the po­liti­cal establishment, and the press w ­ ere expecting of the Bank of Japan. They expected and demanded a monetary policy that could halt the strengthening of the yen and, better yet, induce the yen’s decline. As I have explained, b ­ ecause of ­Japan’s circumstances, I did not think that monetary easing could directly limit the appreciation of the yen. But when the press and economists ­were fixated on such direct effects, ­there ­were occasions when I felt I had to turn a blind eye and consciously avoid ­these arguments. On other occasions I consciously bowed to the expectations of action by the bank to influence the exchange rate, particularly in our December  2009 decision to introduce fixed-­rate fund-­ supplying operations and the October  2010 decision to introduce Comprehensive Monetary Easing. Ideas about how Japan could weaken the yen came directly to us from many sources. The most common idea was for more intervention in the foreign exchange market by the Ministry of Finance. ­There ­were other suggestions for actions by the Bank of Japan—­most commonly for the bank to expand its balance sheet, and the monetary base, through large-­scale purchases of Japa­ nese Government Bonds. But ­unless such an expansion of the balance sheet could influence the all-­important long-­term interest rate differentials, I thought it would have ­little effect on the yen. Looking back at the ­actual data, we can now see that t­ here is no clear correlation in the relationship between the bilateral exchange rates among the dollar, the yen, and the euro or the relative size

Sixfold Suffering and the Currency War | 291

of each central bank’s balance sheets and monetary base and, thus, no causation can be inferred.16 Another group of commentators advocated deploying a duration effect policy, or forward guidance, to weaken the yen. This also faced the l­ imited scope for effectively widening interest rate differentials through forward guidance when long-­term interest rates ­were already so low and the global economy was shaken by a common negative shock. Monetary easing, including forward guidance, for Japan was essentially a strategy to wait for favorable tailwinds that might amplify any weakening of the yen resulting from reduced tensions in global financial markets or from expanding overseas economies.

292 | The Days as Governor

| CHAPTER FIFTEEN |

The Sustainability of Government Finances The most fundamental requirement for the stability of money—­encompassing both price stability and financial stability—is the sustainability of government finances. At the time I became governor of the Bank of Japan, by most metrics the Japa­nese government’s finances w ­ ere already in the worst position of any of the developed economies. The economic stagnation that followed the global financial crisis (GFC) of 2007–9, the increased social security outlays reflecting the aging of Japan’s population, and the many draws from the public purse in the aftermath of the G ­ reat East Japan Earthquake all further mired Japa­nese government finances in red ink. Against this backdrop I felt that the Bank of Japan had to be careful not to be perceived as falling into the trap of “fiscal dominance.” Thus, the conduct of fiscal policy, and the relationship between government finances and monetary policy, ­were in the front of my mind throughout my five years as governor.

WORSENING FISCAL CONDITION In the 2007 fiscal year, the Japa­nese public sector fiscal balance, including both the central and local governments, registered a deficit of 6.5 trillion yen, or 1.2 ­percent of nominal gross domestic product (GDP). ­Those numbers had sharply increased to 36.1 trillion yen and 7.3 ­percent by 2009, when the impact of the GFC was fully reflected. By the end of March 2013, just ­after my term as governor concluded, the figures had fallen slightly, to 28.5 trillion yen and 5.7 ­percent. Long-­term debt outstanding at the end of March 2008 was 767 trillion yen, or 144 ­percent of nominal GDP—­which was quite high already and the highest among developed economies—­increased further to 932 trillion yen or 188 ­percent of GDP by the end of March 2013 (see figs. 15.1–15.2).

293

(Trillions of yen) 1,200

(% of nominal gross domestic product) 250 Debt outstanding Gross domestic product ratio (right-hand scale)

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Figure 15.1 ​Long-­term debt outstanding for central and local governments. Source: Japa­nese Ministry of Finance. (Trillions of yen) 120 Expenditure Tax revenue

100

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Figure 15.2 ​The General Account of the central government. Source: Japa­nese Ministry of Finance.

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(% of nominal gross domestic product) 180 Canada

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Figure 15.3 ​Net government debt outstanding. Source: International Monetary Fund, Fiscal Monitor.

If one includes the government’s social security obligations, Japan’s outstanding general government debt was further increased. While international comparisons are always tricky, according to the calculations of the International Monetary Fund (IMF) Japan’s “general government” debt was 237 ­percent—­the largest on a gross basis among developed economies, far surpassing Italy’s 135 ­percent of GDP (see fig. 15.3).1 On a net basis, ­after subtracting the government’s financial asset holdings, the difference with Italy is greatly reduced, but Japa­nese government debt still stood at 154 ­percent of GDP, surpassing Italy’s 123 ­percent. Both increased spending and decreased revenues contributed to Japan’s expanding fiscal deficits. Government expenditures booked in the General Account increased from 69.3 trillion yen in the 1990 fiscal year to a peak of 101.0 trillion yen in the 2009 fiscal year, mostly due to Japan’s aging population driving up the costs of pensions, health care, and social care. This was despite public works expenditures, which once significantly contributed to government spending, having almost halved from 34.5 trillion yen in the 1996 fiscal year to 17.7 trillion yen in the 2011 fiscal year. On the revenue side, tax receipts booked in the General Account declined from the highs during the ­bubble economy years, Sustainability of Government Finances | 295

from around 60 trillion yen per year to 47.2 trillion yen in the 1999 fiscal year. Revenues recovered to 51.0 trillion yen in the 2007 fiscal year, but the trend was reversed by the GFC to reach a low of 38.7 trillion yen in the 2009 fiscal year. Such a fall in tax revenue resulted in part from declining personal and corporate income tax receipts reflecting stagnation of the economy and in part from the introduction and expansion of vari­ous tax breaks in the 1990s. With re­spect to corporate income taxes, huge accounting carry-­over losses resulting ­ ubble w ­ ere also a f­ actor. Given that ­those losses would from the bursting of the b be netted with profits to reduce taxable income, ­u ntil ­t hose carry-­over losses ­were exhausted corporate income tax receipts would not increase even when economic activity picked up and reported profits increased.2 Meanwhile, the consumption tax rate, which was 3 ­percent at its introduction in April 1989, was increased to 5 ­percent in April 1997 and remained at that level for the next seventeen years. It was only a­ fter my tenure as governor that the consumption tax was increased to 8 ­percent in April 2014 and then to 10 ­percent in October 2019. Tax increases are always unpop­u­lar, but the po­liti­ cal trauma of the 1997 consumption tax rate hike has had enduring consequences. Japa­nese economic policy discourse has been strongly influenced by the view that the tax hike was the culprit for the deep recession of 1997–98. But, in my view, both the Asian financial crisis and Japan’s own deepening financial crisis, coming at the same time, are much more likely to have been the main d ­ rivers of this contraction. Unfortunately, concerns about the role of the consumption tax put a brake on further increases in the early 2000s. The government led by Junichiro Koizumi, which came to power in April 2001, managed to score an impor­tant victory in stabilizing government revenues by abolishing the across-­the-­board income tax relief that was introduced in 1999. But the new Koizumi government would not put forward any changes in the consumption tax, even though it enjoyed high approval ratings.

CHANGING VIEWS ON THE USE OF FISCAL POLICY Over the last three de­cades, the conduct of Japa­nese fiscal policy has under­ gone a transformation. In the economic downturn of the 1990s, a­ fter the bursting of the Japa­nese b ­ ubble, a conventional Keynesian stimulus approach was ­adopted. In addition, as a result of the Japan-­US Structural Impediments Initiative and u ­ nder strong pressure from the United States to reduce Japan’s current account surplus, the Japa­nese government announced in June 1990 that it would spend an astounding 430 trillion yen—­approximately 80 ­percent of 296 | The Days as Governor

annual GDP—­over ten years on public works proj­ects. The subsequent evolution of Japa­nese fiscal policy is harder to characterize, however. As for the active deployment of discretionary fiscal outlays, it is safe to say that it has gradually become less common to deploy Keynesian policies, even as supplementary bud­gets seem to have become an annual ritual in response to sluggish economic activity. But it does not necessarily mean that fiscal policy or fiscal f­ actors have been restrictive on the w ­ hole. Focusing on the deficit in the primary fiscal balance and the resulting increase in the debt-­to-­GDP ratio suggests that the overall stance of Japan’s fiscal policy continued to be expansionary in the early 2000s, reflecting a lack of serious effort of the government to restore fiscal sustainability.3 One reason assertive fiscal policy fell out of ­favor was ­because of po­liti­cal remorse for inefficient government spending, and the infamous “bridges to nowhere” 4 that had been undertaken in the name of countercyclical policies in the 1990s. Another reason was the fundamental shift in academic thinking, strongly influenced by New Keynesian economics, to the view that macroeconomic stabilization fell within the sphere of monetary policy. But the trend away from active fiscal policy was completely reversed by the GFC, particularly as the winds changed in academia ­toward a revival of fiscal policy. Developed and emerging economies alike ­adopted aggressive fiscal policies—­Japan included. In addition to directly increasing government outlays, tax breaks ­were granted to incentivize purchases of durables such as automobiles and ­house­hold appliances as well as housing investment. Looking at the contribution of government spending to quarterly real GDP growth from the 2008 fiscal year, it stood at zero in the third quarter of 2008, around the ­ rothers, and then registered five consecutive time of the collapse of Lehman B quarters of positive contribution—0.1  ­percent, 0.3  ­percent, 0.7  ­percent, 0.1 ­percent, and 0.2 ­percent, totaling 1.3 percentage points.5 Since 1994 t­ here had been no other examples of five consecutive quarterly positive contributions of government spending. Following this, the contribution of government spending to growth was almost zero in 2010, and then increased again in the ­ reat East Japan Earthquake in March 2011. aftermath of the G

CONTROVERSY ABOUT RESTORING FISCAL BALANCE Almost every­one in Japan agreed that the government’s finances w ­ ere not in good shape, but ­there w ­ ere sharply dif­fer­ent views about what should be done, divided between the pro-­fiscal-­reform and anti-­fiscal-­reform camps. Both Sustainability of Government Finances | 297

agreed that economic growth would help restore fiscal balance, but they differed on how to go about it. The former camp argued that mea­sures to fix government finances, including spending cuts and increases in both the tax base and tax rates, as well as economic reforms, w ­ ere imperative in order to restore fiscal sustainability. It highlighted the infeasibility of restoring fiscal balance without serious economic and fiscal structural reforms. The latter camp took a completely dif­fer­ ent approach, contending that countercyclical or so-­called anti-­deflationary policies w ­ ere most impor­tant. Th ­ ose who fell in this camp w ­ ere labeled the “rising-­tide-­lifts-­all-boats” school (ageshio supporters in Japa­nese). Their most salient feature was absolute conviction that more rapid growth of the economy was the central and necessary means for restoring fiscal balance. They opposed fiscal reform mea­sures on the grounds that ­these would hurt economic growth. They also maintained that higher inflation would significantly improve fiscal balance and, thus, they advocated for the Bank of Japan to adopt a higher inflation target and criticized the bank’s reluctance to do so. Naturally, the two camps also disagreed about what would happen in the absence of fiscal reform. The proreform camp pointed to the risks of capital flight from Japan, a rapid decline of the yen, and high inflation if serious reforms of government finances ­were not undertaken. The antireform camp was dismissive of ­these concerns, seeing them as unnecessarily alarmist. ­There ­were, of course, gradations of views among economists and policy makers, but I have set out ­these two archetypal camps to convey the spirit and tenor of the debate. While I believed that both extremes missed the mark, I was especially frustrated by the arguments of the antireform camp for two reasons. Fiscal reform boils down to the idea of setting the government’s finances on a sustainable trajectory of the ratio of government debt outstanding to nominal GDP. To understand my two arguments it is helpful to distinguish clearly between real economic growth and the rate of inflation. First, ­those opposed to fiscal reforms often overemphasized the positive effect of higher economic growth on fiscal balances. Of course, sustained economic growth is both desirable and necessary to creating better balance in government finances. But given Japan’s per­sis­tently high primary fiscal deficit (before accounting for debt payments), it was quite clear that it would be impossible to restore fiscal sustainability without reform of both revenues and expenditures, as many simulation results showed. The fiscal optimism of the antireform camp, in my view, reflected its rosy, unrealistically high assessment of Japan’s potential growth rate. 298 | The Days as Governor

Second, the antireform camp overemphasized the positive effect of higher inflation on the fiscal balance. With Japa­nese government expenditures ­running at almost twice the level of tax receipts, as long as (nominal) tax receipts increased at roughly the same pace as the inflation rate (and, hence, also with nominal GDP growth), improvements in the fiscal balance would be marginal. Whereas the government debt burden could be reduced through increased inflation, even if the inflation rate actually increased this benefit would only accrue to the debt already issued, the debt to be issued in the ­future would not be reduced by inflation. Moreover, the reduction of the real debt burden for bonds already issued would not be significant ­unless ­there ­were a dramatic and unexpected increase in the rate of inflation. Contrary to the antireform optimists, the elusive higher rate of inflation would not solve the fundamental prob­lem of the sizable primary fiscal deficit of Japan. I also had some uneasiness with the arguments put forward by the proreform camp. I fully agreed with its call for fiscal reform; my unease was mainly due to its frequent alarms over the risk of higher inflation or of a rapid yen depreciation, in the absence of serious reform. We w ­ ere prepared to take seriously each of ­these risks, but their prospects seemed remote to me. I thought the more plausible and more likely scenario, in the short term, was a combination of continued subdued inflation and a continued gradual decline in the growth rate due to unfavorable demographic changes and the slow adaptation of the business model of Japa­nese firms to the globalization and technology change, as explained in chapter 10. I was particularly concerned that if the gradual decline in potential growth rate was mistakenly identified as merely a cyclical downturn, further increases in the government deficit and in monetary easing would be easily justified. The result would be open-­ended fiscal expansion without any constraint. In my public comments I tried to express the fundamental logic of the need for reform without adopting alarmist rhe­toric about the imminent prospects for inflation or a rapid depreciation of the yen. Understandably, my arguments ­were criticized by the anti-­fiscal-­reform camp as misguided and by the pro-­fiscal-­reform camp as not being punchy enough.

THE NEED TO REFORM TAXATION AND SOCIAL SECURITY Successive Japa­nese governments have recognized the need to enhance the sustainability of government finances through increased economic growth and through structural reforms on the revenue side (with higher effective tax rates) Sustainability of Government Finances | 299

and on the spending side (by containing social security spending). How to implement comprehensive reform has been the difficult question. In addition to the perennial challenge of raising the consumption tax, the Japa­nese government has had to tackle the reform of the social security system. The public pension scheme was modified in 2004 ­u nder the banner of “peace of mind for the next one hundred years” with the adoption of the so-­called macroeconomic slide formula. This formula aimed at alleviating the effects of an aging population on the government bud­get by cutting pension benefits to offset the burden imposed by a rising number of pensioners on the smaller working-­age population paying into the system. As expected, the formula was quite unpop­u ­lar, even though it was actually not fully implemented. But it was only applied to the public pension program and not yet to public health care and social care programs. If the mushrooming social security outlays w ­ ere to be covered by simply increasing the contributions from the working-­age population, this would not only erode living standards of the contributing generations but would also impede capital accumulation in society, which is essential for the continued growth of the economy. The sustainability of the social security systems is dependent on several key variables. In the case of a pay-­as-­you-go public pension scheme, ­these are (1) the contribution rate; (2) the economy’s potential growth, reflecting both additions to the l­ abor force and increases in l­ abor productivity; (3) the retirement age; and (4) the level of pensions or, more specifically, the “replacement rate,” which is the ratio of pensioner income to average worker income. As I have already noted in chapter 10, productivity increases in Japan per working-­age person since 2000 have been among the highest in the developed economies, though this runs contrary to the popu­lar misconception. But the impact of the decline in working-­age population has also been very large. With per-­worker l­ abor productivity increases in mature developed economies clustered around 1 ­percent, it would be irresponsible to run the social security system u ­ nder the optimistic assumption that Japan could enjoy much higher productivity increases in the ­future. The Japa­nese public pension scheme is now in the pro­cess of raising the retirement age to sixty-­five. But this ­will not be completed ­until April 2025 for men and April 2030 for ­women. Given that Japa­ nese life expectancy is second only to that of Hong Kong, and the target retirement age at sixty-­five is on the lower end of the spectrum among developed economies, I believe that Japan ­will need to consider raising the retirement age even higher. Meanwhile, as for the replacement ratio, the crucial issue is how 300 | The Days as Governor

to define the objective of the public pension system. The desirable replacement ratio reflects a fundamental social choice. The views on social security are quite dif­fer­ent among the Japa­nese ­people and changes ­will be more difficult and are more akin to a complete rewriting of the social contract. But reforms cannot be put off forever. I fear that further delay may erode confidence in the sustainability of government finances, which in turn could devastate the lives of every­one through the instability of the monetary system.

THE RELATIONSHIP BETWEEN GOVERNMENT FINANCES AND THE STABILITY OF THE MONETARY SYSTEM In a broad sense, government debt represents a promise of repayment from the proceeds of f­ uture government tax revenues and social security contributions, both of which are paid by the ­people. The funds available for the f­ uture redemption of government debt come from ­future fiscal surpluses that are generated by aggregate tax revenues and social security contributions, less social security payouts and government spending for public ser­vices and infrastructures. The government is solvent if the net pre­sent value of ­future expected fiscal surpluses is greater than the amount of the government debt outstanding. If  that is not the case—­that is, if the government is deemed insolvent—­ conceptually ­there are three courses of action for the government. The first course is to default on the bonds issued and not repay e­ ither the interest or principal then owed. In this way, the amount of outstanding debt would be reduced by the losses imposed on the current debt holders. This would destabilize the financial system, ­because government debts are widely held by financial institutions as safe and con­ve­nient financial assets, and any default by the government would erode the capital of ­these financial institutions. ­There would also be a negative feedback loop, where instability in the financial system would negatively impact the real economy and thus exacerbate the instability of the financial system, pushing government finances deeper into the red. The mere possibility of this outcome contributed to the dynamics of the Eu­ ro­pean debt crisis. The second course is inflation. This is a policy to finance the government directly by the central bank, or an attempt to plug the hole in government finances by the central bank by expanding its balance sheet to take on the government’s debt on the asset side, while issuing more reserves on the liability side. U ­ nder this scenario, the government would avoid default by filling any Sustainability of Government Finances | 301

funding shortfalls and lowering the redemption burden in real terms through the expansion of the monetary base and the prospect of ­future inflation. The prob­lem is that by abandoning price stability, the government could ultimately undermine social stability and the fundamental conditions that sustain growth, thereby harming the w ­ hole population. Incidentally, we have to understand the nature of inflation in this context. The third course of action is to increase the net pre­sent value of ­future fiscal surpluses by reforming government finances and enhancing the potential growth of the economy under­lying fiscal solvency. Obviously, this is the most desirable scenario of the three outcomes. But in a democracy, both society and its po­liti­cal representatives need to reach a consensus on the combination of mea­sures employed to reduce government expenditures, increase taxes and social security contributions, and enact other reforms to foster real growth. As a practical ­matter, governments ­will undertake a combination of ­these with dif­fer­ent weights attached. All in all, if the sustainability of government finances is in doubt, and if this is not at some point corrected by economic and fiscal structural reforms, the central bank w ­ ill face an unenviable trade-­off between the immediate instability of the financial system and a sharp increase in the price level. It is often overlooked that the stability of the value of money requires price and financial stability and both are ultimately underwritten by the sustainability of government finances. Thus, the stability of money is not something that an in­de­pen­dent central bank can achieve solely on its own. Even if that bank has the best intentions, monetary policy ­will face the difficult choice between price and financial stability, which in ­either case threatens the stability of money, if government finances fail to be sustainable. While the in­de­pen­dence of the central bank is essential, the incon­ve­nient truth is that in­de­pen­dence by itself does not guarantee the stability of money. That stability is ultimately sustained only if the public understands the necessity of fiscal prudence and supports mea­sures necessary to ensure it.

LOW YIELDS OF JAPA­N ESE GOVERNMENT BONDS The dire straits of Japa­nese government finances are obscured from public view. Whereas on the surface every­thing appears to be normal, with no signs of financial strain or crisis, the government’s financial position may have deteriorated significantly. Consequently, anyone who warns of a prospective fiscal crisis is accused of “crying wolf.” Long-­term Japa­nese Government Bond (JGB) 302 | The Days as Governor

yields, and the government’s cost of borrowing, consistently declined during my tenure as governor, with the ten-­year yield averaging 1.17 ­percent and the thirty-­year yield averaging 2.09 ­percent. For years the efforts of overseas investors to profit from a fall in JGB prices, and a rise in yields, have failed miserably. As higher-­yielding JGBs issued in the past ­were replaced by lower-­yielding new ones, the government’s aggregate interest payments on JGBs gradually declined even as the amount outstanding of the bonds increased, from 10.8 trillion yen for the 1998 fiscal year to 7.0 trillion yen in the 2006 fiscal year. Interest payments have increased slightly since then, but still remained at 8.0 trillion yen in the 2012 fiscal year (the last year of my governorship) and, since then, at 7.8 trillion yen in the 2018 fiscal year. Why do JGB yields remain so low even as government financing needs have ballooned? This is another question I was frequently asked when I spoke in public, and the answer is rather technical. Conceptually, the level of long-­term nominal interest rates can be thought of as being composed of the expected equilibrium real interest rate (the natu­ral rate of interest) and the expected inflation rate. Thus, low nominal interest rates reflect some combination of (1) a low natu­ral rate, reflecting low growth, and (2) low inflation.6 So it can be argued that low interest rates must reflect most investors’ expectations that ­Japan’s low-­growth and low-­inflation pattern ­will persist. Even so, why are market participants not pricing a risk premium to compensate for the uncertainties due to deteriorating government finances? Perhaps investors have confidence in the ultimate willingness and ability of Japan to restore the sustainability of its government’s finances, even if the immediate prob­lems are serious. Another pos­si­ble explanation is that Bank ­ nder sustainable growth, is of Japan’s monetary policy, aimed at price stability u credible enough. ­There is also a third explanation, based on supply and demand in the JGB market, that emphasizes the role of the Bank of Japan’s large purchases in compressing the risk premiums. Indeed, the Comprehensive Easing policy, which the bank a­ dopted in October 2010, was clearly aimed precisely at lowering risk premiums as one of its principal objectives. This third explanation has become more impor­tant globally since I left the bank. I would also emphasize that our knowledge of market expectations and market dynamics is both ­limited and imprecise. We should bear in mind the famous observation of the late Rudi Dornbusch, known as Dornbusch’s law, that in finance “the crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”7 Sustainability of Government Finances | 303

THE CROSSROADS OF MONETARY AND FISCAL POLICIES The timing of any reforms in taxation and social security systems ­will be determined ultimately by elected officials in the government and the legislative body. When fiscal reforms are not forthcoming, the central bank is left with the daunting question of how to cope in the meantime. One school of thought takes the s­ imple optimistic view that “since the central bank has in­de­pen­dence, it can bring about price stability through the appropriate conduct of monetary policy” and tailor its communications accordingly. ­Those who take this view would prefer to see the central bank confine its communications narrowly to the conduct of monetary policy and to address only the relatively short time frame that it covers. I do not agree with this position. If the sustainability of government finances is in doubt, the central bank w ­ ill find itself in a condition of fiscal dominance wherein monetary policy is completely subservient to the needs of government borrowing. While many circumstances are beyond the central bank’s control, as governor I thought the Bank of Japan should be careful to avoid adopting mea­sures that would pave the way to falling into the trap of fiscal dominance. Article 5 of the Public Finance Act prohibits in princi­ple the direct financing of the government by the Bank of Japan and, thus, the government cannot issue JGBs directly to the bank. But article 5 is not a categorical prohibition, as t­ here can be exceptions with the consent of the National Diet. ­Under this exemption the bank currently swaps maturing JGBs, which it holds as a result of having purchased them in the secondary market for monetary operations, with new issues of the same amount. Article 5 is of central importance in the separation of fiscal and monetary policy, but adherence to the article alone ­will not prevent fiscal dominance. First of all, even if the Bank of Japan purchases JGBs from the market, and if ­these purchases are sizable and if new issues are purchased shortly ­after they are issued, ­there ­will be a blurring of the distinction between “direct” financing of the government by the bank and market purchases by the bank for monetary purposes. Second, if the bank automatically swaps its maturing JGBs for new issues, its JGB holdings effectively become perpetual bonds. To avoid this it is essential for the bank to retain the option to have its maturing JGB holdings redeemed by the government in cash and, in this way, the bank can maintain control over the size of its own balance sheet. Before the new Bank of Japan Act was enacted in 1998, JGBs held by the bank ­were operationally perpetual, b ­ ecause the practice then was to swap ma304 | The Days as Governor

turing issues for the same number of new issues. A ­ fter the new Bank Act came into force, ­matters improved as an agreement was reached with the ­government that the bank would swap its maturing long-­term JGBs for new issues with one-­year maturity, and that ­these one-­year JGBs would be redeemed in cash at their maturity. The treatment of maturing issues in the bank’s JGB portfolio then became a subject of some importance between the Ministry of Finance and the bank. When the ministry drew up its plans for JGB issuance for the coming fiscal year, as governor I carefully oversaw the discussions to ensure that the new arrangements would become an established practice in ­future years. Depending on the under­lying logic of monetary policy, the bank’s purchase of JGBs posed the risk of effectively morph­ing into unlimited purchases. This, in par­t ic­u ­lar, is why I took such pains for the bank’s purchases of JGBs not to be mechanically linked to a par­t ic­u­lar inflation target.

THE BANK OF JAPAN’S EXTERNAL COMMUNICATIONS REGARDING FISCAL ISSUES A central bank’s public statements about fiscal issues always require delicate ­handling. As a general rule, central banks refrain from commenting on specific fiscal policy decisions. Imposing taxes, specific government spending plans, and the issuance pattern of government bonds are each manifestations of sovereign power and are also both direct and indirect interventions in the allocation of resources in society. In most advanced economy democracies ­these fiscal decisions, which intervene in the other­wise market-­based allocation of resources, are reserved for our elected officials. While we think of monetary and fiscal policy as distinct sets of policies, is the conduct of monetary policy completely ­free of intervention in the allocation of resources? Why can the central bank conduct monetary policy without being directly controlled by the government or the legislative body? We take comfort from the idea that central banks refrain, as much as pos­si­ble, from decision making of a fiscal nature. The central bank supplies money (liquidity) by purchasing government bonds or by lending to financial institutions against financial-­asset-­based collateral, including government bonds. Even when central banks purchase government bonds, how the money so obtained is to be spent w ­ ill be de­cided on by the government and the legislative body. If losses are incurred on government investment proj­ects, this w ­ ill reflect decisions made by the government and the legislature ­under a demo­cratic pro­cess. Sustainability of Government Finances | 305

Meanwhile, in the case of money provided by the central bank to financial institutions, its use w ­ ill be de­cided by the decisions of ­those financial institutions, and any losses that arise must be borne, at least in the first instance, by the shareholders or unsecured creditors of ­those institutions. Seen in this way, the central bank appears to be neutral in terms of resource allocation and income distribution. In the aftermath of the GFC—­and particularly now, a­ fter the crisis brought on by the COVID-19 virus—­the conduct of monetary policy can no longer be described by this conceptual framework. As governor, however, I made it a rule not to lose sight of the impor­tant limitations of the role of the central bank and to reflect them in the bank’s communications, as best I could—­not least when making policy decisions. Th ­ ere ­were two policies that posed particularly awkward difficulties in this regard. One was when the bank attempted to compress credit spreads as a part of its unconventional monetary policy mea­sures. In order to maintain as much neutrality as pos­si­ble, we prioritized the purchases of financial assets, such as asset-­backed commercial papers, exchange-­ traded funds, and real estate investment trusts that w ­ ere composed of a diverse cross-­section of under­lying assets. The second was when the bank began expanding its purchases of JGBs and was concerned that this could weaken fiscal discipline, thus contributing to yet greater JGB issuance in the ­f uture. Unfortunately, ­there was no effective tool to mitigate this risk, and all that the bank could do was express its intentions as clearly as pos­si­ble. During the first two years of my tenure as governor I refrained from proactively commenting on the conduct of fiscal policy in press conferences and public speeches. Like many central bank governors, I felt that anything specific I said concerning fiscal policy would both be unwelcome by members of the government and the National Diet and, in turn, could invite their meddlesome interventions into the conduct of monetary policy. I thus tried to be careful about what I said. But I was naive in hoping for reciprocal nonintervention. Despite my restraint, ministers, members of the Diet, and even se­nior public servants all increasingly took the liberty of publicly commenting on the bank’s monetary policy. In my third year as governor, I moderated my self-­imposed restraint and began to state my opinions more clearly. Th ­ ere w ­ ere two reasons for my change of heart. One was my renewed attention to the decline in Japan’s potential growth rate and its consequences for the sustainability of government finances in the ­future. The other was my alarm at the increasing po­liti­cal clamor for direct financing of the government by the Bank of Japan and other excessive 306 | The Days as Governor

demands on monetary policy. Yet I still drew a line and did not step into po­liti­ cal debates on specific spending items and tax provisions. My aim was to impress upon the public that fiscal sustainability was the prerequisite for stability of currency and, within that bound, I spoke out actively. An example was my speech at a meeting of the Japan Society of Monetary Economics in May 2011 titled “Money, Government Securities and a Central Bank: Interde­pen­dency of Confidence,” where I stressed the importance of confidence at the outset: Let me first emphasize that money and the financial systems are essential for sustained economic growth, and that confidence in them is the most impor­tant foundation for money and the financial system to perform their roles. The starting point is obviously the efforts to maintain the confidence by the government, the central bank and private financial institutions, respectively. The government has to maintain fiscal balance in the medium-­to long-­run. The central bank has to maintain stability in prices and the financial system through the conduct of monetary policy and the lender-­of-­last-­resort function. Private financial institutions have to provide payment and settlement ser­vices and the credit intermediation function properly.8 While few would doubt the importance of confidence, I was trying to stress not just the importance of confidence, per se, but the “interde­pen­dency of confidence”: ­ ose individual efforts are impor­tant, but they alone are not sufficient to Th achieve stability in money and the financial system. Confidence in private financial institutions depends on confidence in the government as well. To maintain confidence in the government, achieving the medium-­to longterm fiscal balance is an impor­tant precondition. Support by the public is also essential in achieving the fiscal balance. Confidence in government securities is underpinned by confidence in the central bank. Confidence in the central bank may be enhanced if the government and ­people re­spect the central bank’s judgments, and it may be eroded if not. In other words, confidence in money and the financial system are interdependent on each other. Confidence is something like the air; nobody doubts about its existence at normal times. Confidence may wane in a discontinuous manner ­unless we make utmost efforts to maintain it. Once confidence is lost, the impact on the economy is enormous. Confidence is fragile.9 Sustainability of Government Finances | 307

Confidence w ­ ill only be sustained if the government, the central bank, financial institutions, and citizens understand its importance and are prepared to act on that understanding.

REALIZING A COMPREHENSIVE REFORM OF THE SOCIAL SECURITY AND TAX SYSTEMS ­ ere is a long history of fiscal reform efforts in Japan. Concentrating on the Th years during and ­after my governorship, even the big spending package enacted in the wake of the collapse of Lehman ­Brothers in the autumn of 2008 did not completely derail the pro­cess of reform. The tax package enacted in March  2009, in Supplementary Article 104, stipulated, “The Government ­shall . . . ​with the understanding that the economy should improve through intensive efforts aiming at economic recovery during a maximum of three fiscal years beginning with the 2008 fiscal year, without delay, and in steps undertake comprehensive reforms of the tax system including the consumption tax, culminating in necessary legislative mea­sures by the 2011 fiscal year.” The co­ali­tion led by the Demo­cratic Party of Japan (DPJ) that came to power in September 2009 encompassed disparate and competing macroeconomic policy preferences. This was no dif­fer­ent from the previous co­a li­tion government led by the Liberal Demo­cratic Party (LDP). But momentum for reforming the social security and tax systems became noticeable ­under the government of the DPJ, particularly as expressed by Naoto Kan, the deputy prime minister and finance minister, in February 2010 (see chapter 11). Shortly thereafter, Kan became the prime minister when Yukio Hatoyama had to resign. Kan abruptly and unexpectedly advocated increasing the consumption tax rate to 10 ­percent in the run-up to the July 2010 election for the members of the House of Councillors. But in that election the DPJ was heavi­ly defeated, and the control of the two ­houses of the National Diet changed hands again. Meanwhile, the LDP, which was in opposition, insisted on the quickest pos­si­ble consolidation of government finances ­after the fiscal expansions in the wake of the GFC. Accordingly, in order to set a target for fiscal consolidation, in October 2010 the LDP tabled the Fiscal Consolidation Responsibility Bill, which aimed to cut the primary deficit in half by the end of March 2016, and returned to primary fiscal surplus (excluding interest payment on government debt) by the end of March 2021. The next efforts to improve government finances began with the New Year’s Address of Prime Minister Kan, on January 4, 2011, in which he called for cross-­ 308 | The Days as Governor

party debate on the necessary fiscal reforms. This was followed up on January 14, when Kaoru Yosano, a former LDP member well known for his advocacy of fiscal prudence, was appointed as the state minister responsible for economic and fiscal policies and was charged with leading the deliberations on social security and tax reforms. Just two months ­later t­ hese reform efforts ­were nearly blown off course by the G ­ reat East Japan Earthquake. Significant reconstruction spending became inevitable, and this led to an intense debate about direct financing of the government by the Bank of Japan (see chapter 13). Social security and tax reform initiatives staggered on in this environment, undermined by the divided Diet and fragile support for Prime Minister Kan within the DPJ. Even so, Kan’s draft bud­get in May 2011 included an increase ­ fter several rounds of po­liti­cal drama, of the consumption tax to 10 ­percent. A the cabinet fi­nally gave its informal consent on July 1 to plans that included a staged increase in the consumption tax to 10 ­percent by the ­middle of the 2010s and a commitment to enact the necessary laws by the end of March 2012. But then Prime Minister Kan abruptly resigned. As the succession was contested by five members of the DPJ, I was initially disheartened ­because, with the exception of Yoshihiko Noda, ­every candidate promised “reflationista” economic policies. Fortunately, Yoshihiko Noda won. Noda was elected prime minister on September 2, and in the new cabinet Jun Azumi became finance minister. Given the divided parliament and policy differences within the ruling co­a li­t ion, it was a rocky pro­cess to have the informal consent of the cabinet be backed by the governing parties. In the end, however, Noda’s cabinet succeeded in tabling a bill, the Social Security/ Tax Integrated Reform Law, that included provisions to raise the consumption tax from 5 ­percent to 10 ­percent on March 30, 2012. In order to make this happen, a supplementary article in the bill called for the government to “implement necessary mea­sures including comprehensive policies so as to attain a desirable path for economic growth,” where the desirable path was understood to be 2 ­percent real growth and 3 ­percent nominal growth over the next ten years. Social security and tax reforms w ­ ere also an impor­tant agenda item in exchanges between the government and the Bank of Japan. I especially recall a private breakfast meeting that I had with Prime Minister Noda on April 6, 2012, shortly ­a fter the bill was tabled, during which we exchanged views on fiscal policy. I explained my views that confidence in the sustainability of ­government finances was the cornerstone of both price and financial stability and that reforms on both the revenue and expenditure sides, including tax Sustainability of Government Finances | 309

r­ eforms, ­were essential. I let the prime minister know that I would be more active in p ­ ublicly explaining the necessity of fiscal consolidation but that I also thought it would still be difficult to hit the growth target of 2 ­percent real growth and 3 ­percent nominal growth given demographic and productivity trends. Noda seemed to be aware that such a target might be overly optimistic, but he also appeared to accept that the establishment of ­these goals was po­liti­cally necessary to advance the reforms of social security and taxes to the next stage. The bill to raise the consumption tax rate was amended following an agreement on June 15 among representatives of the major po­liti­cal parties and was approved by the House of Representatives on June 26. I thought that this agreement was an action that showed considerable courage and responsibility by ­ eople, particularly given the convoluted inthe elected representatives of the p traparty politics of the time and public reluctance to support social security and tax reform. ­There ­were more ups and downs, but fi­nally, on August 10, the tax increase was approved by the opposition-­controlled House of Councillors and it became law, with the LDP and the New Komeito party voting for the bill, fifteen years ­after the previous increase in the consumption tax in 1997. As a result, the tax rate was stipulated to be increased to 8 ­percent in April 2014 and then to 10 ­percent in October 2019, though the second increase was postponed two times.

JAPA­N ESE ECONOMISTS’ VIEWS ON FISCAL POLICY Many Japa­nese economists who argued for aggressive monetary easing ­were not so vocal about the active use of fiscal policy. Some of them called for fiscal expansion financed by the Bank of Japan’s direct purchase of JGBs. But even they did not call for active use of fiscal policy on a stand-­a lone basis, notwithstanding the extremely low borrowing costs. This was in a stark contrast to the situation in other developed economies. Policy makers and economists in the United States w ­ ere more balanced. For example, the chair of the Federal Reserve Board, Ben Bernanke, often warned against the economic impact of “fiscal cliffs” resulting from large cuts in government spending or tax hikes. Several years ­later, a­ fter I had left the Bank of Japan, the leadership at the central banks in both Eu­rope and the United States ­were still calling for more active use of fiscal policy on the ground of ­limited monetary policy space.

310 | The Days as Governor

I do not know why Japa­nese economists have remained so quiet, nor have I understood how they have assessed the effectiveness of fiscal policy. Perhaps recognition of Japan’s dire fiscal situation has made them reluctant to advocate the active use of fiscal policy. But I think it was, more importantly, an optimistic belief in the effectiveness of monetary policy mea­sures that was responsible for their silence.10 The starting point was often the famous quote from Milton Friedman that “inflation is always and everywhere a monetary phenomenon.” Friedman did not say that “deflation is always and everywhere a monetary phenomenon,” but many Japa­nese economists held this up as a corollary. Inflation may be a monetary phenomenon, but it is an extreme position to argue that any fiscal shock, including tax increases, can be offset by monetary policy. I have never been an advocate of big government per se. I believe that it was sensible to deploy expansive fiscal policy in the aftermath of situations like the GFC and the G ­ reat East Japan Earthquake, but once the critical phase of stabilization or reconstruction is over, I do not believe that open-­ended, debt-­financed government spending ­will solve the fundamental prob­lems facing the Japa­nese economy.

THE TAKAHASHI FISCAL POLICY Japa­nese economists often speak of active fiscal policy when discussing the coordination of monetary and fiscal policy, particularly when they praise the policies of Korekiyo Takahashi, who became finance minister for the fourth time in December 1931.11 The Takahashi Fiscal Policy is the name given to both the fiscal and monetary policies ­adopted during this period. On the day in 1931 when he took office, Japan came off the gold standard, three months a­ fter Britain had done so. Takahashi deployed expansionary fiscal policy funded by issuing JGBs directly to the Bank of Japan, and his policies are often cited as a successful example of combining monetary and fiscal policy.12 But, in my view, the Takahashi Fiscal Policy does not offer useful guidance for the challenges that Japan has faced since the 1990s, and during my years as governor of the Bank of Japan, ­because of the stark differences in the economic and financial environment that characterized the Takahashi era.13 First, the health of government finances was quite dif­fer­ent. Just before the Takahashi Fiscal Policy was implemented, the level of JGBs outstanding was 47.6 ­percent of GNP, a mere trifle compared with the 200 ­percent level of recent years.

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Second, regarding the depreciation of the yen during the time of the Takahashi Fiscal Policy, it was merely the result of the correction of an artificially high exchange rate when Japan came off the gold standard. This was again completely dif­fer­ent from the modern situation, where Japan has had a floating currency for many de­cades. On top of that, the state control of cross-­border capital flows was quite dif­fer­ent at the time. Finance Minister Takahashi strengthened capital controls before commencing bond purchases by the Bank of Japan so as to prevent capital flight. Fi­nally, Japa­nese domestic financial markets ­were much smaller in Takahashi’s time, and the government bond market was less developed. It was not pos­si­ble then to sell a large number of JGBs quickly and without a hitch, and the usual practice for raising funds was to approach the underwriting syndicate or­ga­nized by private financial institutions or to have the bonds purchased by the Government Deposit Bureau, into which postal savings ­were funneled. Moreover, at least during the first few years of the Takahashi Fiscal Policy, before Takahashi was assassinated, the Bank of Japan sold the purchased bonds quickly to the public; the amount of bonds held by the bank, which influences the monetary base, did not increase significantly. By contrast, in modern Japan, t­here is a well-­functioning JGB market through which the government finds no difficulty in issuing bonds. This discussion of the Takahashi Fiscal Policy is, in effect, about the “entrance” to fiscal dominance. But in adopting an unconventional combination of fiscal and monetary policies, it is also necessary to consider strategies for the “exit.” Finance Minister Takahashi prudently attempted to put a brake on the burgeoning military expenditures as the economy recovered, which led to his tragic assassination in a failed coup d’état on February 26, 1936. The consequence was inflation, which certainly suggests that the Takahashi Fiscal Policy failed in its exit. The lesson to be drawn is not that Takahashi could not prevent mushrooming military expenditures by a quirk of fate but that direct financing of the government, unchecked by the market, led to an uncontrollable expansion of fiscal expenditures. It is noteworthy that direct financing began, in Takahashi’s own words, as an “expediency”: in a speech before the Imperial Diet, he stressed that direct financing was only a temporary mea­sure. But history has shown other­wise. Deputy governor Eigo Fukai, who presided over the direct financing on the part of the Bank of Japan at the time and ­later became the thirteenth governor, wrote an in­ter­est­ing story in his memoir Seventy Years in Retrospect. Written in 1941, ­after Fukai had left the bank and just before Japan entered World 312 | The Days as Governor

War II, it describes a meeting he had with Émile Moreau, governor of the Bank of France, during a visit to Eu­rope shortly a­ fter the start of direct financing: “The method of issuing Government bonds, where the Bank of Japan directly purchased them from the Government, came up in many conversations during my visit to Eu­rope, and most ­people readily praised it as a clever idea. Against that backdrop, Governor Moreau was not willing to evaluate it. He did not criticize, but he also did not offer indulgent words. He would only say that it was ­going so far so good. His words ­were so philosophical, and he would repeat the same line over and over.”14 I can only speculate as to what was on Moreau’s mind. And I cannot know what Fukai was thinking in 1941 ­after he had resigned as governor. But in my reading, Fukai seems to be asking the question of ­whether, in managing money itself, we should entrust decision making to a few wise men or ­whether we should rely on a system that puts the decision makers u ­ nder an external discipline. Fukai does not ask this question explic­itly and he does not give any answer. My own review of history points to the latter answer as the better course. If wisdom would always prevail, in the conduct of public policy, t­ here would be no need for rules prohibiting the direct financing of the government by the central bank. Given our imperfect understanding of the economy and financial markets, and the delays and biases that characterize h ­ uman decision making, a lesson that I have learned is that we should not belittle the importance of rules.

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| CHAPTER SIXTEEN |

Enhancing the Stability of the Financial System In the aftermath of the global financial crisis (GFC) of 2007–9, macroeconomists and policy makers in the developed economics have come around to the idea that financial stability is impor­tant for achieving sustainable economic growth. Viewed from Japan, this is overdue but encouraging. Previously, financial crises tended to be viewed as something that only happened to emerging and developing economies. A ­ fter the GFC, however, developed economies could no longer take financial stability for granted. To prevent the buildup of financial imbalances that engender crises, numerous efforts ­were undertaken to strengthen the regulation and supervision of financial institutions. This is laudable. But ­there remain ideological and institutional hurdles to an integrated understanding of the role that financial stability plays in sustainable growth. In par­tic­u­lar, t­ here is a lingering orthodoxy that insists on treating price stability and financial stability as distinct objectives and on assigning monetary policy to the former and financial regulation and supervision to the latter. I consistently challenged this “separation princi­ple” throughout my time as governor of the Bank of Japan.

THE STABILITY OF THE FINANCIAL SYSTEM While ­those who have experienced a financial crisis can recognize the significance of financial stability, p ­ eople who have not w ­ ill find it more difficult to understand. In times of financial crises our routine uses of money, credit, and other financial ser­vices become difficult to enjoy. If ­there is a bank run, and depositors alarmed at the prospect of not being able to withdraw deposits immediately demand the withdrawal of their funds all at once, banks ­will not be able to

314

lend. If this happens at bank a­ fter bank, in a chain reaction, national economies can grind to a halt. In financial markets, where firms normally trade with each other, t­ here w ­ ill be heightened concerns about the risk that a trading counterparty may fail, and this ­will also hinder both lending and borrowing among financial firms. As the willingness of financial firms to trade and transact decreases, the prices available on large-­scale transactions can change abruptly, reducing market liquidity and negatively impacting the “price discovery” function of the market. This would also make it difficult to strike deals in the derivatives markets, impairing the ability of both financial institutions and nonfinancial businesses to manage, or hedge, the risks they face in their borrowing and in their buying or selling of foreign currencies. All of ­t hese ­things w ­ ill impede the flow of funds from t­ hose who have them to t­ hose who need them and thus w ­ ill reduce economic activity. To maintain financial stability we need both to prevent financial crises from occurring and to contain their consequences when they do occur. For some years a­ fter World War II, t­ here w ­ ere no serious financial crises in the more developed economies, and as a consequence, crises came to be regarded as something that only emerging and developing economies suffered. Japan was one of the few developed countries to learn that this was not so by suffering through a serious financial crisis in the 1990s. But the notion that one economy can be singled out as “dif­fer­ent” was completely undermined by the GFC and the serious harm that it brought to the advanced developed economies. Reflecting on the GFC, we have all been forced to reconsider what it w ­ ill take ­ ere are two requisites: one to maintain the stability of the financial system. Th is to build a financial system that is resilient enough to withstand any likely shock, and the other is to prevent sowing the seeds of crises by preventing excesses in the be­hav­ior of financial institutions, nonfinancial businesses, and ­house­holds. To this end, financial institutions are required to hold sufficient buffers of capital and liquidity to survive shocks and are subject to vari­ous regulations. They are also subject to supervision by relevant authorities, not only to ensure that they are following applicable regulations but also to monitor ­whether they are soundly managed. Since management and operations differ from one firm to another, supervision needs to be tailored to take account of specifics of each supervised institution. ­These efforts focused on financial institutions are impor­tant, but t­ here inevitably exists a perimeter between the supervised and the nonsupervised, such as nonfinancial businesses and ­house­holds.

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THE TRAGEDY OF THE COMMONS The stability of the financial system is said to be a bit like the air around us: invisible but essential. We are often oblivious to its value and can enjoy or consume it without paying for it. A single financial institution may aggressively increase leverage and invest funds in risky financial assets. In this way, the institution consumes financial stability and increases its profits but does not immediately reduce the consumption of stability by o ­ thers. But if other financial institutions follow suit, increasing their own leverage and expanding their investments in risky assets, the financial system as a ­whole may end up holding excessive risk, creating the possibility of a financial crisis in the ­f uture. Thus, excessive consumption by some can deplete availability so that nobody can consume the ser­vice of financial stability in the ­future. In that sense, consuming the ser­vice of financial stability is quite costly, not ­free. Financial stability is often described as an example of the “tragedy of the commons.”1 The term commons refers to resources, such as grazing land or the seas, that can be used by more than one person. A herder who owns a parcel of grazing land is likely to adjust the number of ­cattle so that the land ­will not be overgrazed and depleted. But if the land in use is public or common land, the same herder would be likely to continue adding c­ attle b ­ ecause o ­ thers ­entitled to use the land are likely to increase their herds and diminish that herder’s return even if the herder holds back. As long as herders freely use ­ ill be depleted, the common grazing land, the resource of the grazing land w harming ­every herder in the end. The same mechanism lies ­behind the prob­ lem of excessive consumption of financial stability. One solution to the tragedy of the commons is to establish clear rights of use, which would thwart overgrazing or overfishing. But ­t here are also the commons of financial stability, where it is not pos­si­ble to establish ­these types of use rights. Consequently, consumers of financial stability, including participants in financial markets who are not subject to any rules on usage and do not have to pay for the usage, ­will attempt to maximize their own benefits accruing from financial stability. They may pursue profits by, for example, increasing leverage or taking on more maturity mismatches (e.g., borrowing short and lending long). While such transactions individually might be a drop in the ocean from the perspective of the ­whole economy, t­ here would be an overuse of financial stability when more and more ­people do the same, ending in a financial tragedy of the commons.

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We can also think of maintaining financial stability, and preventing financial crises, in the same way we think about forest fires. Two types of fire prevention mea­sures are essential. One is to build effective “firebreaks” that consist of efficient and resilient payment and settlement systems. The other is to “watch for smoke,” which for financial stability means to establish effective regulation and supervision of financial institutions. Moreover, considering that wildfires tend to start when the air is too dry, policy makers must be especially mindful that the conduct of monetary policy, which influences macrolevel economic and financial conditions, can itself stimulate exactly the conditions of leverage and risk taking that should be of par­tic­u­lar concern.

ESTABLISHING EFFICIENT AND RESILIENT PAYMENT AND SETTLEMENT SYSTEMS Central banks are vested with a wide range of payment and settlement ser­ vices, and the Bank of Japan is no exception. I have already illustrated the bank’s ­ reat East ser­v ices relating to the issue of banknotes on the occasion of the G Japan Earthquake (see chapter  13). ­Here I ­w ill describe the bank’s ser­v ices related to large-­value payments, which are affected through current accounts at the bank. The Bank of Japan operates an electronic payment system called BOJ-­NET that connects private financial institutions and the bank. Most yen-­based financial market transactions, including ­those in short-­term money, foreign exchange, and the bond and stock markets, are ultimately settled through current accounts at the bank using BOJ-­NET. The bank also offers settlement ser­vices to a private payment mechanism called the Zengin System, which is used for fund transfers smaller than 100 million yen between businesses and individuals. The efficiency and resiliency of Japa­nese payment and settlement systems have been enhanced over the years through reform efforts by stakeholders.2 While such initiatives confer significant long-­term benefits on society, they are less likely to occur if left to the private sector alone. The long-­term returns are not readily vis­i­ble, particularly where the immediate costs for updating computer systems are high. Consequently, in many countries, the central bank plays a catalytic role, and the Bank of Japan is no exception. I first worked on payment and settlement systems when I was a relatively ju­nior member of the bank’s staff. I saw the extremely long time frames over which improvements in ­these systems had to be pursued, as the ball was passed

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on from one generation of staff to another. When I became governor, I took special care to follow this work and to emphasize the importance of our banking operations in my messages addressed to bank staff. Business continuity planning—­that is, sustaining operations in the face of unforeseen events—is essential to the resilience of payment and settlement systems. This was especially evident during the G ­ reat East Japan Earthquake. To Japan’s payment system ­ r unning smoothly, key staff members ­were rekeep quired to be able to quickly return to their stations in any emergency. For my part, when I was an executive director in charge of payment and settlement systems, ­every other week I would spend the night in quarters where I could return promptly to the bank on short notice.

THE INTERNATIONAL FRAMEWORK FOR DEVELOPING FINANCIAL REGULATORY STANDARDS Financial regulations are written and enforced by the national authorities of each country, but the pro­cess for developing the princi­ples, and many of the specifics, of regulations have gained an international dimension that reflects the globalization of financial markets and institutions. If each country goes about regulation in its own way, financial activity ­w ill shift to locations where regulations are the most lax. This can eventually destabilize the ­whole global financial system and thus compromise domestic financial stability for individual countries. Beginning almost fifty years ago, the practice has gradually evolved for the representatives of national authorities from around the world to discuss and then develop international standards that each country ­will then set in their regulations, which follow the agreed-­ upon global standards. One of the early fruits of the pro­cess was the Basel Accord, which was a set of regulations on the minimum capital requirement for financial institutions. The first set of ­these regulations, called Basel I, came into being in 1987. The Basel Accord has been revised since then, taking into account changes in the business of finance, and Basel II was being implemented when the GFC struck. Following the crisis, discussions on ­Basel III began in earnest. The pro­cess leading up to international consensus on financial regulations is especially notable for the breadth and complexity of the subjects that are covered and, thus, the wide range of authorities that must be involved. Many countries have separate regulatory authorities for banks, securities ­houses, and insurers. Accounting rules are essential for evaluating the soundness of finan318 | The Days as Governor

cial institutions and affect disclosures by all issuers of financial securities. But accounting rules are usually written not by the financial regulators but by specialized standard-­setting bodies for accounting rules. Moreover, while the framework for resolving troubled financial institutions has impor­tant implications for financial stability, bankruptcy rules fall outside the competence of most financial regulatory authorities. To develop effective standards for financial regulation in such a complex and diverse environment requires both expertise and legitimacy. A body with full global membership, such as the United Nations, might confer legitimacy but would be challenged in developing a meaningful consensus on highly technical subjects over relatively short periods of time. Discussion among a smaller number of economies might be practical and efficient but wanting in terms of legitimacy, and if the membership is too narrow, any emerging consensus might not be widely ­adopted and thus would be less effective. When Basel I came into being, discussions ­were led by a group of developed economies that came to be commonly known as G10 (the Group of Ten). As emerging economies gained more and more prominence on the international stage, ­there was increasing awareness of the need to reflect their greater share of the world economy and the number of economies participating in the discussions was increased gradually. T ­ oday the Financial Stability Board (FSB) is entrusted with decision making in the area of financial regulation, which is a good compromise, balancing expertise and legitimacy.3 The board comprises representatives of twenty-­five economies and ten international bodies, and the Japa­nese del­e­ga­tion is composed of representatives of the Bank of Japan, the Financial Ser­vices Agency, and the Ministry of Finance. When I was governor, Mario Draghi was the FSB chair.4 Pro­gress in rule making is reported by the FSB chair to the meeting of finance ministers and central bank governors of G20 economies, and the result of discussions are, in turn, delivered to and approved by the G20 Summit, which is a forum for po­liti­cal leaders of the world’s leading economies. This arrangement reflects the fact that the G20 framework was deemed to be the premier forum for international economic cooperation at the Pittsburgh G20 Summit of September 2009. How does the FSB develop the consensus to establish global norms and rules? In some cases the board itself conducts its own discussions. But more often it receives reports and other inputs that reflect discussions and consensus at vari­ous other international forums of regulators and supervisors. The development of banking regulations undertaken by the Basel Committee on Banking Supervision (BCBS) is just one example of the pro­cess. The BCBS is The Stability of the Financial System | 319

composed of representatives of twenty-­eight economies, and ­these representatives usually come from both the financial regulators and the central banks; in the case of Japan, experts from the Bank of Japan and the Financial Ser­ vices Agency are members. The BCBS also has u ­ nder its wings vari­ous working groups that deal with specific issues requiring expertise. In this multitiered framework, even if legitimacy is bestowed by the final approval of the leaders of the G20, t­ here is still a question of who is accountable for approving expert opinion before G20 Summit meetings. Before the G20 was created, meetings of G10 central bank governors, and regular meetings of the Bank for International Settlements, had the last word. But ­because of its ­limited geographic scope, and ­because in a number of countries central banks did not have regulatory and supervisory powers, this arrangement lacked legitimacy. Taking this into account, the Group of Governors and Heads of Supervision (GHOS) was established in order to give approval to expert agreements on banking regulations.

THE LAUNCH OF INTERNATIONAL REGULATORY REFORM EFFORTS The review of financial regulations began soon a­ fter the onset of the GFC. In October 2007, just two months a­ fter the incident involving funds sponsored by the French bank BNP Paribas, the G7 finance ministers and governors asked the Financial Stability Forum to examine the ­causes of the stresses and the necessary responses. The forum, which was the precursor of the FSB, reported back to ministers and governors at their meeting in April 2008, which was the first such meeting I attended as governor. From then on, many forums, including the BCBS, embarked on extensive reviews of regulatory frameworks. The reform efforts w ­ ere wide-­ranging. Discussions first began on strengthening capital adequacy rules for financial institutions; the introduction of more stringent liquidity regulation followed. Work also began on the development of an effective framework for resolving internationally active financial institutions to address the prob­lem of firms being “too big to fail.” In addition, vari­ous streams of work began to address the lack of effective regulation over the shadow banking sector, which was perceived as a major cause of the GFC. Changes in the institutional framework of financial regulation and supervision are almost always prompted by financial crises. In Japan, for example, bank examinations by the Bank of Japan began a­ fter the 1927 financial crisis. 320 | The Days as Governor

The new Bank of Japan Act—­which explic­itly stipulated the responsibility of the bank for the financial system—and creation of both the new Financial Ser­ vices Agency (initially the Financial Supervisory Agency) and a resolution framework for financial institutions were responses to the financial crisis that ­ ubble. In the United States, the Federal followed the bursting of the Japa­nese b Reserve System was created following the Panic of 1907, and the G ­ reat Depression gave birth to the Federal Deposit Insurance Commission and the Securities and Exchange Commission. The BCBS, as well as the pre­de­ces­sor ­ ere both created of the current Committee on Payments and Infrastructures, w in a response to the failure of Herstatt Bank in 1974, which shook the global financial system at the time.

CAPITAL ADEQUACY RULES The Bank of Japan took an active part in the discussions on the reform of financial regulations in the wake of the GFC, which made it apparent that Eu­ ro­pean and US financial institutions did not have sufficient capital to cushion the risks that manifested themselves in the crisis. Accordingly, rules on required capital ­were strengthened ­after the GFC, both in terms of quantity and quality. As to quantity, minimum capital levels w ­ ere raised substantially, and as to quality, the definition of what would be regarded as capital was tightened and more emphasis was placed on core tier 1 capital, which consisted of common equity and retained earnings. The most contentious international discussions focused on the margin of increase in minimum capital and the date by which banks would have to meet ­these new minimum standards. In general, the authorities from Switzerland, the United Kingdom, and the United States sought higher levels of required capital while the authorities from France, Germany, and Japan tended to support more moderate increases. The countries demanding higher capital ­were ­those that had experienced the more severe financial strains during the GFC. For our part, Japa­nese authorities recognized the need for higher capital but also w ­ ere concerned about the impact on economic activity of too rapid a change in the level of required equity. As the issue was debated t­ here ­were analyses on the macroeconomic impact of higher capital standards at the BCBS, and the Bank of Japan contributed to the effort through conducting a simulation, using its macroeconomic model explic­itly linking the financial sector and the macroeconomy, and producing a report that underscored the Japa­nese position. ­A fter much back and forth, the broad framework of new capital The Stability of the Financial System | 321

standards was approved by the GHOS in July 2010; liquidity rules (explained below) and the specific levels of minimum capital ­were approved by the GHOS in September 2010.

ENHANCED DISCLOSURE OF INTEREST RATE RISK The capital adequacy rules cover credit, market risk, and operational risk, but interest rate risk is also an impor­tant prob­lem financial institutions must confront. Most financial institutions, like banks, fund themselves with relatively short-­maturity liabilities in the form of deposits and short-­term debt issued to investors. The maturity of their assets tends to be much longer in the form of loans and securities they have purchased. In normal times, long-­term interest rates are higher than short-­term rates, and financial institutions earn on this positive spread. When monetary policy is tightened, short-­term interest rates normally rise, and this spread then narrows or can even turn negative if short-­ term interest rates are higher than long-­term ones. The risk of changes in earnings due to fluctuations in interest rates is called interest rate risk. Before the GFC, interest rate risk was not reflected in capital adequacy regulations but was to be carefully monitored by both management and supervisors. Interest rate risk is particularly impor­tant to the transmission mechanism of monetary policy. Monetary easing begins with the lowering of short-­term interest rates. This is expected to support economic activity through two channels: one is the be­hav­ior of borrowers, who would, eyeing the lowering of the general level of interest rates, increase their borrowing from banks or their issuance of bonds; the other is the be­hav­ior of banks that would increase lending when short-­term rates fall, giving them a stronger incentive to lend or invest in securities b ­ ecause of the widening of margins given their balance sheet structure of borrowing short and lending long. Increased lending is thus one of the most impor­tant transmission channels for monetary easing to stimulate the economy. But if financial institutions assume interest rate risk beyond their risk-­bearing capacities and interest rates are then raised in response to improving economic conditions or rising prices, lenders’ profitability can deteriorate abruptly b ­ ecause of their own narrower spreads and as their borrowers’ ability to repay may suffer. Their impaired lending capacity could, in turn, adversely affect the real economy. Accordingly, the treatment of interest rate risk in financial regulation is impor­tant not only from the perspective of financial supervisors but also from that of monetary policy makers. International discussions about interest rate risks at the BCBS 322 | The Days as Governor

continued throughout my tenure as governor of the Bank of Japan. A standard was agreed upon in April  2016 and subsequently implemented, which mandated enhanced disclosure of interest rate risk by banks.

LIQUIDITY REGULATION The GFC revealed that Eu­ro­pean and US financial institutions lacked not only adequate capital but also sufficient liquidity to meet their obligations in conditions of stress. Reflecting on this, international authorities eventually agreed to introduce a new set of regulations on liquidity risk borne by financial institutions. The new Liquidity Coverage Ratio was introduced, which required the holding of par­tic­u­lar high-­quality liquid assets, including central bank deposits and government bonds at least equal to each firm’s net expected outflow of funds over one month. Liquidity regulations, by influencing the composition of assets held by private financial institutions, affect firm-­level profitability and, notably, the macroeconomy. If liquidity regulation is too stringent, banks w ­ ill be l­ imited in the extent to which they can perform their impor­tant economic role of maturity transformation—of turning short-­term liabilities (like deposits) into longer-­ term assets (like loans). This is of importance for monetary policy through the impact of credit availability on economic activity and b ­ ecause monetary policy is, in part, affected through the level and distribution of reserves—­and, thus, the liquidity—of financial institutions. Central banks also play the role of “lender of last resort” to banks precisely to ensure that banks can meet their liquidity needs in circumstances of stress. The ability of banks to draw on central banks’ standing facilities also needs to be considered in thinking about their a­ ctual minimum liquidity needs. Fi­nally, the liquidity of banks has been influenced by quantitative easing, which has, in many cases, created a huge overhang of the deposits held by banks with the central bank. While existence of the Liquidity Coverage Ratio may not be a constraining f­actor for central banks when they are expanding their balance sheets, it might be relevant when central banks head ­toward an “exit” and try to reduce their balance sheets.

MACROPRUDENTIAL POLICIES In the wake of the GFC, on top of enhanced supervision and regulation, interest in macroprudential policies has increased tremendously.5 That regulatory policies should focus not just on the soundness of individual firms but, The Stability of the Financial System | 323

more broadly, on risks in the financial system as a w ­ hole was not a novel idea in 2009. Indeed, the term macroprudential policies was already in use when the Bank of Japan established its Financial System Department in 1990. Given the systemic failures that appeared to contribute to the GFC, the issue now was how to put flesh on the bones of the concept. ­After the GFC, countries that a­ dopted variable macroprudential policy instruments increased. Th ­ ese instruments intended to influence the risk-­bearing activities of individual institutions in the light of changing macrolevel financial conditions. Even before the GFC, some countries—­especially emerging ones—­had introduced mea­sures to limit real estate lending ­either in proportion to the value of the property as collateral (the loan-­to-­value ratio) or to certain multiples of income (the debt-­to-­income ratio). Following the GFC, ­these mea­sures w ­ ere a­ dopted by a number of the more developed economies. Many international discussions focused on the possibility of improving the resilience of the financial system by adopting countercyclical capital buffers that would force financial institutions to procure additional capital, above minimum requirements, when authorities determined that they should put a brake on lending activities. In a symmetrical manner, when financial institutions w ­ ere thought to be too cautious, and lending constrained, firms would be allowed to hold lower levels of capital to encourage more lending. Attention on macroprudential supervision would not lessen the importance of firm-­level or microprudential supervision. Verifying that individual firms ­were complying with regulations that set out minimum standards, and ensuring their sound management through oversight and supervision, would, of course, continue and be strengthened. Microprudential and macroprudential policy would be additive. I thought macroprudential policy was impor­tant to pursue, but I was—­ and remain—­d isturbed by the tendency of discussions of macroprudential policy to focus excessively on the pros and cons of par­tic­u ­lar individual policy mea­sures or instruments. When considering macroprudential policy, attention cannot be ­limited to the operation of this or that individual instrument, such as adjusting the loan-­to-­value ratio, but must instead take on the breadth of all private be­hav­ior and public actions that affect the level and distribution of risks impacting the financial system as a ­whole. If risks are building up in the financial system from a holistic perspective, and if it is determined that inaction would result in the eventual destabilization of the financial system, something must be done to stop the risks from playing out. I call this approach the macroprudential perspective; without it we 324 | The Days as Governor

cannot judge ­whether and when we should invoke macroprudential mea­ sures. A macroprudential perspective is needed both for the operation of variable macroprudential policy instruments and in the design of financial regulations itself. My concern with macroprudential policy was the way in which this policy was discussed and presented. Many supporters of this idea, especially ­those with backgrounds in macroeconomics and monetary policy, argued that if both microprudential and macroprudential policies ­were conducted properly, ­bubbles and crises could be prevented. The crux of their argument was that the responsibility for avoiding financial crisis lay not with monetary policy but instead with financial policy: supervision, regulation, and macroprudential policy. To my ears, this is a strange argument and one I strongly disagree with. Price stability and financial stability are inseparably related; so are monetary policy and financial policy. I have already critically touched on the separation princi­ple several times in this book, but ­here l ­will explain more systematically why it is misguided.6

THE INSEPARABILITY OF PRICE STABILITY AND FINANCIAL STABILITY One dimension of the orthodox separation princi­ple relates to the expression of policy objectives. I do not remember when this notion started to be used, but it is now common to hear price stability and financial stability described as conceptually separate objectives, particularly in macroeconomic policy discussions. Th ­ ere is ­today a growing awareness that both are impor­tant in achieving sustainable economic growth and that they are interrelated, but in the past, the dominant view was that ­there was a conflict and a trade-­off to be made between price stability and financial stability. I disagree with this; my view is strongly influenced by my experience with the Japa­nese ­bubble economy and the resulting financial crisis and also through my reading about con­ temporary and historical experience in many parts of the world. I would suggest that the phenomenon that may look like a trade-­off can be better understood as the product of an arbitrary definition of the term price stability. As I explained in chapter 9, the deflation that should concern us (the deflationary spiral, to be more exact) is caused by financial system collapse. Irving Fisher’s theorizing was quite right: if financial imbalances are unchecked, they ­will lead to asset ­bubbles and eventually financial crises, resulting in deflation. In the medium to long term, which is appropriate for both monetary The Stability of the Financial System | 325

and macroprudential policy, ­there is neither a conflict nor a trade-­off but a complementarity. The idea of a trade-­off is only plausible if we look at the economy and the financial system over a relatively short time frame. Many macroeconomists and central bankers have thought that a medium-­to long-­term perspective was appropriate when considering the price stability objective of monetary policy. But along with flexible inflation targeting regimes, many central banks, in their regular reports, ­adopted projection periods for growth and inflation of just two or three years. But the time frame for financial stability is inherently long. In the case of the Japa­nese financial crisis, it was more than fifteen years; in the case of the GFC, it was more than ten years. If we think of price stability over just a two-­or three-­year time frame and financial stability over a ten-­year (or longer) period of time, ­there may be a trade-­off, but it is not between price stability and financial stability. Rather, it is an intertemporal trade-­off between price stability and growth ­today versus price instability and a lack of growth ­later on. In my view, the central bank’s objective is best expressed as trying to achieve the stability of money values in the long term (or, put simply, long-­term price stability). According to this definition, t­ here may be a trade-­off between price stability in the short term and price stability in the long term. But ­there is not a trade-­off between price stability and financial stability in a common longer time frame. Taking a medium-­to longer-­term perspective, price stability and financial stability are inseparable and just two sides of the same coin.7

THE INTRICACY OF MONETARY POLICY AND FINANCIAL POLICY The separation princi­ple is also reflected on the dimension of policy tools. Financial crises strike when financial institutions take on more debt than they can safely cover—­that is, far beyond the levels warranted by their capital—or when they assume more short-­term or “runnable” obligations than they could meet comfortably with their liquidity levels (i.e., excessive maturity mismatch); such be­hav­ior is significantly influenced by monetary policy. Admittedly, financial regulation and supervision would affect the be­hav­ior of individual financial institutions at the microlevel and seem to reduce risks. Nevertheless, they do not guarantee financial stability. This is the basic message of the tragedy of the commons. First, loopholes always exist, even though financial institutions are subject to supervision and regulation. Second, t­ here are always 326 | The Days as Governor

entities not subject to regulation and supervision; a good example is the growth of shadow banking prior to the GFC. The point is that if ­there are opportunities to profit from increasing debt or maturity mismatches in the economy, somebody ­will be bound to take advantage of that opportunity. Many f­ actors are responsible for creating such profitable opportunities, but undoubtedly monetary policy plays an impor­tant role. If monetary easing engenders an environment where increased debt or maturity mismatches are lucrative, financial institutions are faced with a dilemma that even if they, as individual institutions, might wish to act prudently, by d ­ oing so they w ­ ill lose competitiveness and risk losing market share. Variable macroprudential policies can play some role, but I doubt that they can become a power­ful tool by themselves when monetary policy is unchanged. The ­whole debate surrounding the effectiveness of variable macroprudential mea­sures reminds me of the old debate about the Bank of Japan’s “win­dow guidance” in the 1960s and 1970s.8 In t­ hose days the bank set an upper limit to major private banks’ lending individually when it conducted monetary tightening by raising the official discount rate. Win­dow guidance could be regarded as a very crude form of what t­oday we call macroprudential policy. Interest rate increases w ­ ere unpop­u­lar then, as now, so some preferred a combination of stringent win­dow guidance and less aggressive interest rate hikes. In fact, ­there was academic debate as to ­whether win­dow guidance was effective on a stand-­a lone basis. The bank always took the view that it was meaningful as a mea­sure complementary to interest rate increases and that it was effective only when it was accompanied by a corresponding interest rate hike.

THE INTELLECTUAL UNDER­P INNINGS OF THE SEPARATION PRINCI­P LE Mainstream macroeconomic thought has profoundly affected the thinking of policy makers, but, unfortunately, it effectively assumes away the prob­lem of financial instability and of financial crises. First, mainstream macroeconomics failed to think through the implications of the transmission mechanism of monetary easing on financial stability. Th ­ ere are essentially only two channels in terms of the transmission mechanism. We can take demand from the f­ uture by inducing more borrowing at lower rates of interest against our ­future income and also by elevating asset prices due to a lower discount rate. This could work for some time. But if monetary easing is pursued aggressively and over an extended period of time, it can The Stability of the Financial System | 327

ultimately lead to too much borrowing relative to our ability to repay it. ­Future monetary tightening, which is supposed to be enabled by a successful monetary easing, ­will risk undermining financial stability by causing unfavorable debt dynamics via increased interest payments against a fixed amount of debt and suppressed asset price. Alternatively, we can take foreign demand from trading partners by weakening our currency and exporting more. This could also work for some time. But our trading partners w ­ ill tend to borrow more to finance their increased import bill. To the extent their borrowings are denominated in our currency, our ­future monetary tightening ­will weaken their currency and aggravate their debt dynamics by increasing their repayment burden. Second, in the model of mainstream macroeconomics, financial institutions have been absent. Financial institutions, and especially banks, are highly leveraged when compared with nonfinancial businesses and ­house­holds. In ­normal conditions, with some room between ­actual and potential growth, economy-­wide leverage enabled by financial institutions can raise the current rate of growth. But high leverage, beyond what can be sustained by real income growth, combined with the maturity mismatches incurred by most financial intermediaries, can also be the source of financial instability and crises. Thus, neglecting the impor­tant role of financial institutions in the transmission of monetary policy is a fatal ­mistake in understanding the be­hav­ior of the macroeconomy. Even when financial institutions exist in macroeconomic models, they tend to appear as robot-­like actors who simply connect ­house­hold savings to investments by firms. The transmission mechanism of monetary easing presupposes that nonfinancial businesses and ­house­holds can borrow more at lower rates of interest. But the ­actual credit extension is determined by both credit demand and credit supply, just as is the case in markets for goods and ser­vices. The failure of economic theory and macroeconomic models to incorporate the role of financial intermediaries, and especially their frailty, leaves out an essential ele­ment that brings about economic fluctuations. In this context I was not altogether comfortable with the meaningfulness of the portfolio rebalancing effect, which was emphasized by advocates of aggressive monetary easing as its crucial transmission channel. I must admit that, even though the return is too low, many financial institutions would increase risk taking on the hope that this situation would be temporary. Still, some other financial institutions may well abandon any investment in risky assets ­because the returns may no longer compensate for the risks taken. The worst-­case scenario is that financial markets come to be dominated by the financial institu328 | The Days as Governor

tions that would be investing just b ­ ecause they have no other choice: they w ­ ill not have sufficient revenues if they stand still and hope that storms are not coming their way. If storms come, the risk takers w ­ ill inevitably fail. Short-­ term macroeconomic benefit has to be weighed on the long-­term costs of macroeconomic instability.

COOPERATION BETWEEN THE BANK OF JAPAN AND THE FINANCIAL SER­V ICES AGENCY In some countries the central bank is also the principal financial regulator, while in other countries the central bank does not have ­these powers. But given its broad perspective on the macroeconomy, reflecting its responsibilities for maintaining the stability of the overall economy, the central bank’s engagement in developing financial regulation is valuable. The relations between the Bank of Japan and the Financial Ser­vices Agency ­were cooperative and complementary when they participated in the discussions on regulatory reforms. ­ ubble economy and financial crises My own experience with the Japa­nese b has demonstrated the importance of looking beyond the microprudential view of the activities of individual financial institutions, to incorporate the perspective of the macroeconomy and the ­whole financial system in order to properly discharge responsibilities regarding financial regulation and supervision. In par­tic­u­lar, the central bank’s capabilities for research is critically impor­tant. The Bank of Japan’s most useful contributions at international forums on financial regulation ­were a product of its extensive capacity for research and analyses, reflecting its comparative advantage as a central bank. In the popu­lar imagination international negotiations on financial regulation are often seen as a “­battle of ­wills,” with each country’s representatives pursuing their own national interest. This is only partly true. In a multilateral forum ­there would be ­little sympathy for claims promoting the narrow interests of just one country. To be successful in persuading ­others, arguments must be grounded in analy­sis. In addition to the institutional strength of the central bank, the close relationship of the Bank of Japan with overseas central banks was helpful in resolving cross-­border regulatory and supervisory issues b ­ ecause many other central banks ­were formally responsible for financial regulation and supervision in their economies. When t­ here are differences of views, it is often the case that they are discussed at meetings attended by central bank governors. In fact, the agendas of meetings such as that of finance ministers and central bank governors of The Stability of the Financial System | 329

the G7 and G20 economies changed considerably during my time as governor of the Bank of Japan. At the beginning of my tenure, discussions ­were dominated by macroeconomic policy or the foreign exchange market, but over the years we increasingly spent more time debating financial regulation.

INSTITUTIONAL REFORMS IN FINANCIAL REGULATION AND SUPERVISION IN OVERSEAS ECONOMIES In the wake of the GFC, the reform of financial regulation and supervision in overseas economies extended to institutional reforms. In the United States, the Financial Stability Oversight Council was established, which was chaired by the Trea­sury secretary and consisted of heads of federal financial regulatory and supervisory agencies, including the FRB, which was designated as the ­regulator of investment banks and insurance companies that w ­ ere deemed systemic. The Eu­ro­pean Central Bank, whose original competence was in macroprudential policy, was empowered to supervise larger financial institutions ­after the Eu­ro­pean debt crisis. The Bank of ­England regained regulatory and supervisory powers, which was transferred to the Financial Ser­vices Authority when the bank gained in­de­pen­dence of monetary policy, and it was also entrusted with macroprudential policy. In contrast, ­there ­were no changes in the institutional framework in Japan following the GFC, mainly ­because the framework had already under­gone a big change a­ fter the Japa­nese financial crisis in the 1990s. I have often been asked for my thoughts on the current institutional design against the backdrop of overseas developments. The current system is not perfect, but is functioning reasonably well; I do not believe that it is crucial for a central bank to have supervisory powers backed by capacities to enforce remedial actions over individual financial institutions. Considering that supervisory powers are associated with microlevel interests, it might be desirable not to have such powers from the perspective of maintaining the in­de­pen­dence of monetary policy. But I do think it is absolutely essential for the central bank to take a keen interest in what is happening at financial institutions. I strongly agree with Paul Volcker, who said, “I insist that neither monetary policy nor the financial system ­w ill be well served if a central bank loses interest in, or influence over, the financial system.”9 When the central bank does not have the wherewithal to obtain granular information from financial institutions, its macroprudential views on both price and financial stability ­will be compromised. The Bank of Japan has the authority to conduct on-­site examinations of individual banks stemming 330 | The Days as Governor

from its provision of banking ser­vices. This allows it to gather granular information that inform its views on both monetary policy and macroprudential policy and when changes in e­ ither are desirable.

MEDIUM-­ TO LONG-­T ERM RISKS FACING THE JAPA­N ESE FINANCIAL SYSTEM The most acute prob­lem facing the Japa­nese financial system as viewed from the macroprudential perspective is the low profitability of financial institutions. As potential growth gradually drifted downward against the backdrop of the declining ­labor force, all financial institutions have been hard-­pressed to generate revenues given diminishing opportunities for domestic lending. This has particularly affected regional banks and credit cooperatives outside Tokyo, where a decline in population has been most pronounced and, thus, lending opportunities acutely diminished. The three “megabanks” headquartered in and around Tokyo have been less affected and have even tried to increase their lending. But this has only resulted in lower lending rates and fierce competition. I am concerned that, in this environment, the be­hav­ior of weaker regional banks that are tempted to invest in risky financial assets or take excessive interest rate risk to secure revenue in the short term might pose an eventual risk to financial stability. The conditions of regional banks are monitored by the Bank of Japan. In addition, ­there are many opportunities to directly hear from the leaders of such institutions, in both regularly held industry forums and face-­to-­face meetings. In industry forums, attended by regional bank presidents, the bank’s Policy Board members, and other se­nior officers, the bank CEOs do not harshly criticize the bank. But during my tenure I could recognize the subtle signals they sent when they w ­ ere very unhappy with the monetary easing of the bank. For my part, I would always explain that monetary easing was aimed at improving the ­whole economy and, if that ­were successful, regional banks would eventually reap the benefits. But ­because I did not believe that easy money could single-­handedly bring about improvements in economic conditions, I made it a rule also to stress the overarching importance of efforts to improve growth potential through all economic agents, that monetary easing alone would not be sufficient, and that I was well aware of the plight of regional banks. How should one understand the narrowing of interest margins, which was the source of discontent among the leaders of financial institutions (and not only regional banks but practically all banks and insurance companies)? Even The Stability of the Financial System | 331

as the interest rates paid by banks on their deposits and other liabilities neared zero, ­because long-­term interest rates ­were also declining to such low levels banks ­were faced with diminishing interest-­rate margins. The main forces ­behind the narrowing margins reflected both monetary easing and the real economic f­ actors under­lying the Japa­nese economy, such as the declining population. As for the former, the situation surrounding financial institutions ­were more or less the same globally. As for the latter, the situation was more serious in Japan. As I noted in chapter 10, I had attempted to redouble the efforts by economists at the Bank of Japan to study the effects of aging and the ­ ere deliberately declining population on the Japa­nese economy. Such efforts w reflected in the bank’s semiannual Financial System Report. Faced with diminishing interest margins, Japa­nese banks would attempt to maintain their revenues by lending for an even longer duration or taking on even more credit risk. That would, in turn, collectively depress returns on assets, further narrowing margins. Consequently, even if banks appeared to be turning profits, they would also have more risks on their balance sheets. Some would argue that the prob­lem of narrowing interest margins could be solved if interest rates on deposits could be made negative or if financial institutions could charge account maintenance fees on deposits. The difficulty of charging fees on ­house­hold deposits is rather universal, but compared with overseas financial institutions, it is more difficult for Japa­nese banks to lower their funding costs ­because deposits represent a much higher proportion of how banks fund themselves in Japan.10 Costs of funding in money markets, being populated by professionals, could be lowered more easily. ­Those technical discussions aside, the ­whole argument for negative interest rate is essentially neglecting the impor­tant role of credit and financial institutions, which are a prerequisite for growth. This argument seems to try to save monetary policy from the zero lower bound of interest rates at the expense of the financial system. It is like a geocentric view of monetary policy. During my time as governor, the negative effects of monetary easing and lower long-­term interest rates on credit intermediation by banks was not well understood, although I tried to call attention to the prob­lem. But this has been changing as monetary conditions became easier around the world, as is noted in the April 2017 edition of the International Monetary Fund’s semiannual Global Financial Stability Report: Advanced economies have experienced a prolonged episode of low interest rates and low growth since the global financial crisis. . . . ​[T]he ex332 | The Days as Governor

perience of Japan suggests that an imminent and permanent exit from a low-­interest-­rate environment need not be guaranteed. A combination of slow-­moving structural ­factors, notably population aging and slower productivity growth common to many advanced economies, could conceivably generate a steady state of lower growth and lower nominal and real interest rates in t­ hese countries. . . . Over the long term, the scenario would entail significant changes to the business models of banks, insurers, and pension funds and the products offered by the financial sector. In such an environment, yield curves would likely flatten, lowering bank earnings and presenting long-­lasting challenges for life insurers and defined-­benefit pension funds. . . . ​As banks reach for yield at home and abroad, new financial stability challenges may arise in their home and host markets. Th ­ ese hypotheses are supported by the experience of Japa­ nese banks.11

The Stability of the Financial System | 333

| CHAPTER SEVENTEEN |

The Joint Statement by the Japa­nese Government and the Bank of Japan In the general elections of the House of Representatives on December  16, 2012, the Liberal Demo­cratic Party (LDP), led by Shinzo Abe, clinched an overwhelming victory and returned to power. During the campaign Abe insisted on strengthening coordination between the government and the Bank of Japan, and the need for more aggressive monetary easing, and he often referred to the possibility of revising the Bank of Japan Act. I confronted two conflicting responsibilities: I needed to re­spect the outcome of Japan’s demo­ cratic pro­cess and to recognize that, by a wide margin, the population voted for a po­liti­cal party that was committed to pursuing a monetary policy that I thought misguided. But I also needed to carry out my duties as governor of the bank, ­under the existing Bank of Japan Act, to ensure the stability of the currency. The efforts to reconcile ­these conflicting responsibilities produced the “Joint Statement of the Government and the Bank of Japan on Overcoming Deflation and Achieving Sustainable Economic Growth.” My agreement to the publication of the statement and the pro­cess leading up to it was my most difficult task of my tenure as governor.

THE PRO­C ESS LEADING TO THE “JOINT STATEMENT” The “Joint Statement” was the culmination of more than ten years of fierce debate in Japan on the conduct of monetary policy. The debate was, in part, theoretical: How does economic theory suggest that monetary policy should be conducted at the zero lower bound of interest rates (see chapter  12)? It was also a debate about how we should understand the fundamental ­c auses of the low rate of economic growth in Japan and, at the same time, a debate about the role of an in­de­pen­dent Bank of Japan in a demo­ cratic society. 334

The focal point of this debate became the idea of an accord—­a formal and specific policy agreement—­between the government and the Bank of Japan. For t­ hose promoting this idea, the fundamental cause of low growth was deflation; thus, overcoming deflation was the most impor­tant policy objective. The idea first surfaced in 2000 and found its most vocal advocate in Heizo Takenaka, the state minister for economic and fiscal affairs in the cabinet of Prime Minister Junichiro Koizumi. The debate intensified during the second half of my tenure as governor, especially early in 2012. The idea of an accord gained traction not only among economists critical of the bank but also, increasingly, among the po­liti­cal establishment and the press. A watershed moment came with the announcement by the Federal Reserve Board (FRB), on January 25, 2012, that it had ­adopted a “long-­run goal for inflation” of 2 ­percent, as mea­sured by the Personal Consumption Expenditure (PCE) deflator. The FRB had not previously made public any quantitative formulation of price stability, but ­after Ben Bernanke became the chair, the FRB gradually changed its approach and fi­nally arrived at the announcement of the 2 ­percent inflation goal. This was a boon for ­those in Japan who thought that the Bank of Japan’s monetary policy was not sufficiently forceful. It also quickly intensified the debate in Japan on both a numeric inflation target and on the need for an accord. I was frequently called before committees of the National Diet; in February 2012 alone I appeared on nine dif­fer­ent days. I was reprimanded by members from both the ruling co­ali­tion and the opposition and was called upon to enter into an accord with the government. Politicians threatened to amend the Bank of Japan Act to repeal the bank’s in­de­pen­dence. Specifically, the bank was being asked to do three t­ hings: (1) to adopt a 2 ­percent inflation target, (2) to increase the monetary base more aggressively, and (3) to set a specific date by which the bank would achieve the inflation target. In addition, ­there ­were voices arguing that the bank should also have goals for maximizing employment, weakening the yen, and improving other economic conditions. Taken together, ­these ele­ments would add up to a uniquely complicated approach to inflation targeting and one at odds with how it was understood and practiced by other central banks. I was strongly opposed to adopting this uniquely Japa­nese variety of inflation targeting. The mainstream view on inflation targeting abroad had three features: (1) defining price stability numerically, (2) publishing the central bank’s views on the ­future path of the economy and prices, and (3) explaining and conducting policy aimed at sustainable growth, with low and stable inflation, in the medium to longer run. In t­ hese re­spects, then, the ongoing conduct of monetary policy The Japanese Government and the Bank of Japan | 335

by the Bank of Japan was not called inflation targeting per se, but it differed ­little from that being practiced by central banks abroad. Having said that, if I had been asked ­whether I was ­wholeheartedly in ­favor of flexible inflation targeting as practiced by other central banks, I would have replied that while I was not keen on it, it was acceptable. The reason I was not particularly enthusiastic had to do with prob­lems I saw in the logic of the promoters of inflation targeting in Japan. In Japan ­there ­were two dif­fer­ent rationales offered in support of inflation targeting: the first was to increase the effectiveness of monetary easing, while the second was to enhance central bank accountability. I thought they both ­were misleading. With Japan at the zero lower bound of interest rates, and confronting our inability to depreciate the currency by widening interest rate differentials, the adoption of a numeric inflation target by itself was unlikely to do much to enhance the effectiveness of monetary policy. So the first rationale, offered by the Japa­nese promoters of inflation targeting, was that the announcement of a ­target inflation rate by the central bank in itself would increase the expected rate of inflation, which would then lower real interest rates and stimulate the economy. I was skeptical about this argument; if the central bank did not have effective tools at its disposal, the mere announcement of a target could not have much influence on expectations. But proponents—­both “reflationistas” and “expectationistas”—­believed that the central bank had the ability to achieve its inflation target at ­will. They emphasized the role played by “regime change.” ­There ­were prob­ably relatively few who innocently accepted the argument that an increase in the quantity of money would solve the prob­lem in a literal sense. But when combined with the idea that the mere announcement and commitment of the central bank to a target would raise inflation expectations, ­there was the appearance of skillfully solving the prob­lem: if the Bank of Japan would just show its unwavering ­w ill to achieve a higher inflation rate, ­actual rates of inflation would also rise. Put together in this way, t­ hese arguments ­were mischievous in creating false hope. Such thinking in itself was actually not heretic but rather orthodox in mainstream macroeconomics, which held the view that the central bank could act to anchor the a­ ctual inflation rate. As I have emphasized in previous chapters, high rates of inflation can be tamed if the central bank tightens monetary policy sufficiently. Similarly, a sharp fall in the price level can be avoided if the central bank can act promptly as the lender of last resort in a financial crisis. But given the under­lying c­ auses of slow growth in Japan, it does not fol336 | The Days as Governor

low that more willpower, an inflation target, and a gung-ho attitude on the part of the Bank of Japan could have changed the course of inflation in Japan. Since the global financial crisis (GFC) of 2007–9, central banks in other developed countries, with 2 ­percent inflation targets, have shown plenty of willpower in aggressively expanding their balance sheets to ease monetary conditions but have also consistently undershot their inflation targets. But this was not in evidence in 2012, and the views of academics then ­were quite dif­fer­ent from ­t hose of ­today (see chapter 18). I was also not keen on the idea that inflation targeting would enhance central bank accountability, the second rationale offered by Japa­nese proponents of it. The impor­tant question is, accountable for what? The proponents of inflation targeting in 2012 had a ­simple answer, and it was to get inflation higher and, implicitly, to do so at all costs. This seemed to me to be a prescription to ignore the risks to financial stability (and the deflationary pressures of falling ­ ubble economy, which asset prices) that we had experienced ­after the Japa­nese b was caused, at least in part, by the extended period of monetary easing that was justified by the extremely stable inflation—­until it was too late. ­Later, in the wake of the GFC, I was hopeful that this naive reliance on inflation targeting would recede as it came to be recognized as an insufficient guide for the actions of central banks. Indeed, in February 2012, when Mervyn King, governor of the Bank of ­England, was asked by Japa­nese reporters for his views on the usefulness of inflation targeting, he answered as follows: From our point of view, inflation targeting I think has proved a very helpful framework in which to set monetary policy. But I do think that the experience of the last four to five years has raised some question marks about what inflation targeting can hope to achieve and ­whether it’s sufficient. I think our feeling now is that on its own it’s not ­sufficient; it did not prevent the build-up of a large degree of financial ­instability. . . . ​ Governor Shirakawa has written extensively on this and most illuminatingly on it too. . . . ​And once the crisis is a l­ittle bit further down the road, I hope ­we’ll have more time to sit back and reflect on the lessons of the past.1 The impor­tant lessons of the past that I felt ­were most impor­tant w ­ ere ­ ubble economy and our subsequent t­hose born of reflections on the Japa­nese b financial crisis. And in March 2006, when it came off a period of quantitative The Japanese Government and the Bank of Japan | 337

easing, the Bank of Japan had explic­itly ­adopted a policy framework that included consideration of the importance of both price stability and financial stability, in the medium-­to long-­term perspective. Unfortunately, the bank failed to gain supporters for this approach at that time. In 2012, however, central banks around the world ­were beginning to change their views and to incorporate considerations of financial stability in their framework of inflation targeting. Given Japan’s own ­bitter experience in the aftermath of the ­bubble economy, now reinforced by the aftermath of the GFC, I was ­eager to avoid the Bank of Japan adopting the murky, Japa­nese version of inflation targeting that was so at odds with the direction of monetary thinking in other countries. But I found myself trapped by the tyranny of labels, with so many other central banks calling their monetary policy regimes inflation targeting. Resisting the idea of inflation targeting created the impression that the bank was not aggressive enough in its monetary easing. This was unfortunate. If the Bank of Japan ­were to declare it had ­adopted inflation targeting, and particularly the extreme version of it, I thought it very likely that the bank would find itself compelled to purchase open-­ended quantities of Japa­nese Government Bonds (JGBs) and thus fall into the trap of fiscal dominance in a manner that would make it even harder to achieve the overarching objective of sustainable growth ­under price stability. Continuous purchases of JGBs by the bank, in naive pursuit of inflation targeting, would, I feared, narrow the interest rate margins on loans to the point at which financial intermediaries would cease to be v­ iable. This, in turn, could weaken the economy as a w ­ hole. Given the already low of rate of potential growth due to rapid aging and outright population decline, as well as the worsening fiscal balance, the impact of a further erosion of private credit creation on overall demand was not an abstract concern. The challenge we faced was to try to attain consistency between form and substance. I was e­ ager to have an in­de­pen­dent Bank of Japan held accountable for the conduct of monetary policy that sought to avoid further weakening of the economy. We hoped that we could do this without being forced to adopt an extreme version of inflation targeting.

THE IDEA OF AN ACCORD The promoters of inflation targeting in Japan often called for policy coordination between the government and the Bank of Japan in the form of an accord. ­There is no doubt that both the government and the bank had impor­tant roles 338 | The Days as Governor

to play in order to achieve sustainable growth u ­ nder price stability. It should also be obvious that ­there needs to be good communication between the two. But the word accord carried far more baggage in Japan. The very idea of an accord, I thought, confronted the conceptual and practical challenge of exactly who would be the parties to such a formal agreement. For the Bank of Japan, decisions would have to be made by the nine members of the Policy Board. Given member terms of five years and, thus, average remaining terms of just two and a half years, the board should not be able to commit to a course of monetary policy beyond the remaining terms of its members. The same forward commitment prob­lem was shared by the government with re­spect to its expected term in office. In addition, it was not clear who in the government would conclude such an accord. Common sense would equate the government with the cabinet. But an agreement between the current cabinet and the bank would not necessarily constrain the actions of ­future cabinets, even of the same party. In fact, during my tenure as governor, power passed from one ruling co­a li­tion to another on two occasions and t­ here w ­ ere six dif­fer­ent prime ministers. Moreover, policies agreed to by the cabinet could not be implemented, immediately or even in the f­ uture, without bud­gets, taxes, and other changes in laws being approved by the National Diet, which comprises two h ­ ouses that are not required to follow decisions by the cabinet. So even if the cabinet and the bank could reach some sort of formal agreement, both current and ­future parliamentarians could ignore or overturn any resulting accord. The only known example of such an accord between a government and a central bank was concluded in 1951 between the US Trea­sury and the FRB. The aim of that agreement was to remove the Federal Reserve’s price support for Trea­sury securities, which had begun during World War II. While this agreement heralded the restoration of the FRB’s in­de­pen­dence, the promotion of an accord in Japan sought to do exactly the opposite by constraining the in­de­ pen­dence of the Bank of Japan and increasing the influence of the government over monetary policy.

THE PUBLICATION OF “THE PRICE STABILITY GOAL IN THE MEDIUM TO LONG TERM” Even if the Bank of Japan was not prepared to explore the possibility of an accord with the government, it found itself being painted into a corner by the FRB’s announcement of a 2 ­percent inflation target. Had the bank continued to resist any numeric target for inflation, the threat of legislative changes to The Japanese Government and the Bank of Japan | 339

alter the Bank of Japan Act ­were quite real. ­After intensive discussions among MPM members, we agreed to publish a document titled “The Price Stability Goal in the Medium to Long Term” on February 14, 2012. The document stated that “the Bank judges ‘the price stability goal in the medium to long term’ to be within a positive range of 2 ­percent or lower in terms of the year-­on-­year rate of change in the CPI [Consumer Price Index] and, more specifically, sets a goal at 1 ­percent for the time being.”2 Our decision contained two impor­tant messages. First, the numeric part of the language of the inflation target was the same as before (“within a positive range of 2 ­percent or lower in terms of the year-­on-­year rate of change in the CPI”). Second, the bank clearly indicated its position on the current stance and near-­term objective for monetary policy by setting “a goal at 1 ­percent for the time being.” The bank’s previous expression of its inflation objective was more passively stated in that “the midpoints of most Policy Board members’ ‘understanding’ are around 1  ­percent.”3 The new words w ­ ere a­ dopted to express the ­w ill and intention of the bank. At the same time, it was clearly stated that the bank would aim for 1 ­percent inflation as a goal for the time being and maintain aggressive monetary easing (with interest rates at effectively zero) and the purchase of financial assets ­u ntil such time as the bank could foresee that the goal would be reached. This was intended to be forward guidance. In addition, the bank de­cided to increase the size of the Asset Purchase Program by 10 trillion yen from about 55 trillion yen to about 65 trillion yen. ­There ­were both positive and negative reactions. The nuanced message of our announcement was missed by many observers. At the post-­MPM press conference, I was repeatedly asked why we had not a­ dopted 2 ­percent but, rather, “1 ­percent for the time being” as the goal. I answered, “If the Bank of Japan suddenly released a number, heretofore not experienced and unmoored from public consciousness of prices, t­ here would be a risk that h ­ ouse­holds and firms could face unnecessary uncertainties, and also a risk that long-­term interest rates could jump. If the Japa­nese p ­ eople literally believed in the 2 ­percent figure, long-­term interest rates would have to rise.” 4 But this was only half the story. If I w ­ ere to admit to the other half, I would have had to explain that it was unconceivable that the rate of inflation could reach 2 ­percent anytime soon. I refrained from saying this in order to avoid being criticized for abandoning the much-hyped 2 ­percent target.

340 | The Days as Governor

A “GOAL” OR A “TARGET”? Our decision was particularly criticized for not clearly giving a specific time frame during which the price stability goal had to be met. One typical remark of the time was heard from a member of the House of Representatives, Kozo Yamamoto, at a session of the House Financial Affairs Committee on February 29, 2012: First and foremost, t­ here is no—­I ­will repeat no—­vis­i­ble time frame. If ­there is no time frame, you w ­ ill be evading responsibility. . . . ​I ­will tell you the period, since you do not seem to know, is between one and a half to two years. . . . ​­People at the bank are trying to wiggle out by saying it is not a target but a goal, and adding insult to injury by not specifying a time frame. This is the only way I could describe the bank’s decision. It is utterly irresponsible. Nobody in the market ­will be convinced.5 Views such as t­ hese ­were gaining traction not only among politicians but also among the press. They reflected the Japa­nese view that a par­tic­u­lar inflation rate could be achieved on a set schedule, thus ignoring the experience of other countries where inflation targeting had been ­adopted. As is evident in the quote from Yamamoto, the bank was also derided for using the word “goal” rather than “target,” as if it w ­ ere a proof of the bank’s unwillingness to act decisively to end to deflation. We anticipated this criticism during the Policy Board’s extensive discussion of the appropriate word to use. In the end, we de­ cided to use “goal” b ­ ecause many members of the board specifically wanted to resist the idea that the bank was committing to a mechanical monetary policy given the poor comprehension of inflation targeting in Japan. Many in the po­liti­cal establishment and the press ­were fixated on the issue of ­whether or not the bank had in fact ­adopted inflation targeting. I had no appetite for continuing an unproductive debate on the taxonomy of inflation targeting regimes and consciously made public my view that the new framework could be called inflation targeting if p ­ eople so wished. The Policy Board’s decision received fire from three dif­fer­ent ­angles. The first was t­ hose economists who w ­ ere calling for more aggressive monetary easing. This critique was expected, as it only confirmed their well-­k nown difference in perspective. The second, coming from the complete opposite direction, was ­those who thought that the bank had caved in and succumbed to po­liti­cal pressure. I often heard that this group concluded that “the Bank has now The Japanese Government and the Bank of Japan | 341

embarked on the monetization of government bonds,” and, even more harshly, that “the Bank has crossed the Rubicon.” I found this line of criticism perhaps the most frustrating. If the real issues confronting the Japa­nese ­economy had been correctly appreciated, t­ here would have been no room for inflation targeting to have occupied such a dominant position in the public discourse. Nevertheless, in an environment where the real issue was not appreciated by many, the bank had to take a very narrow path, maintaining accountability with the public at large on the one hand and ensuring the stability of the economy on the other. The third line of fire was that of bond market analysts who meticulously followed the bank’s monetary policy. They expressed concern that, ­under the new framework, the rules governing the bank’s conduct of monetary policy ­were now murkier and harder to anticipate. This was, in a sense, a valid argument. Monetary policy should be eased when e­ ither the economic or the price outlook declined. But at that February’s MPM the board made no change in assessment of the outlook when, in fact, the economy was ­doing better than expected. ­Because the bank had eased policy by increasing the amount of its Asset Purchase Program, when the outlook appeared to be improving, the analysts rightfully complained that the bank’s rationale for easing was difficult to understand. ­Those who professionally forecast the ­future path of short-­term interest rates play a central role in the transmission of monetary policy to the broader financial markets and to the real economy. As bond market analysts play exactly this role, their critique that the bank’s newly articulated inflation goal made it harder to understand the course of monetary policy was one we took quite seriously. We w ­ ere left to won­der ­whether the Policy Board’s attempt to adapt inflation targeting to Japa­nese conditions had enhanced or had diminished the transparency and accountability of the bank’s monetary policy.

A “VALENTINE’S DAY PRE­S ENT” The clearest and sharpest market reaction to the announcement of the price stability goal came in the foreign exchange market. The yen weakened, with the dollar-­to-­yen exchange rate reaching 83.98 yen on March 15, compared with 77.63 yen on February 13, the day before the announcement. ­Because the announcement was on February 14, market participants described the fall in yen as a “Valentine’s Day pre­sent,” suggesting that the foreign exchange market interpreted the announcement as a forceful easing of monetary policy. 342 | The Days as Governor

I was uncomfortable with this explanation and feared that the yen’s movements w ­ ere more of a m ­ atter of coincidence. The more significant ­factor ­behind the yen’s fall was, in my view, the reduced demand for yen as a safe-­haven currency (chapter 14), thinning the exchange market just then, than it was a profound reappraisal of the bank’s policy with the adoption of inflation targeting. Events in Europe—­particularly the introduction of the three-­year long-­term refinancing operation by the Eu­ro­pean Central Bank and the agreement on the second bailout of Greece—­prompted market participants to believe that the breakup risk of the euro had receded and briefly reduced safe-­haven demand for the yen. But within a few months ­ ere raging again. This led to rethe flames of the Eu­ro­pean debt crisis w newed interest in safe-­haven assets which, in turn, resulted in appreciation back to the seventy-­eight-­yen level by the end of July. The adjustment of the yen exchange rate seen a­ fter the publication of the price stability goal was, in real­ity, a mere interlude between the second and third stages of the Eu­ ro­pean debt crisis.

“MEA­S URES AIMED AT OVERCOMING DEFLATION” U­ NDER THE GOVERNMENT OF THE DEMO­C RATIC PARTY OF JAPAN Renewed po­liti­cal interest in an accord began again ­after Prime Minister Yoshihiko Noda reshuffled the cabinet on October 1, 2012. Cabinet ministers with economic portfolios generally stood above the fray of the heated debates on deflation. In par­tic­u ­lar, Noda was sympathetic to the views of the Bank of Japan. The exception was Seiji Maehara, the new state minister for economic and fiscal affairs. In his prior capacity as chair of the Policy Research Council of the Demo­cratic Party of Japan (DPJ), Maehara had sharply criticized the conduct of monetary policy by the bank and was known as a vocal advocate of an accord between it and the government. I was initially taken aback by his appointment, but his demands w ­ ere not as aggressive as expected; perhaps ­because he recognized his responsibilities as a minister, he turned out to be somewhat mindful of the bank’s in­de­pen­dence and toned down his rhe­toric a bit. I judged that it would be unwise for the Bank of Japan to reject any idea of agreeing to a document signed by both the bank and the government. Negotiations ­were entrusted to staff at the Cabinet Office, the Ministry of Finance, and the bank, and I was regularly updated on their pro­gress. The effort culminated in a document titled “Mea­sures Aimed at Overcoming Deflation,” which The Japanese Government and the Bank of Japan | 343

was signed by Maehara, Finance Minister Koriki Jojima, and myself and published on October 30, 2012. As published, the document did not take the form of an accord, and the language it contained was sensible. It was less than perfect from the bank’s point of view, but it came within what I thought was our tolerance zone—­though just barely. Notably, it included language emphasizing the need for economic and fiscal reform and thus at least made reference to the economic challenges under­lying the low rate of growth and the need to restore fiscal balance. With re­spect to monetary policy, the text followed the language the bank had ­adopted in February to spell out its “Price Stability Goal in the Medium to Long Term.” The very next day, October 31, the Policy Board de­cided to enhance monetary easing, and ­t hese mea­sures ­were extended again in an MPM on December 20. The size of the Asset Purchase Program was further increased. In addition, in order to encourage more active lending and investment by commercial banks and to help increase credit demand of firms and house­ holds, the board de­cided to introduce its Framework for the Fund-­Provisioning Mea­sure to Stimulate Bank Lending or, for short, the Loan Support Program.6 ­Under this framework, the bank would provide low-­interest long-­term loans in an amount equivalent to the net increase in lending by commercial banks that applied. As a result of ­t hese mea­sures, it was expected that the sum of the Asset Purchase Program and the Loan Support Program, which made up a sizable portion of assets of the bank, would increase substantially from 68.5 trillion yen at the end of 2012 to more than 120 trillion yen at the end of March 2014, which corresponds to a 39  ­percent increase in the monetary base.

DISSOLUTION OF THE HOUSE OF REPRESENTATIVES, AND A GENERAL ELECTION In spite of the agreed-­upon text and the bank’s steps to ease monetary policy, a third round of po­liti­cal calls for an accord quickly started. But ­there was also a rapid shift in the po­liti­cal winds caused, in part, by the impending increase in the rate of the consumption tax and the reform of social security. The Noda cabinet had tabled a bill in the National Diet on March 30, 2012, proposing to raise the tax rate of the consumption tax rate from 5 ­percent to 10 ­percent (see chapter 15). An agreement to amend the bill was reached by representatives of the three major parties in the Diet—­the DPJ, the LDP, and the New Komeito—on June 15, which was confirmed by the secretaries-­general of 344 | The Days as Governor

the three parties on June 21 and approved by the House of Representatives on June 26. But during this period the po­liti­cal capital of the ruling DPJ was wearing thin and the opposition, led by the LDP, was clamoring for an early general election. In response, Prime Minister Noda made an unusual reference to the timing of the next general election with the words “when the tax-­ hike bill becomes law, I ­will ask the public if they still have confidence in this government.” Consequently, the bill to raise the consumption tax rate fi­nally became law on August 10, with support from the LDP and the New Komeito in the opposition-­controlled House of Councillors. While the consumption tax increase became law, a parallel bill to allow the government to issue some 38 trillion yen of JGBs to cover the deficit spending did not make it through the National Diet. As a result, funding of the daily operations of the government gradually became more difficult. On September 26 the opposition LDP brought back Shinzo Abe as its leader, replacing Teiichi Tanigaki. Abe demanded the dissolution of the House of Representatives, and during a debate among party leaders in the Diet on November 14, Prime Minister Noda stated that he would dissolve the House; two days ­later a snap election was called. During the campaign the LDP’s election manifesto clearly committed the party to “set an explicit (2 ­percent) inflation target, and in order to attain it, conduct aggressive monetary easing, through establishing a framework for enhanced cooperation between the government and the Bank of Japan, amending the Bank of Japan Act if necessary.”7 Abe threw extremely rash words at the Bank of Japan as he campaigned, demanding aggressive monetary easing. He also attempted to push the exchange rate lower by referring to its specific levels. The Asahi Shimbun reported on November 20, 2012 that Abe had told an audience in Yamaguchi City that he would direct the Bank of Japan “to roll and roll the printing press and issue unlimited piles of paper money.” That same day the Mainichi Shimbun reported that Abe had promised to “aggressively ease monetary policy, set an inflation target at 2 ­percent or 3 ­percent, and ease money without limit.” The LDP was seeking a complete “regime change” in monetary policy. It was very unusual for the conduct of monetary policy to gain such prominence in an election campaign in a mature developed economy; the long-­standing po­liti­cal wisdom to avoid the politicization of monetary policy was now in smithereens. On November 20 we also had a regularly scheduled MPM, and it was easy to imagine that I would receive questions related to monetary policy and the LDP’s election manifesto during the post-­MPM press conferences. Thinking The Japanese Government and the Bank of Japan | 345

about this, I perceived some tension between my desire to have the bank’s current framework and policies widely understood and the importance of not overstepping the bound­aries of an in­de­pen­dent central bank in a demo­cratic society. With valuable advice from deputy governor Hirohide Yamaguchi, I carefully planned to offer my views without commenting directly on specific manifestos and to avoid provocative language. At the press conference, I noted the following on central bank in­de­pen­dence: Institutional arrangement for the central bank and the in­de­pen­dence of the central bank is something that has been put in place against the backdrop of vari­ous painful lessons gained through the long history of the economy and finance both in Japan and abroad. In other words, it was gradually understood that the society had to take a relatively long-­term perspective if it wished to sustain the stability of the economy and finance, and for that purpose it was necessary to have a dedicated institution to pursue such an end. That culminated as the institutional design of the central bank. If I may quote the words of a prominent academic, the central bank is to the economy something like an alarm clock is to us. We set alarm clocks to wake up the next morning. When the alarm goes off, we often find that it is not easy to wake up, but we would be better off acting upon the alarm. When certain developments are observed in an economy, the central bank is expected to alert the society at large from the ­ eople’s liveliperspective of maintaining the stability of the economy, or p hoods, in the long term, much like ­those alarm clocks in our bedrooms in the morning. The in­de­pen­dence of the central bank has gradually gained ac­cep­tance through humankind’s long history, and has become, in this globalized world, an arrangement that is upheld by economies. The Bank of Japan ­will aim at conducting appropriate monetary policy to the best of its ability without becoming detached from economic real­ity, and earnestly hope that the society would support its in­de­pen­dence.8

THE LAUNCH OF THE ABE CABINET In the general election on December 16, the opposition LDP won 294 seats, while the ruling DPJ suffered a historic defeat with only fifty-­seven seats. Although the vote was not an explicit referendum on the monetary policy of the Bank of Japan, it was impossible to ignore that Shinzo Abe had taken extreme positions on monetary policy and his party had won by a landslide. 346 | The Days as Governor

The Bank of Japan Act sets out the aim of monetary policy as “achieving price stability, thereby contributing to the sound development of the national economy” (article 2). The act incorporates reference to the bank’s in­de­pen­dence by stating, “The Bank of Japan’s autonomy regarding currency and monetary control ­shall be respected” (article 3). At the same time, the act requires that “the Bank of Japan ­shall, taking into account the fact that currency and monetary control is a component of overall economic policy, always maintain close contact with the government and exchange views sufficiently, so that its currency and monetary control and the basic stance of the government’s economic policy s­ hall be mutually compatible” (article 4). In the history of banking ­there are plenty of examples of in­de­pen­dent central banks who made their own decisions that unfortunately led to subsequent economic turmoil, including examples involving the Bank of Japan. History also has examples of governments that pursued shortsighted policies and forced their central banks to adopt monetary policies that ended in economic calamity. In each case, however, and taking a broader view, it might also have been that the pressure of social opinion caused the central bank to act or not act in a manner that led to economic misfortune—­with or without interference from the government. Many countries have a­ dopted the institutional arrangement of central bank in­de­pen­dence to guard against the temptation of social or po­liti­cal pressures to choose growth in the short term at the expense of stability in the longer term, particularly by empowering the central bank to conduct monetary policy aiming for a medium-­to long-­term perspective. But even episodes of severe economic destabilization, such as the Japa­nese b ­ ubble economy and its subsequent burst, should not be understood as the consequence of s­ imple ­mistakes in short-­term economic forecasting. The root c­ auses lie deeper. In the case of the Japa­nese b ­ ubble economy, t­ hese are to be found in neglect t­ oward the buildup of financial imbalances and, in the case of Japan’s recent slow growth, they are found in demographic change and the slow adaptation of Japa­nese society to globalization and technological change. Central bank in­de­pen­dence does not guarantee that all decisions ­will turn out well; indeed, looking back on the long history of the Bank of Japan, not a few judgments by the bank can, in hindsight, be recognized to have turned out poorly. But given the purpose of the bank’s in­de­pen­dence, I felt a responsibility to make the best judgments that I could. Having spent a long, professional c­ areer of almost thirty-­nine years at the bank, I found the prospect of abandoning my own judgment about the course of monetary policy to be almost unbearable. The Japanese Government and the Bank of Japan | 347

What is the appropriate course of action for the central bank when the electorate has thrown its weight b ­ ehind gambling on an experiment? The decision we faced was both delicate and difficult. Conceptually, the Bank of Japan could reject e­ very request from the government. But the public would be likely to regard the bank as obstinate, resulting in a loss of public sympathy. This could eventually lead to the amendment of the Bank of Japan Act and an end to the bank’s ­legal in­de­pen­dence. In fact, ­there ­were intensifying demands from parliamentarians to amend the act, with three dif­fer­ent legislative proposals coming forward in December 2012 from dif­fer­ent po­liti­cal parties, including both the ruling DPJ and the LDP. Given the state of po­liti­cal opinion, I concluded that the release of some sort of joint document, with signatures of ministers and the bank’s governor, was unavoidable. But I was determined to avoid the prospect that a f­ uture Policy Board of the bank might be prevented from taking an action it thought appropriate ­because of a document I had signed. To prevent this, I wanted any joint communication to set out fundamental princi­ples that the bank could not abandon. This would, I hoped, at least leave the interpretation of the communication, and its consequences for monetary policy, in the hands of a f­ uture Policy Board, composed of tomorrow’s governors, deputy governors, and other board members. Just as I had visited the headquarters of the DPJ ­after its landslide victory in the August 2009 general election, on December 18, 2012, two days ­after the LDP’s election victory became apparent, I visited the LDP headquarters and paid a courtesy call to Shinzo Abe. On that occasion Abe indicated his wish to conclude a policy agreement regarding a 2 ­percent inflation target and asked the Bank of Japan to consider it. While I avoided making a specific commitment, I told him that the Policy Board would carefully deliberate, ­because it would be concerning fundamental princi­ples of the bank’s monetary policy, and then discuss the m ­ atter with the new administration. Once again I expected criticism for visiting so soon ­after an election, before Abe was even appointed prime minister and had formed a new government. But for several reasons it was my judgment that it would be better to go when I did. This provided a more informal opportunity to pre­sent my thoughts while Abe was still just the leader of the opposition. Had I waited longer, our first encounter would have been in a much larger gathering at one of the formal meetings at the prime minister’s offices, such as the Council on Economic and Fiscal Policy. In front of so many stakeholders, the risk was that such a meeting would be something of a po­liti­cal set piece in which the bank’s gov348 | The Days as Governor

ernor would be confronting the new prime minister. Moreover, by meeting directly with Abe in private, l felt more at liberty to express my views on the bank’s policies and thereby influence the debate on inflation targeting, raising public awareness about risks of the new government’s aggressive approach. In terms of timing, t­ here was also the coincidence that the bank was scheduled to revisit the price stability goal annually. Consequently, at the press conference on December 20, I laid out the impor­tant issues that I thought would have to be addressed in any joint statement.

THE BANK’S PRINCI­P LES AS EXPRESSED IN THE “JOINT STATEMENT” The pos­si­ble content of a joint policy document was first discussed among the very se­nior staff of the Bank of Japan, the Ministry of Finance, and the Cabinet Office. As the pro­cess wore on, negotiations w ­ ere conducted by deputy governor Yamaguchi and the administrative vice ministers, who ­were the chief bureaucrats in the respective organ­izations. Pro­g ress was reported to me regularly, and I instructed the bank’s negotiating team on the preferred course on ­every impor­tant issue. At the final stage, t­here ­were two meetings among Finance Minister Taro Aso, State Minister for Economic and Fiscal Affairs Akira Amari, and myself to reach agreement on remaining differences. I took care to keep all members of the Policy Board informed about the issues u ­ nder discussion with the government and to have their views reflected in the negotiations. The Policy Board approved the draft of the “Joint Statement” at the MPM held on January  22, 2013.9 The vote was seven in ­favor and two against, with the dissenting votes being cast by two board members—­Takahide Kiuchi and Takehiro Sato. It was a momentous vote for all concerned, no ­matter which way we voted. ­A fter the MPM concluded, I went to the prime minister’s offices with Ministers Aso and Amari and informed Prime Minister Abe of the outcome. The “Joint Statement” was announced si­mul­ta­neously by the Cabinet Office, the Ministry of Finance, and the Bank of Japan. Article 1 of the statement addressed “policy coordination.” The idea was to avoid language, such as “accord” or “policy compact,” that conveyed a ­future constraint by the government on the conduct of monetary policy by the Bank of Japan. The statement made clear that both the government and the bank would each conduct policies at their own initiative and did not presuppose any The Japanese Government and the Bank of Japan | 349

one-­way relationship. “Beating deflation” was treated as the joint task of the government and the bank. Article 2 of the “Joint Statement” referred to the monetary policy of the Bank of Japan, recognizing that fluctuation in prices resulted from many f­ actors and clearly noting that the bank was aiming for price stability on a sustainable basis and not in the short term. The target inflation rate was set at 2 ­percent but was made conditional on economic conditions. Instead of a rigid target, the bank successfully inserted in the text that “the inflation rate consistent with price stability on a sustainable basis ­will rise as efforts by a wide range of entities ­toward strengthening competitiveness and growth potential of Japan’s economy make pro­gress.”10 This sentence was carefully negotiated between the government and the bank and may lend itself to dif­fer­ent interpretations. For the bank’s part, we intended to convey the idea that the inflation target would rise from 1 ­percent to 2 ­percent only if and when t­ here w ­ ere more widespread confidence of an increase in Japan’s potential rate of growth (see chapter 10). ­Toward that end, “Based on this recognition” was inserted before the 2 ­percent figure.11 This was an attempt to convey the long-­standing message from the bank that it was necessary for the government to carry on with structural reforms of the economy. At the same time, ­there was also a recognition of the possibility of turning the 2 ­percent target against the government, where it could be used to justify timely increases in interest rates when, in the f­ uture, t­ here might be a heightened risk of pressures pushing inflation beyond 2 ­percent. The most contentious part of article 2 was the time frame for hitting the inflation target. The Bank of Japan argued for the “medium-­to long-­term,” but the government was insistent on setting a definite time limit of two years. I do not know ­whether this was due to the ignorance of how inflation targeting frameworks operated abroad or to optimistic thinking that aggressive monetary policy would save the day. Nevertheless, the bank stood firm with its view that it could not conduct monetary policy committing to hit 2 ­percent inflation target within two years. Accordingly, ­after much debate, the signatories agreed to the expression “at the earliest pos­si­ble time” as a compromise.12 In any case, the bank made a maximum effort not to create an impression that it had promised to achieve the 2 ­percent inflation target within a predetermined period such as two years. For that purpose it also insisted on its own red line, over strong objections from the government, to state clearly that monetary policy also needed to evaluate other risk ­factors, particularly the buildup of financial imbalances. Article 3 described the actions to be taken by the government, which reiterated its commitment to strengthening competitiveness and the growth potential 350 | The Days as Governor

of Japan’s economy by carry­ing out bold regulatory, institutional, and tax reforms. The government also promised to promote mea­sures aimed at establishing a sustainable fiscal structure with a view to ensuring the credibility of fiscal management.

REACTIONS TO THE “JOINT STATEMENT” The “Joint Statement” left room for dif­fer­ent interpretations, particularly depending on w ­ hether one stood in the shoes of the government or of the bank. From my viewpoint, the bank did all that it could to have the text include the ele­ments we thought essential. I pinned my hopes on the thought that wiser heads might again prevail in ­future discourses on policy. With po­liti­cal pressures to adopt “2 ­percent in two years” almost insurmountable, we sought to block “in two years” but to accept “2 ­percent.” This was a deliberate decision. The months leading up to the release of the “Joint Statement” ­were a bizarre time in Japan, with discussion about monetary policy so highly politicized. While the outcome was not ideal, again I would say that the Bank of Japan at least succeeded in avoiding the worst-­case outcome. ­There ­were two reasons this was pos­si­ble. One was the enhanced public understanding of the issues ­because of our efforts—­from November 2012, onward in particular—to explain the bank’s views through deliberate public outreach. The other was the appointment of Taro Aso as the finance minister. He understood from experience that successive increases in the monetary base would have ­little effect, and he did not hide his conviction about this in private conversations and in meetings of parliamentary committees. Shortly ­after the “Joint Statement” was released, I received a letter written with a brush on a traditional scroll. It was signed by Taro Aso, and was a superb work of Japa­nese calligraphy offering his deep appreciation for my contributions to the statement. I promptly wrote back, though with a fountain pen on my part, thanking Aso for his kindness. If Aso had not been my counterpart in the negotiations, the pro­cess would have been much more difficult and the eventual outcome much more in doubt.

MONETARY EASING MEA­S URES At the MPM held on January 21 and 22, 2013, the Policy Board not only approved the “Joint Statement” but also voted to increase amounts purchased ­under the Asset Purchase Program. Whereas the board had previously set The Japanese Government and the Bank of Japan | 351

upper limits to assets purchases, the new mea­sure was “open-­ended,” meaning a fixed amount of assets would be purchased e­ very month without a specific end date. Our decision to do this was strongly influenced by the mea­sures introduced by the FRB in December 2012. The FRB, which had previously indicated an end date and an upper limit to its asset purchases, for the first time made a commitment without a specific date for ending the purchases, saying instead that it would continue purchasing assets ­if “the outlook for the ­labor market does not improve substantially.”13 Given that in December the Policy Board had already de­cided on the significant increase in asset purchases for next year, “open-­ended” purchases by the bank would start at the beginning of 2014, when the previously announced purchases w ­ ere to have been completed. The Policy Board de­cided that when open-­ended purchases began they would be at a pace of about 13 trillion yen each month, including 2 trillion yen of long-­term JGBs. The aggregate increase in funds supplied by the bank over the next two years was set to be an astounding 60 trillion yen (see fig. 17.1). Explaining the conditions u ­ nder which purchases would continue, the Policy Board stated, “The Bank ­will pursue aggressive monetary easing, aiming to achieve the . . . ​price stability target, through a virtually zero interest rate policy and purchases of financial assets, as long as the Bank judges it appropriate to continue with each policy mea­sure respectively.”14 In this way the bank avoided referring to a specific numeric target for price stability and retained the option to conduct policy in a flexible manner if necessary, consistent with article 2 of the “Joint Statement.” The amounts to be purchased ­were extremely large. The Policy Board saw both pros and cons in d ­ oing this. By choosing such a large increase, any sign of improvement in the economy or in financial conditions would be more likely to be attributed by market participants to the bank’s actions even if the outcomes ­were the result of f­ actors unrelated to monetary policy. And by choosing an unexpectedly large amount the bank could gain praise for fortuitous outcomes. Had we chosen only modest increases in purchases, in the event of lackluster results the bank would have again been criticized for a failure to be forceful enough. Most members of the Policy Board, however, continued to believe that the prob­lems faced by the Japa­nese economy would not be solved without wide-­ranging economic and fiscal reforms. Perversely, a pos­si­ble benefit of significantly increasing the aggregate current account balances at the bank was that perhaps both politicians and economists would eventually come to understand the meaninglessness of such massive increases in quantity. But this outcome was not assured. The press and business leaders ­were still think352 | The Days as Governor

(Trillions of yen) 140 130

Loan Support Program (schedule) Loan Support Program (actual) Asset Purchase Program (schedule) Asset Purchase Program (actual)

120 110 100

Aiming to achieve the price stability target, the bank will continue a virtually zero interest rate policy and purchases of financial assets as long as the bank judges it appropriate to continue with each policy measure.

90 80 70 60 50

For some time, the bank will purchase financial assets of about 13 trillion yen, 2 million yen of which is Japanese Government Bonds, every month.

40 30 20 10 0 CY 2010

2011

2012

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2014

Figure 17.1 ​Amount outstanding of Asset Purchase Program and Loan Support Program. Source: Adapted from Shirakawa (2013).

ing that increases in quantities would have a large effect or that, while the effect of quantity was ambiguous, it was an experiment worth a try. In this environment, I was pessimistic about fi­nally ending the debate. Even if it became clear that an extreme increase in quantity did not have much effect, I feared that the advocates of quantity would come up with a new explanation, blaming unfavorable winds for diminishing the effects of quantity and pushing the day of reckoning farther down the line. A significant risk of adopting such large increases in quantity lay in the prospect that patterns of be­hav­ior and action on the part of the government and private agents would become reliant upon continued increases, or high levels, and make it difficult for the bank to change course in the f­ uture without disturbing the w ­ hole economy. As Ryutaro Komiya once described the effects of quantitative easing as “modest costs and modest benefits,”15 the policy’s benefits remained “modest.” The key was to ensure that costs remained “modest,” but we had no assurance that they would be. But this is precisely why the bank sought to ensure that the “Joint Statement” allowed ­future policy makers to change tack if necessary. We did not want to abandon the assessment of the costs and benefits only to current policy makers and sought to have all of the levers that could be useful in the ­future available. The Japanese Government and the Bank of Japan | 353

DEVELOPMENTS FOLLOWING THE “JOINT STATEMENT” Following the release of the “Joint Statement,” I had a number of occasions to explain the bank’s thinking, including press conferences, meetings of the Council on Economic and Fiscal Policy, and in appearances before the National Diet. At a meeting of the council, held on the night of the statement’s release, ­there was an exchange of views among the council members. I took pains to refer to the specific text of the statement, noting, “Taking into consideration that it ­will take considerable time before the effects of monetary policy permeate the economy, the Bank ­will ascertain ­whether ­there is any significant risk to the sustainability of economic growth, including from the accumulation of financial imbalances.” I did not mention “two years” or any specific time frame. I also stated that “the Bank of Japan welcomes the government’s commitment that it w ­ ill formulate mea­sures for strengthening the growth potential of Japan’s economy such as carry­ing out bold regulatory and institutional reforms, and ­will steadily promote mea­sures aimed at establishing a sustainable fiscal structure.”16 Unsurprisingly, t­ here ­were comments from “expert members” belonging to the private sector who called for achieving the inflation target as early as pos­ si­ble and for more aggressive monetary easing. One member, who was the head of one of the largest Japa­nese companies, argued that the time frame for achieving the inflation target “had to be short and should be one or two years at most.”17 Further, while I stuck closely to the script of the “Joint Statement,” the prime minister chose to ignore the carefully negotiated wording of the statement and made comments consistent with the murky perspective of an extreme version of inflation targeting. ­ ntil the end of my tenure as governor of From January 22, 2013 onward, u the Bank of Japan, the effective dissemination of the bank’s view on the “Joint Statement” became my most impor­tant remaining responsibility. Another meeting of the Council on Economic and Fiscal Policy was held on January 24, with the agenda including “an intensive discussion on monetary policy and prices.” The prevailing mood at the meeting was no dif­fer­ent from the previous meeting, with one council member, who was a leading businessman, taking a stab at the Bank of Japan’s commitment to assess any “accumulation of financial imbalances,” which was clearly recognized in the “Joint Statement.” I was saddened to hear such remarks, sounding much like ­those of politicians, coming from “expert” members who w ­ ere expected to offer in­de­pen­dent views from the perspective of the private sector. 354 | The Days as Governor

­There ­were also repeated discussions in committees of the National Diet, where the focus was on both who was responsible for achieving the 2 ­percent inflation target and on when it was to be achieved. In the statements of government representatives, one would often hear the phrase that had not been used in the “Joint Statement.” I cite two statements by Abe in a response to questions from opposition parliamentarians in the following manner. “As for the 2 ­percent price stability target, as it is noted in the recent Joint Statement, the Bank of Ja­ pan promised that it would achieve 2 ­percent as soon as pos­si­ble, regarding it as the Bank’s own responsibility. That is how I understand it.”18 “We believe that we need to aggressively ease monetary policy now. The Bank of Japan should aggressively ease policy, and since it is a monetary phenomenon, the Bank should properly do what it should as a central bank in order to achieve the 2 ­percent price stability target.”19 In the “Joint Statement,” the clause declaring that “deflation is a monetary phenomenon” was not used. I myself carefully followed the words in the statement, which was signed by the representatives of the government and the bank. For example, I stressed that “the government and the Bank of Japan ­will strengthen their policy coordination and work together, in order to overcome deflation early and achieve sustainable economic growth with price stability,” and that “the Bank recognizes that the inflation rate consistent with price stability on a sustainable basis w ­ ill rise as efforts by a wide range of entities ­toward strengthening competitiveness and growth potential of Japan’s economy make pro­gress.”20 I never made references to a specific time frame for hitting the inflation target, such as two years.

THE OUTLOOK ON THE ECONOMY AND PRICES AT THE TIME OF THE “JOINT STATEMENT” Between November 2012 and January 2013, while the politics surrounding the Bank of Japan had under­gone seismic shifts, international financial markets ­were also showing subtle signs of changes in prevailing trends (see fig. 17.2). The most impor­tant under­lying ­factor was the receding of the Eu­ro­pean debt crisis, which gradually became evident from the summer of 2012 onward. As investors became less risk-­averse, the demand for safe-­haven currencies declined in the foreign exchange market, leading to a weakening of the yen exchange rate. The dollar-­to-­yen rate, which remained at around seventy-­eight to seventy-­nine yen u ­ ntil October 2012, increasingly weakened, hitting the eighties in November and reaching eighty-­two yen by the end of the month. The The Japanese Government and the Bank of Japan | 355

120 115 110

Appreciation

Depreciation

105 100 95 90 85 80 75 70 2012/4

Japanese yen US dollar Euro UK pound Swiss franc Korean won Australian dollar 2012/6

2012/8

2012/10 2012/12

2013/2

2013/4

2012/6

2013/8

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Figure 17.2 ​Nominal effective exchange rates (narrow index). Source: Bank for International Settlements.

fall of the yen accelerated in December, when the rate reached the eighty-­six-­ yen level at the end of the year, and further weakened to 90.03 yen a few days before the release of the “Joint Statement” in late January 2013. The fact that the main driver of such downward movement of the yen exchange rate was the easing of the Eu­ro­pean debt crisis could be confirmed by the movements in the nominal effective exchange rate. If the levels on July 26, 2012, when Mario Draghi made his famous remarks, was regarded as the benchmark, the euro had appreciated by 1.7 ­percent, 3.0 ­percent, and 3.8 ­percent at the end of August, September, and October, respectively. In contrast, the yen depreciated by 1.7 ­p ercent, 1.9 ­percent, and 5.0 ­percent over the same period (see fig. 17.2). Moreover, noninvestment trade-­related flows in the foreign exchange market also pointed to a weaker yen, as the Japa­nese trade accounts fell deep into the red, reflecting increasing imports of crude oil and natu­ral gas in the aftermath of the nuclear power plant accident in Fukushima. The campaign rhe­toric of then opposition leader Abe in the run-up to the general election, which was calling for weaker yen and demanding aggressive monetary easing by the Bank of Japan, might have had some influence on the exchange rate movements as well. Nevertheless, the depreciation of the yen would not have happened if the global financial markets had not experienced a profound sea change in the summer of 2012. 356 | The Days as Governor

With both of ­these improved sentiments in international financial markets, and particularly with the weaker yen, the Japa­nese economy also began to turn around. Business conditions, which entered a brief downturn in March 2012 when the Eu­ro­pean debt crisis was in full swing, fell to its lowest point in November, one month before the government led by the DPJ lost power.21 The Nikkei Index, which bottomed on June 4, 2012, at 8,295 yen and remained in the doldrums, began to rise markedly around November. Against this backdrop, and also taking into account the new easing mea­ sures then a­ dopted, at the MPM of January 2013, the Bank of Japan reviewed its economic and price outlook, previously released at the end of October 2012. The central tendency for gross domestic product growth was revised up considerably for the 2013 fiscal year, from 1.6 ­percent to 2.3 ­percent, and the growth outlook for the 2014 fiscal year was also slightly lifted, from 0.6 ­percent to 0.8 ­percent.22 The dynamics ­behind t­ hese expectations for recovery included the increasingly stimulative monetary conditions, as interest rates remained low while the outlook for profits and growth improved, as did the recovery of overseas economies. In fact, the final number for growth in the 2014 fiscal year topped the bank’s expectations by coming in at 1.5 ­percent, while growth in the 2013 fiscal year had been 1.7 ­percent. The central tendencies for the forecasted increase in the CPI, excluding fresh food and adjusted for the increase in the consumption tax, w ­ ere 0.4 ­percent and 0.9 ­percent for the 2013 and 2014 fiscal years, respectively. At that time, medium-­to long-­term inflation expectation polled among economists and market prac­ti­tion­ers remained stable at around 1  ­percent.23 In this environment the Bank of Japan envisaged that a gradual tightening of the output gap would steadily, if slowly, push up the a­ ctual rate of inflation. The final outcome showed that the CPI ­rose by 0.8 ­percent in both the 2013 and 2014 fiscal years.

DECIDING TO LEAVE OFFICE BEFORE THE END OF MY TERM AS GOVERNOR ­ fter completing the critical pro­cess of issuing and of explaining the “Joint A Statement,” my next impor­tant decision was to decide on the best timing for leaving the office of governor. By a quirk of the po­liti­cal environment that had led to my appointment five years e­ arlier, my term was set to expire on April 8, 2013, but the term of the two deputy governors would expire on March  19. Consequently, between March 20 and April 8, I would remain as governor and chair The Japanese Government and the Bank of Japan | 357

the MPM, even ­after two new deputy governors had taken office. This could have resulted in a rather awkward three weeks. From time to time I had thought about this during my term as governor, but it became a more pressing concern ­after the launch of the Abe cabinet and the release of the “Joint Statement.” I did not agree with Prime Minister Abe’s views on monetary policy. But ­because his government had received a mandate from the Japa­nese ­people in the general election, I thought it would be preferable to allow a new governor to be appointed by the new government to assume responsibilities at the bank concurrently with the new deputy governors. I de­cided to resign as governor to take effect on March 19, and I visited the prime minister on February 5 so that I could inform him directly of my decision, which I announced to reporters ­later that eve­ning. As I faced reporters, I stressed that my resignation was intended to allow the new governor and deputy governors to assume office at the same time and, thus, that I would carry out my responsibilities as governor u ­ ntil March 19. Reporters asked w ­ hether I was resigning in protest or had been pressured by the government, but I explained that neither was the case. ­Later that night, I phoned several overseas central bank governors, with whom I was often in close contact, to inform them of my decision.

MY LAST MONTH IN OFFICE I spent my final month as governor tying up loose ends. I concluded that during that month I should refrain from commenting in public on the current intricacies of monetary policy and instead try to lay groundwork for ­f uture attention on the fundamental issues confronting the Japa­nese economy. Over the previous years I had begun to elucidate my thoughts on the ­causes of Japan’s slow rate of growth, but now I wanted to cap my time at the Bank of Japan with a valedictory that would try to encompass the breadth of the economic challenges facing Japan. I made use of an opportunity offered by the Japan Business Federation to deliver a speech titled “­Toward Strengthening the Competitiveness and Growth Potential of Japan’s Economy” at the end of February.24 The speech was strongly colored by the “Joint Statement” and the 2 ­percent inflation target, which had been announced only a few weeks e­ arlier. As the statement succinctly explained, the 2 ­percent target was not an unconditional objective but also required that t­ here be pro­gress on structural reforms. Although the po­liti­cal environment did not appear to be favorable, I took this occasion to reiterate the bank’s views on the necessity of structural reforms and also to 358 | The Days as Governor

leave a reference point that could be used to mark ­future governments’ pro­ gress in addressing the impediments to higher rates of potential growth. My last trip abroad as governor was to attend the bimonthly Bank for International Settlement (BIS) governors’ meetings in Basel, Switzerland, on March  10–11, 2013. Over my five-­year tenure I had visited Basel twenty-­eight times. Having begun my pilgrimages to Basel long before becoming governor, it was quite a sentimental occasion to realize that this visit would be my last as a central banker. ­After the formal meetings ­were finished, ­there was a farewell dinner at the top floor of the BIS Tower. Since I was asked to say a few words of farewell at the end of the dinner, I penned a draft, remembering the speeches of the past out­going governors, and wishing to focus especially on the environment at that time where the central bank had become “the only game in town.” When one envisaged central bank in­de­pen­dence, it usually meant in­de­pen­dence from the government, juxtaposed to the idea of avoiding fiscal dominance. That had been an impor­tant consideration, but something more complex seemed to be ­going on around the world. ­There was more to it than simply governments asking their central banks to shore up public finances for the time being. Governments could not go against the grain of public opinion so hostile to painful reforms. The central banks ­were fixated on delivering something that would satisfy the calls for them to behave in an accountable manner. They ­were, in fact, ­under collective pressure from society at large. It seemed to me that, in response to this pressure, ­there was a tendency for ­these banks to adopt policies that aimed to generate short-­term benefits without consideration of the longer-­term consequences, which I labeled as being a prob­lem of “social dominance.” I expressed the view that central banks would have to face this prob­lem in the ­future. On my last day as governor, March 19, I held my final press conference. I faced many questions on deflation, the strong yen, communications with financial markets, and the responsibilities of the Bank of Japan. I most carefully prepared some remarks to address the idea that the bank had failed to “work on expectations” to beat deflation and weaken the yen—­a refrain that I had heard from many of the bank’s critics, that had animated the po­liti­cal campaign and the economic policies pursued by Prime Minister Abe, and that had reached a crescendo in the last few months of my tenure. Responding to a reporter’s question, I answered, “If ‘working on expectations’ meant that ‘the central bank could move markets at ­will through its words,’ I would find such a view on markets or policies rather precarious.”25 Obviously, I explained, I did not believe that central bankers’ words have no effect; they are indeed impor­tant. But words must be substantiated by effective actions. For example, it would be The Japanese Government and the Bank of Japan | 359

vital for the central bank to communicate clearly that it w ­ ill uphold the stability of the financial system and to back up ­these words when the central bank can hand out “manna from heaven” by providing unlimited liquidity as the lender of last resort. In contrast, as I have tried repeatedly to explain in t­ hese pages, the under­lying ­causes of Japan’s low rate of potential economic growth cannot be solved by monetary policy. It would be dangerous to conduct a monetary policy aimed at “working on expectations” in such an environment. Following the press conference, I addressed the staff of the Bank of Japan in a large hall on the ninth floor of the bank’s headquarters. I thanked the staff and reiterated my thoughts that banking operations are the most concrete form of ser­vice that the central bank can provide to society. ­These operations appear as common as the air around us for most p ­ eople. But, in this case, considerable efforts are required to ensure that the air can circulate properly. In addition, imagining that many of the staff and their families might feel insecure as a result of all the sharp criticism, I explained what I thought the Bank ­ atter, I said, of Japan stood for. Of central bank in­de­pen­dence, the crux of the m “The central bank is expected to pursue the stability of the economy from a longer-­term perspective than the society at large, and the underpinning of that function is central bank in­de­pen­dence. The central bank is expected to have a strong sense of responsibility to achieve such a goal, and at the same time, the bank must remain h ­ umble and not become arrogant. The central bank is always pursuing such a delicate balancing act.” Looking back at my time as governor, especially the last few months, the calls for a “regime change” of monetary policy had been aggressive and I had resisted. As governor I had tried my utmost to serve the country and do what I thought was right. It is true that “only history is the jury” and that it w ­ ill take many years for an accurate assessment of our actions to emerge. But the interpretation of history is not always unan­i­mous. Given the difficulty of anticipating the judgment of history, I tried to focus on the inner criterion of being faithful to my own professional judgment—as a central banker and a public servant. I was happy to be able to end my remarks with this sense of quiet reflection and confidence. With the farewell to staff over, I returned to my office to clear out what l­ ittle remained on my desk. I then took the elevator down to the bank’s lobby. ­There I was presented with flowers from my secretary, Tomoko Ishikawa, who had provided the most dedicated support to me over the previous five years. I slipped inside a car, which took me out of the bank headquarters where I had spent thirty-­nine years, amid applause from staff members who thronged the driveway. 360 | The Days as Governor

| CHAPTER EIGH­T EEN |

The G­ reat Monetary Experiment and the Spread of Japanification The experience of Japan’s economy since the bursting of the ­bubble has been extensively studied by foreign academics and policy makers. Many lessons have been learned that have profoundly affected debates about monetary policy in the other major developed economies and also in Japan. Broadly speaking, the global debate inspired by Japan’s experience has gone through four phases. Initially t­ here was a rather sanguine view about the consequences for Japan’s economy. In the second phase, foreign observers harshly criticized the Japa­ nese policy responses as being responsible for a “lost decade”—­and then “lost decades”—of economic per­for­mance, with an intensity that peaked from 2012 to early 2013, as was discussed in chapter 17. In the third phase, starting in 2013, Japan’s deployment of an extremely aggressive monetary policy, which could be called a “­great monetary experiment,” was greeted with enthusiasm, and optimism prevailed for a while. Now, in the fourth phase, t­ here has been a growing realization that the experiment has not delivered what was promised. In parallel, similarities between Japan’s experience and t­ hose of other developed economies have been discussed ­u nder the label of Japanification—­t he meaning of which remains in the eye of the beholder.

“SELF-­I NDUCED PARALYSIS” In the immediate aftermath of sharp declines in the Japa­nese equity and commercial real estate markets, most overseas observers w ­ ere unconcerned about the consequences for ­either the Japa­nese financial sector or the per­for­mance of the economy. Perhaps influenced by the strong per­for­mance of the Japa­nese economy in prior de­cades, expectations centered on a resumption of the prior growth pattern. In a 2002 paper, a group of Federal Reserve Board (FRB) economists, drawing lessons from Japa­nese experiences in the 1990s, documented 363

the consistent downward revisions of forecasts for Japa­nese growth and inflation that ­were made by FRB staff, private economists, and staff at the International Monetary Fund (IMF). The paper notes that “only in the latter half of the de­cade did a fundamental reassessment of the outlook for Japan appear to take place.”1 In the second phase, the mood of the foreign academic community was best captured by then Prince­ton University professor Ben Bernanke’s criticism of what he called Japan’s “self-­induced paralysis.”2 Foreign journalists ­were also more critical. A case in point was Martin Wolf of the Financial Times; in an article titled “Japan on the Brink,” Wolf argued that a sufficient expansion of money in Japan would invite inflation—­which, in turn, would lower both real long-­term interest rates and the real exchange rate, stimulating growth. He maintained the need to deploy a policy of “successful monetary expansion,” arguing, “If orthodoxy ­will not work, the right response is not to do nothing but to do something unorthodox.”3 Most mainstream macroeconomic academics supported this reasoning and ­were confident about the effectiveness of aggressive monetary easing. Criticism of the Bank of Japan for not pursuing a greater monetary expansion was a par­tic­u­lar feature of the Washington Consensus at the time. Much ­later, in 2019, the In­de­pen­dent Evaluation Office of the IMF noted in its evaluation report on IMF advice on unconventional monetary policies that “­until 2012, fund staff ­were critical of the BOJ’s [Bank of Japan’s] reluctance to ease more strongly” and that “fund staff gave fairly detailed prescriptions about the easing tactics that the BOJ should use, even more so than in the case of the ECB [Eu­ro­pean Central Bank].” 4

AVOIDING JAPANESE-­S TYLE DEFLATION Critical views of both Japan’s economic per­for­mance and of the Bank of Japan’s monetary policy affected the thinking about monetary policy in other developed economies that appeared to face conditions that looked similar to ­those Japan had experienced. It was precisely a fear of a “Japa­nese style of deflation” that prompted the FRB to embark on additional monetary easing in 2003. In his famous speech “Deflation: Making Sure ‘It’ D ­ oesn’t Happen ­Here,” Bernanke explic­itly cited the need to avoid repeating Japan’s ­mistakes as the rationale for maintaining a highly accommodative stance for US monetary ­policy.5 The possibility that this course might lead to a financial crisis (like ­Japan’s) was flatly dismissed by US policy makers (see chapter 6). The Japa­nese experience was again cited as a reference ­after the United States was faced with 364 | The Roles of the Central Bank

early signs of financial crisis in 2007. ­After the global financial crisis (GFC) of 2007–9 erupted, Japa­nese experience was yet again discussed. The transcripts of the Federal Open Market Committee (FOMC) meeting in December 2008 ­were particularly in­ter­est­ing in this re­spect. Participants extensively discussed the zero lower bound of interest rates, as well as unconventional monetary policy (UMP), and the experience of Japan and the use of quantitative easing by ­ ere repeatedly referenced. The consensus was that the the Bank of Japan w United States should avoid a scenario similar to the Japa­nese one at all costs and could do so by deploying bold policy actions promptly.

THE MONETARY EXPERIMENT AND A­ FTER The third phase, of optimistic enthusiasm, began just ­a fter I left the Bank of Japan in March 2013. In April of that year the bank ­adopted a much more aggressive stance t­oward easing that they called quantitative and qualitative monetary easing (QQE). The bank specified a horizon of “about two years” for achieving a 2 ­percent price stability target and announced that it would “double the monetary base and the amounts [purchased of] outstanding of Japa­nese Government bonds” in the same period. The bank explained that QQE would drastically change the expectations of markets and economic entities. What was intended was “regime change” in monetary policy. The new government’s economic policy package was welcomed by market ­participants and dubbed “Abenomics” (­a fter Prime Minister Shinzo Abe)—­ providing a combination of aggressive monetary easing, fiscal stimulus, and structural reform. Indeed, the expansion of the Bank of Japan’s balance sheet, and thus of the monetary base that followed, was huge (see fig. 18.1). Foreign economists, in par­tic­u ­lar, w ­ ere quite enthusiastic about the expected effectiveness of QQE, though Japa­nese economists w ­ ere somewhat less sanguine.

THE EXPLOSIVE EXPANSION OF CENTRAL BANK BALANCE SHEET What was the outcome of this g­ reat monetary experiment? A paper by FRB economist Taisuke Nakata, published in early 2020, best summarizes the outcome: Since March [sic] 2013—­when the BOJ introduced quantitative and qualitative monetary easing (often referred to as QQE)—it has taken vari­ous The ­Great Monetary Experiment | 365

(% of nominal gross domestic product) 120 Japan United States Euro area

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40

20

0 1995

1997

1999

2001

2003

2005

2007

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2011

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2015

2017

2019

Figure 18.1 ​The size of central bank balance sheets. Sources: Bank of Japan; Federal Reserve Economic Data, Federal Reserve Bank of St. Louis.

steps to stimulate the Japa­nese economy and increase the rate of inflation. Th ­ ose mea­sures include, among o ­ thers, a rapid and substantial expansion of the central bank’s balance sheet, more aggressive use of forward guidance, negative interest rate policy, and purchases of private securities through exchange-­traded funds (ETFs). Most notable is the expansion of the BOJ’s balance sheet. The size of the BOJ’s balance sheet relative to GDP [gross domestic product] increased from around 30 ­percent in the first quarter of 2013 to over 100 ­percent in the third quarter of 2019. . . . ​Currently, the size of the balance sheet of the BOJ relative to the GDP in Japan is by far the largest of all central bank balance sheets.6 As for the inflation (see fig. 18.2), a focal point of the heated debate in the past, Nakata notes, However, inflation still remains below the new target level of 2 ­percent. It is even below the old target level of 1 ­percent. . . . ​The difficulty of raising inflation to the new target level has surprised the BOJ and seasoned observers of the Japa­nese economy. . . . ​Soon ­a fter the introduction of 366 | The Roles of the Central Bank

(Year-on-year change, %) 3.0

2.0

1.0

0.0

–1.0 Actual Projection Explicit inflation target Implicit inflation target 2005

2010

2015

2020

–2.0

–3.0

Figure 18.2 ​The inflation rate and its projection by the Bank of Japan. Source: Nakata (2020).

QQE in March 2013, the BOJ appreciably raised the projected path of inflation, forecasting that inflation would reach the new target of 2 ­percent in two years. As the ­actual inflation rate came in below the projections, the BOJ adjusted its forecasts downward. According to the most recent projection, the BOJ expects that inflation ­will not reach the 2 ­percent target ­until at least the end of FY2021—9 years ­after the adoption of the 2 ­percent target.7 Market expectations of inflation have also been subdued. Indeed, the expected inflation rate derived from the ten-­year inflation-­indexed bond consistently followed a downward trend from early 2013 onward, in contrast to the upward trend in the prior period of 2009–12.8 And as of this writing, year-­on-­ year increase of CPI is −0.9 ­percent (November 2020). The fact that inflation did not respond to the monetary “regime change” surprised a number of economists. A report by the IMF In­de­pen­dent Evaluation Office noted that “the The ­Great Monetary Experiment | 367

impact of UMP appears to have been much more muted, particularly in Japan, than asserted when Fund staff ­were pushing ­these policies.”9 ­There appears to have also been a rethinking among some of the previous detractors of the Bank of Japan. As Mark Gertler—­a long-­standing critic of the Bank of Japan’s previous monetary policy but ­later an adviser to the bank’s Institute for Economic and Monetary Studies—­argued at the annual research conference at the bank in 2017, “In the spring of 2013 the Bank of Japan introduced a state-­of-­the-­art monetary policy which included among other ­things inflation targeting and aggressive use of forward guidance. In contrast to the predictions of conventional macroeconomic theory, ­t hese policies have had only very ­limited success in reflating the economy.”10 Gertler was candid in his assessment, noting, “Chief among the challenges is accounting for the sustained low inflation and economic weakness in Japan. It is no longer pos­si­ble to blame the stagnation in Japan on mismanagement of monetary policy.”11 Former US Trea­sury Secretary Larry Summers, writing with Anna Stansbury, was even more direct in 2019: “The utter failure of the Bank of Japan’s extensive efforts to raise inflation suggest that what was previously treated as axiomatic is in fact false: central banks cannot always set inflation rates through monetary policy.”12 Five months ­a fter the conference, and sixteen years ­a fter he had penned his highly critical article “Japan on the Brink,” Martin Wolf returned with a dif­fer­ent tune in December 2017, a Financial Times article titled “Conventional Wisdom on Japan Is Wrong.” By “conventional wisdom” Wolf means the monetary policy proposals of mainstream macroeconomists. In the article he points out that inflation in Japan had showed only a 0.2 ­percent increase despite all the many efforts of the Bank of Japan to grow the quantity of the monetary base. Arguing that “the failure to raise inflation appears no disaster,” Wolf turned his policy evaluation to a real side focus. Japan had entered a cyclical upturn from the trough of November  2012 ­a fter only a brief downturn, but the average growth rate in this cyclical upturn was lower than that of the previous cyclical upturn of 2002–7 (see fig. 18.3). But the recovery from the end of 2012 onward had been essentially due to the global recovery. Wolf ’s policy evaluation was, “Given Japan’s demography and currently low unemployment, raising productivity is essential, though increasing participation of ­women and older ­people also ­matters.”13 I agree with this, but unfortunately, Japan experienced a decline in total ­factor productivity growth in the period of the ­g reat monetary experiment in subsequent years (see fig. 18.4). 368 | The Roles of the Central Bank

(Year-on-year, %) 8 6 4 2 0

X

X

X

X

X

–2 –4 –6 –8

X

Real gross domestic product growth Average since 1990Q1 (1.12%) Average from 2002Q1 to 2008Q1 (1.39%) Average since 2012Q4 (1.01%) Peak Bottom

–10 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

Figure 18.3 ​Real gross domestic product growth. Source: Japa­nese Cabinet Office.

(Year-on-year, %) 5 Total factor productivity Capital input Labor input Potential growth rate

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Figure 18.4 ​Estimate of Japan’s potential growth rate. Source: Bank of Japan, Outlook Report, April 2020.

2015

Looking back at the ebb and flow of intellectual fashion reflected in t­ hese commentaries, and at the ­actual data for growth and inflation in Japan, I am both saddened and frustrated. Even so, we now can reexamine assumptions under­lying the prevailing intellectual models in light of the ­actual consequences of Japan’s extreme monetary experiment.

THE SPREAD OF JAPANIFICATION For mainstream macroeconomists ­there was another surprise in store—­one that was not so vis­i­ble initially but increasingly evident a­ fter the GFC, when the experiences of many developed economies followed a path of disappointingly slow growth quite similar to what Japan had experienced ­after the bursting of its b ­ ubble. Mainstream Western economists have used the term Japanification to describe a low-­growth path without acknowledging the numerous similarities both in causation and consequences.14 One similarity is low growth. The potential growth rate of the United States projected by FOMC members was continuously revised downward. In fact, we can see that ­there was no material difference between Japan and other developed economies in terms of real GDP growth in the periods following the peak year of the respective b ­ ubbles (1991 in Japan, 2007 in the United States; see chapter 10). A second similarity is low inflation. Almost all central banks in developed economies have consistently undershot their 2 ­percent inflation targets since the time of the GFC. While the inflation rate was the lowest in Japan, all developed economies have followed the same declining trend. Th ­ ese growth and price developments have come to be reflected in declining and low levels of long-­term interest rates. It was on October 31, 2002, that yields on ten-­year government bonds in Japan went below 1 ­percent. At the time, yields on long-­term government bonds in Eu­rope and the United States did not fall as low as ­those in Japan, but all the major developed economies now share the fate of per­sis­tently low long-­term interest rates, and in some cases even negative ones. Thus, a third similarity can be found in the ongoing per­sis­tence of very low interest rates. When the Bank of Japan introduced the UMP mea­sures, including the zero interest rate policy, forward guidance, quantitative easing, and purchase of risk assets in the early 2000s, I never expected central banks in other developed economies to adopt t­hose policy mea­sures subsequently and to be stuck at similarly low rates of interest. I suspect my counter­parts at foreign central banks have been similarly surprised. 370 | The Roles of the Central Bank

A fourth similarity has been in the response of both policy makers and the society at large. Policy makers and economists the world over have tended to be optimistic in the initial stages ­after the ­bubbles have burst. Many appear to have been in complete denial that economic activity would severely suffer, while ­others grossly underestimated the negative impact. Moreover, ­after the acute financial crisis was passed, initial signs of economic recovery led first to spreading optimism that prior rates of growth would resume, but then to disappointment and the recognition of the “false dawn” (see chapter 9). Fi­nally, a similarity can also be found in the hostile public response to the use of public funds to recapitalize banks, resulting in delays of needed policy actions. ­After the GFC, demand for more stringent regulation intensified, but then, ­after a while, criticism of overly restrictive regulations returned. In response, government authorities veered from actions that restrict bank lending to t­ hose that took the opposite tack: promoting lending.

WHAT LESSONS SHOULD BE LEARNED? Over the past de­cade, a number of countries have followed a path very similar to the one that Japan has taken; additionally, Japan’s ­great monetary experiment has failed to deliver what was promised. How w ­ ill ­these two facts influence the intellectual framework for monetary policy in the ­future? One ­thing is clear: as the inflation rate remains far below the 2 ­percent target, no one in Japan ­today utters any longer the once frequently heard mantra “Deflation is a monetary phenomenon.” Many Japa­nese may have already forgotten how frequently this misguided platitude was repeated by economists and Japa­nese politicians. But overall ­there seems to be no strong appetite among academics and policy makers for change in the intellectual framework of monetary policy at this juncture. The remarks by Bernanke, as president of the American Economic Association in 2020, still seem to be the standard argument: “As the experience of Japan in recent de­cades has demonstrated, low inflation can become a self-­perpetuating trap, in which low inflation and low nominal interest rates make monetary policy less effective, which in turn allows low inflation or deflation to persist.”15 The argument implicitly suggests that the prob­lem is simply that policy makers had allowed inflation to become too low in the first place. Olli Rehn, the governor of the Bank of Finland, makes this point more explic­itly when he notes that “one of the lessons from the Japa­nese experience is that central The ­Great Monetary Experiment | 371

banks should at all costs avoid letting inflation fall too low.”16 Lessons once drawn from the Japa­nese experience now appear to be hardwired and unthinkingly accepted. Commenting on the muted response of the rate of inflation to the ­great monetary experiment, the IMF In­de­pen­dent Evaluation Office observes that “­there does not seem to be a systematic pro­cess for identifying such forecast errors and drawing lessons from them in a way to guide ­future policy advice.”17 Oddly, even as other countries appear to follow the trajectory of Japanification, the lessons of Japan’s experience, both before and a­ fter the GFC, are still treated as exceptional and unique to Japan.18

372 | The Roles of the Central Bank

| CHAPTER NINETEEN |

Lessons from the Experiences of the Japa­nese Economy As was discussed in chapter 18, the lesson most typically associated with the Japa­ nese experience by outside observers is prob­ ably that central banks should, at all costs, avoid letting inflation fall too low. Over the past two de­ cades this message has become deeply ingrained in the thinking of policy makers and academics. But is it right to characterize Japa­nese economy since 1990 as suffering from “lost de­cades”? Is deflation the root cause of the low growth of the Japa­nese economy? Now that the monetary experiment did not deliver on its promise and so-­called Japanification is so widespread as a phenomenon, we have to reconsider seriously the validity of mainstream macroeconomics.

THE ARGUMENT OF “THE LOST DE­C ADES” According to a search of articles in the Nikkei newspaper that included the words “the lost de­cade” or “the lost de­cades,” the term first appeared in 1998, and its use increased substantially a­ fter 2007. The use of “the lost de­cade” reached its peak in 2010, and “the lost de­cades” in 2013. My views on the use of “the lost de­cades” to describe the Japa­nese economy have evolved considerably over time. I initially was not so uncomfortable with this characterization of the economy. On the contrary, it perfectly resonated with my feeling of frustration with the delay in deploying public money necessary for prompt response to the nonperforming loans prob­lem. Yet ­a fter many years I started to feel a sense of unease with the expression. The biggest reason for this change is that “the lost de­cades” had gradually come to represent the argument that the root cause of the prob­lem was deflation, and aggressive monetary easing was its solution. I came to disagree with this diagnosis and policy prescriptions. My views changed further ­a fter the global 373

125 120

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 (Index, 1991 = 100)

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80 75

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Figure 19.1 ​Real gross domestic product ­after the burst of the ­bubble. Sources: Eurostat; Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Japa­nese Cabinet Office.

financial crisis (GFC) of 2007–9 by observing many similarities between the early Japa­nese experience and postcrisis developments in other developed economies. It is true that the Japa­nese growth rate is on a declining trend. The expression “the lost de­cades” has two kinds of connotation. One is that low growth could have been avoided if macroeconomic policies, especially monetary policy, had been deployed more aggressively. The other is that this phenomenon is unique to Japan. As Olivier Blanchard and Lawrence Summers noted almost a de­cade ­after the eruption of the GFC, “The Japa­nese ‘lost de­cade’ was interpreted as the result of a succession of policy failures.”1 Yet if we look at the statistical facts of the past three de­cades ­after the ­bubble economy of Japan, ­these conclusions are not supported. For one, we can compare gross domestic product (GDP) growth across advanced economies during the period ­after their respective ­bubbles burst (see fig. 19.1). No material difference is observed between US and Japa­nese GDP growth in terms of the path relative to their cyclical peaks during the b ­ ubble periods. Compared with non-­US advanced economies, the Japa­nese GDP per­for­mance was better than that of the euro and almost the same as that in the United Kingdom. We can also compare real GDP growth over the same time period ­after 2007, when economic 374 | The Roles of the Central Bank

(Index, CY 2007 = 100) 125 120 115 110 105 100 95 Japan 90

United States United Kingdom

85 80

Euro area 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Figure 19.2 ​Real gross domestic product ­after the onset of global financial crisis of 2007–9. Sources: Eurostat; Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Japa­nese Cabinet Office.

activities peaked (see fig. 19.2). The US economy showed higher growth than did other advanced economies. Yet if we compare real per capita GDP growth, no material difference can be found between Japan and the United States until 2013 (see fig.19.3).

THE ROOT ­C AUSES OF A DECLINING GROWTH TREND IN THE JAPA­N ESE ECONOMY However inappropriate it may be to describe the period from 1990 to 2010 as “lost,” we have to explain clearly why Japan’s growth rate has declined. In my view, arguments identifying the ­causes of a declining growth rate in Japan during ­ ubble can be categorized into three types. the period following the burst of the b The first argument stresses the lack of demand. The second highlights the negative impact caused by the impaired functioning of the financial system ­after the bursting of the ­bubble—­that is, the decline in the credit intermediation capacity of banks due to their shortage of capital. This argument focuses on the supply side of the economy, and it puts par­tic­u­lar weight on the financial sector. The third argument is more structural in nature, and emphasizes the decline of the potential growth rate. This does not deny the impact of an Lessons from the Japanese Economy | 375

(Index, CY 2007 = 100) 125 120 115 110 105 100 95 Japan United States

90

United Kingdom Euro area

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Figure 19.3 ​Real gross domestic product per capita ­after the onset of global financial crisis of 2007–9. Sources: Eurostat; Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Japa­nese Cabinet Office.

impaired financial system but takes a much broader view. E ­ arlier discussion along t­ hese lines had been provided by two famous academics, Fumio Hayashi and Edward Prescott (the latter a Nobel Prize winner), in which they focused on the decline in ­labor input through the decline in working hours.2 ­Later discussions on the source of declining productivity shifted the focus to the decline in total f­actor productivity—­namely, that many companies had failed to adapt their business models to changes in the global economy and technology, and many inefficient companies—­often called zombie companies—­had not been forced to exit the market. The importance of ­these supply-­side or structural ­factors is still not fully recognized. Observers who think that the Bank of Japan’s monetary policy was not forceful enough have argued that, since t­ hese f­actors w ­ ere not changing in the short term, the true prob­lem was shortfall of demand. But when we discuss economic per­for­mance over a period spanning one or two de­cades, my sense is that the distinction between demand and supply becomes increasingly blurred ­because the gradually ingrained expectation of a declining potential growth generates ongoing weakness in demand. 376 | The Roles of the Central Bank

MY TAKE ON THE LESSONS FROM THE JAPA­N ESE EXPERIENCES The first lesson—­not a very novel lesson—is that the economy is doomed to stagnate and grow at an exceptionally low rate for a long time if it ­earlier veers from its sustainable growth path for an extended period. In the case of Japan, the deviation from the sustainable path took the form of a huge ­bubble, accompanied by a massive increase in debt as well as asset prices. Monetary easing a­ fter the burst of the ­bubble could mitigate the pain due to adjustment, but it could not nullify the need for adjustment itself. Preemptive mea­sures are required in financial regulation and supervision and in monetary policy. With regard to monetary policy, it should not be conducted with a view of economic activities and prices over a relatively short span; due consideration should be given to financial imbalances that could threaten sustainable economic growth. The second lesson, though it sounds like a statement of the obvious, is that what determines the long-­term growth path for a de­cade or so are not nominal variables such as prices and money but fundamentally real variables such as productivity, innovation, and growth of the ­labor force. It may be a ­little strange to reiterate this point, as this is “Economics 101.” That said, even though monetary policy is neutral to potential growth, if ­there is too much reliance on it, it may become a f­actor that inhibits economic growth by creating distortions in resource allocation.3 In this strict sense, a perfect separation between nominal and real outcomes does not hold. The third lesson is that we have to recognize the sober real­ity that our understanding of the economy is inherently inadequate. This is not only ­because our knowledge is ­limited but also ­because economic and social systems are changing constantly. If big changes take place, say, in technology or demographics, many economic agents adjust to ­those changes. Institutional frameworks and policy rules also change, and they bring about behavioral changes in businesses and individuals. In this regard, the economy or a society can be regarded as a very complex adaptive system, or ecosystem. Accordingly, even if we succeed in understanding how the system works at a single point in time, the system does not stay constant. Therefore it is necessary to constantly rewrite one’s understanding of the mechanisms of how the economy works. It is a welcome change that the above three lessons have come to be recognized more or less by most educated observers ­after the GFC. As for the first, the remarks by Jerome Powell, the chair of the Federal Reserve Board in 2018, are most encouraging: “What­ever the cause, in the run-up to the past two Lessons from the Japanese Economy | 377

r­ ecessions, destabilizing excesses appeared mainly in financial markets rather than in inflation. Thus, risk management suggests looking beyond inflation for signs of excesses.” 4 As for the second, since the GFC ­there has been a growing discussion on the c­ auses of a decline in potential growth rate in many parts of the world, including demographic change. This is encouraging, at least compared with past, when it was more of a niche topic. But my impression is that the importance of demographic change is still underappreciated, and we need to pay more attention to this issue. As for the third, again—at least compared with the time prior to the GFC—­healthy recognition of the limits to our understanding are now emerging. For example, when Olivier Blanchard, then chief economist at the International Monetary Fund, pointed out five lessons of the GFC in 2013, he identified “humility is in order” as the first lesson.5 Yes, we need intellectual humility.

IS THE ZERO LOWER BOUND OF INTEREST RATES A TRUE CONSTRAINT? I cannot agree with the lesson “central banks should, at all costs, avoid letting inflation fall too low” if its reasoning is based on a reading of the Japa­nese experience. Deflation was not the cause of low growth in the Japa­nese economy. The prob­lem was not about the past per­for­mance of the Japa­nese economy but about its ­future sustainability. It ­will become difficult to sustain the current growth of per capita income g­ oing ahead given the rapid aging of the population, simply ­because fewer workers w ­ ill have to support more of the el­derly. A central issue has been the fear of the zero lower bound (ZLB) of interest rates. A fear of low inflation and the ZLB has very much affected the thinking of macroeconomists and policy makers. The ZLB issue was recognized as a theoretical possibility in the early 1990s, but it took center stage in the late 1990s when many economists, including Paul Krugman, came to focus increasingly on the Japa­nese economy. At first glance, it seems that the ZLB must constrain the efficacy of monetary policy. But is it true? If a central bank has enough room for lowering its policy rate, including ­going deeply into the negative range, is it pos­ si­ble to avoid low economic growth and low inflation? My answer is that it depends on the nature of the shock hitting the economy. A case in point is the experience of a post-­bubble economy—­such as that ­ ubble in late 1980s or the credit b ­ ubble in Western following the Japa­nese b economies in the period from 2003 to mid-2007. Without eliminating the excesses created in a b ­ ubble period, conditions for sustainable growth are not 378 | The Roles of the Central Bank

established. Lowering interest rates, including pushing them down to negative territory, may be able to slow the speed of adjustment for eliminating excesses, but it also prolongs the length of time necessary for completing the adjustment—­ and, for that m ­ atter, the period of low growth. In order to explain why the ZLB of interest rates per se is not a real constraint, we have to look into the essential mechanisms through which monetary easing works (see chapter 16). One mechanism is to bring forward f­ uture demand of private economic agents to the pre­sent. If the economy is faced with a temporary shortfall in demand, this policy works perfectly. But if the weak economy is not caused simply by the lack of demand, the very act of monetary easing ­will make the natu­ral rate of interest fall faster, ­because would-be ­future demand becomes used up. If this kind of a strategy of front-­loading ­future demand is constantly relied upon, the economy ­will eventually get stuck at the zero interest rate. Negative interest rates do not change the under­lying situation. The prob­lem facing Japan over the de­cades was not a temporary demand shock; rather, it was the steady decline in the potential growth rate. The second mechanism through which monetary easing can work is to expand demand from foreign countries by engineering a depreciation of the exchange rate of the country’s own currency. This mechanism works for countries with a higher interest rate, but not for countries like Japan, where the short-­term interest rate is zero and long-­term interest rates are already the lowest in the world. More impor­tant, if the shock hitting the economy is of a global nature, and not confined to a small number of countries, this strategy does not work. According to the prevailing intellectual model, low interest rate is justified on the ground that natu­ral rate of interest is low. And a decline in real interest rate is often cited as evidence of a lower natu­ral rate of interest. I would argue that the decline in the natu­ral rate of interest is partly a result of aggressive monetary easing itself.6

IS FISCAL POLICY ­R EALLY A SOLUTION? Economists’ understandings of the ZLB of interest rates—­and, for that ­matter, the effectiveness of monetary policy—­are still divided. Th ­ ere are some economists who are relatively sanguine about the effectiveness of monetary policy, even though they stress the need for maintaining a margin of safety so as to not slip into deflation. They seem to believe in the efficacy of more forceful forward guidance and asset purchases, as well as negative interest rates. But overall such views are gradually losing their influence compared with the period prior to the GFC. Lessons from the Japanese Economy | 379

Instead, ­there is an increasing number of economists now arguing for more active use of fiscal policy or the coordination of monetary and fiscal policy. Hearing t­ hese arguments, I realize that many economists’ understandings of the ZLB of interest rate is dif­fer­ent from mine. The effectiveness of fiscal expansion as demand-­management policy also derives from bringing forward ­future demand to the pre­sent. In the case of fiscal policy, front-­loading of ­future demand is more direct and the resulting increase in debt is mainly in public debt, while in the case of monetary policy, the front-­loading of demand is more indirect and the resulting increase in debt is mainly private debt. Regardless of which macroeconomic policy is deployed, the capacity to front-­load ­future demand itself is ultimately constrained by the potential growth rate.

WHAT JAPANIFICATION IS TELLING US The alleged lessons from the Japa­nese experience ­were drawn in order to avoid Japanification—­the situation whereby many developed economies are stuck at zero interest rates. Thus, we have to think seriously about why Japanification is now globally observed. One hypothesis is that countries did not implement the bold monetary policy actions, as was advised. This argument is not plausible. Central banks truly acted boldly. Another hypothesis is that the lessons themselves w ­ ere not correctly drawn. I have sympathy with the latter hypothesis. Japanification is a complex phenomenon, but it seems to be partly the result of the logic of monetary easing as embraced by its critics. I am not flatly denying the argument that the ZLB of interest rates should be avoided. Th ­ ere could be cases in which this argument holds, but it is confined to when the main shock is purely a temporal demand shock or confined to a small number of countries, as I have explained above. If monetary easing continues to be used, we have to consider seriously what would happen when ­these conditions are not met. What we have to examine more generally is the validity of the current monetary policy framework and its intellectual under­pinnings.

DIFFERENCES IN THE SOCIETAL RESPONSE ­A FTER THE BURSTING OF THE ­B UBBLE It is a welcome sign that views about “the lost de­cades of Japan” have been changing. At the same time, we should not go too far, and must continue to recognize that impor­tant differences among economies and socie­ties exist. To

380 | The Roles of the Central Bank

demonstrate this point, I would like to introduce the views of Gillian Tett, a journalist at the Financial Times who was a correspondent in Tokyo in the late 1990s, when Japan went through its severe financial crisis. In October  2017 she wrote an article a­ fter visiting the grave of Katsunobu Onogi, who had passed away a few months ­earlier. Onogi had been the CEO of the Long-­Term Credit Bank of Japan (LTCB), which collapsed during the Japa­ nese financial crisis of the 1990s. Onogi had been prosecuted for the violation of commercial law, on the charge of illegal dividend payments. He was found guilty in the first and second ­trials, but the final trial at the Supreme Court of Japan in 2008 established his innocence. Tett’s article is filled with warmth and a pluralistic perspective brought in part by her background in cultural anthropology: In 2008 ­t here came a new, unexpected twist as the American financial crisis exploded and Lehman ­Brothers collapsed. Initially, Onogi and other Japa­nese bankers ­were fascinated by the parallels they saw with their own lives, and the se­nior man­ag­ers who w ­ ere being tossed out of their jobs. But then their stories diverged: in sharp contrast to their Japa­nese counter­parts, the US bankers did not lose their pensions, or “voluntarily” decide to hand over their wealth. Nobody se­nior on Wall Street went to prison. Instead, they mostly kept their vast wealth intact, having run their banks to protect this. Many took on new jobs. My Japa­nese banker friends could scarcely believe this. They did not think they had acted in a criminal way when LTCB (or other banks) collapsed. But they had never denied a sense of responsibility ­ ere decent men and knew they for the Japa­nese financial crisis. They w ­were part of a system that had failed so shamefully. So why, they asked me, d ­ idn’t the US bankers feel any similar embarrassment? Why d ­ idn’t the Wall Street titans feel that they should give back some of their wealth? I ­d idn’t know what to tell them. Like them, I was dismayed that the American bankers had mostly escaped censure. But I was also dismayed by how brutally the Japa­nese system had treated the decent Onogi and his colleagues, given that what happened at LTCB—­ covering up bad loans and putting a flattering spin on the accounts—­ was standard practice in Japan at the time. Both systems, in other words, seemed deeply “unfair,” albeit in opposing ways, and I was unsure which was worse.7

Lessons from the Japanese Economy | 381

ROLES PLAYED BY ECONOMIC STRUCTURE AND SOCIAL CONTRACT The social contract differs among countries. It is imperative to understand the role played by economic structure and social contract in each country to comprehend economic developments in the post-­bubble period and to come up with optimal policy responses. For example, one of the most challenging tasks faced by policy makers ­after the bursting of the ­bubble and during the financial crisis, was figuring out how to forge the necessary consensus of the society as a ­whole in order to solve prob­lems. How to tackle this task could be dif­fer­ent from country to country. In the case of the United States, intentionally or not, a very drastic policy of allowing the disorderly collapse of Lehman B ­ rothers was taken, which brought the global economy and the financial system to the brink of collapse. Yet from the viewpoint of forging a needed consensus, it is true that this drastic mea­sure was effective in securing the Troubled Asset Relief Program and setting the stage for the prompt injection of public money. Implementation of a credible stress test was made pos­si­ble only by the existence of the backstop of ­these public funds. And without t­hese stress tests, I cannot imagine that the US financial system and the economy could have stabilized at a relatively early stage. In thinking of the responses of the US authorities to the collapse of Lehman ­Brothers, I recall the criticism that Japan had hidden ­behind minor institutional or technical difficulties in order to avoid taking action.8 ­After all, each country has dif­fer­ent constraints, which sometimes make it difficult to take needed actions promptly. The United States might have been unable to take needed actions as the lender of last resort due to l­egal constraints. Likewise, Japan could not take drastic action to liquidate failed financial institutions in a disorderly manner b ­ ecause of a resulting huge loss of jobs or a breach of social order, neither of which would have been tolerated. Thus, “gradualism” was chosen ­until a broad social consensus was fi­nally formed, and it took a long time to restore the stability of the Japa­nese financial system. The l­abor market conditions deteriorated significantly by Japa­nese standards, but the unemployment rate—­especially that of youth unemployment—­did not surge, as was witnessed in Eu­rope and the United States. Thus, it is necessary to look into the economic structure or social contract rooted in each country. It is not simply a justification of the status quo; it is a real­ity that the central bank cannot simply dismiss. The same observation might apply to the Eu­ro­pean debt crisis. In my conversations with policy makers in 382 | The Roles of the Central Bank

the euro area, I often felt their frustration over the lack of understanding on the part of US authorities on how the Eu­ro­pean Monetary System worked. In an in­ter­est­ing chapter in a book on the Eu­ro­pean debt crisis, Markus Brunnermeier, Harold James, and Jean-­Pierre Landau write, “Suspicions on both sides of the intellectual divide grew. In the increasingly acrimonious debate, Eu­ro­pe­ans detected what they held to be a fundamental lack of understanding of the Eu­ro­pean proj­ect as well as a self-­oriented defense of a dif­fer­ent ­interest. . . . ​Eu­ro­pe­ans felt frustrated that the major vehicles of international opinion, which set the term of the debate, all came from the Anglo-­American perspective.”9 I do not believe that we can find an immutable answer to the question of how much we should care about the stability of the society. This is an issue of value judgment on the part of ­people in a society, and this judgment can be dif­fer­ent across time and place. Vari­ous institutions and frameworks have been established based on the implicit social contracts that have been formed by the historical experiences of each country. Such institutions and frameworks are the core of the economy and society, and they change only gradually. Central banks cannot take policy actions on the basis of their own judgment about a par­tic­u­lar social contract, simply ­because unelected officials do not have the legitimacy to make such judgments. Treating policies as if a central bank can bend and alter ­those institutions as it wishes as an experiment of social engineering is not only unrealistic but also arrogant.

DOES A GLOBAL STANDARD EXIST? I cannot help but notice that my views have changed considerably from my younger days. Immediately upon coming back to Japan, a­ fter finishing my studies in the United States, I often felt uncomfortable with economic policy discussions in Japan that emphasized the “peculiarities” of Japa­nese economy and society. I was of the strong view that economic policy discussions should be made based on an intellectual model that was as universal as pos­si­ble, without bringing in the concept of peculiarities. But the more universal we try to make the discussions, the more we neglect the impor­tant, significant aspects of each society and economy. Simplification is necessary and useful when we try to capture the predominant trends in the economy, but it sometimes becomes the case that the neglected parts are crucial in formulating economic policy. Theoretical models are useful, but it is also crucially impor­tant to try to check carefully the assumptions upon which ­these models are constructed. Lessons from the Japanese Economy | 383

(% of nominal gross domestic product) 60 Japan United States

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1985

1990

1995

2000

2005

2010

2015

2020

Figure 19.4 ​The share of l­abor compensation. Note: Japa­nese figures prior to the fourth quarter of 1993 are calculated by splicing the old series to the current one. Source: Japa­nese Cabinet Office.

Other­wise we are inadvertently trapped in the situation of seeing the a­ ctual economy only through the lenses of existing, inadequate theoretical models. The term most frequently used in debates on economic policies in Japan since the early 1990s would be the global standard. It is certainly impor­tant to learn from good practice in many foreign countries. In fact, ­people who promote introducing a par­tic­u­lar policy or institution often say, “This is the global standard.” But global is too s­ imple a word. Do we have literally a global economy? The truth is that the real world is still full of home bias. Similarly, do we have literally a global standard? Not necessarily. When the idea of a 2 ­percent inflation target was hotly debated in Japan, promoters almost always said, “2 ­percent is the global standard. Why ­doesn’t the Bank of Japan adopt the same number?” But if we r­ eally follow through the argument of 2 ­percent as a global standard, we have to consider the global standard of employment practice, ­because wage bills account for a significant portion of input costs and, ultimately, resulting output prices. Japa­nese employment practice is far from the global standard as such—at least the US standard. When the economy ­faces a sudden shock in the form of falling demand, 384 | The Roles of the Central Bank

the share of l­abor income w ­ ill go up in Japan while it w ­ ill go down in the United States (see fig. 19.4). This reflects that in Japan, large firms take the role of cushioning the macroeconomic shock. This is a kind of social contract that has been deeply embedded in postwar Japa­nese society. Naturally, dif­fer­ent employment practices produce dif­fer­ent wage and price dynamics in response to big macroeconomic shocks. What brought me unease about the argument of 2 ­percent inflation as a global standard was that it neglected another, more fundamental, global standard. International economics has long recognized the differences between countries. That is why flexible exchange rate systems are regarded as the global standard as far as developed economies are concerned. The flexible exchange rate system means that country differences in wages and inflation are adjusted by fluctuations in foreign exchange markets. In that sense, the flexible exchange rate system presupposes differences in target inflation rates.

GROSS DOMESTIC PRODUCT AND SOCIAL WELFARE Thinking of the importance played by the social contract and economic structure, I cannot help but think of the notion of social welfare as opposed to conventional mea­sures of economic activity, such as GDP. Many foreign policy makers and economists who visited my office during my tenure as governor of the Bank of Japan often expressed their honest impressions ­after having discussed typical topics such as deflation: “I do not believe this country is undergoing ‘the lost de­cades’ and plagued by deflation, from what I see on the streets in Tokyo. Is my impression wrong?” Their observation was to the point, though not entirely correct. It is conventionally assumed that changes in social welfare can be reasonably approximated by changes in GDP. This assumption can be regarded as legitimate, considering that the major role of macroeconomic policy is the stabilization of economic activities within a relatively short time frame. Yet completely ignoring the differences between the two may not be innocuous when assessing economic per­for­mance from a long-­term perspective, such as in the debate on “the lost de­cades.” For a macroeconomic policy decision maker, it is impor­tant to reflect on ­factors that may generate differences between GDP and social welfare on occasion.10 One of the f­ actors that generates such differences is the number of working hours. The level of social welfare w ­ ill be dif­fer­ent between cases in which the same GDP level is achieved by relatively short working hours, with ­people enjoying leisure time, versus long working hours without much leisure time. Lessons from the Japanese Economy | 385

According to statistics from the Organisation for Economic Co-­operation and Development, working hours are still long in Japan, but as a result of efforts made since the early 1990s, per capita working hours declined by as much as 16 ­percent, and this decline is large in comparison with that of other countries.11 A second f­ actor can be found in differences in average life expectancy. Standard discussions on the economy focus on how to maximize “utility” derived from consuming goods and ser­vices. In this regard, how long a person can derive this utility becomes impor­tant. With other t­ hings being equal, if the average life span becomes longer, it means that the total utility enjoyed by a person becomes larger. A third ­factor is the distribution of income and assets. The growth of GDP or per capita GDP only carries information on averages. But happiness or the utility for the w ­ hole society, which economists call social welfare, cannot be mea­sured by averages, for what also ­matters is distribution. Although value judgments ­will be necessary to assess to what extent the current distribution of income and assets is fair and equitable, this issue is certainly a f­ actor that affects the level of social welfare. A fourth ­factor can be found in the difference of noneconomic values that each society pursues. For example, in Japan, the importance of punctuality is always emphasized in daily life. A good example is the punctuality of the bullet train, Shinkansen. Rigorous international comparison is very difficult, but based on my casual observation as well as foreign visitors’ reactions I often hear, the Japa­nese bullet train is extremely punctual. Compared with manufacturing goods, which is tradable internationally, most ser­vices such as train ser­ vice is not tradable internationally. In theory, price mea­sure­ment is supposed to be adjusted for quality differences but, in fact, that pro­cess is not ­simple. To the extent such adjustment is not complete, the value of goods and ser­vices are underestimated. This issue is particularly relevant for making an international comparison of prices and, for that ­matter, real GDP and productivity. As a result, I cannot rule out the possibility that the level of social wellness in Japan may be higher than what the difference of GDP suggests. It is not appropriate to overly emphasize this kind of argument, but equally, it misses the impor­ tant issue to totally neglect it. If we dare to estimate the level of social welfare in Japan by taking account of only the average working hours and life expectancy (which are the easiest to calculate among the four f­ actors mentioned above), the image of social welfare derived from Japan’s GDP is revised somewhat. According to one estimate (see fig. 19.5), per capita GDP in Japan is around 70 ­percent of that in the United 386 | The Roles of the Central Bank

Changes in welfare and income between 1985 and 2014 % per annum 4.5

Welfare and income in 2014 United States = 100 120

4.0

100

3.5

80

3.0 2.5

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1.5 1.0

20 0

0.5 USA

DEU

CAN

GBR

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FRA

ITA Welfare

JPN

0.0

USA

DEU

CAN

GBR

GDP per capita

FRA

ITA

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Welfare

Figure 19.5 ​Social welfare and income of G7 countries. Source: Nakaso (2017).

States, but when the broader social welfare mea­sures are taken into account, the difference is 92 ­percent. Looking at the growth rate of social welfare between 1985 and 2014, it is highest in Japan and Germany among the G7 countries, at above 4 ­percent, reflecting longer life expectancies and increases in leisure time. International comparisons of this sort can be problematic, but ­these estimated numbers fit well with the often expressed impressions of the foreign economists and policy makers who visited me at my office, as mentioned ­earlier. Of course, macroeconomic policy should not be conducted on the basis of arbitrarily calculated numbers that may or may not represent social welfare. My point is that we should not forget about the ultimate goal of public policy. This point is all the more relevant as we observe the rising trend of pop­u­lism in many parts of the world, which has become increasingly evident since I left the Bank of Japan.

HOW TO LEARN FROM THE EXPERIENCES OF ­O THERS Data on the experiences of foreign countries are a rich source of information and insight. At the same time, it is not easy to make the best use of such data. As Blanchard and Summers candidly remarked at a conference marking the Lessons from the Japanese Economy | 387

tenth anniversary of the GFC in October 2017, “In advanced countries, the poor per­for­mance of Japan ­after the bursting of the ­bubble was ­there for all to see. Yet, prevailing macroeconomic paradigms largely ignored the possibility of financial crises. In macroeconomic models, the role of the financial system was often reduced to the determination of a yield curve, based mostly on the expectation hypothesis with fixed term premia.”12 This frank introspection is on the mark, and leads to a question: Why did so many prominent foreign academics draw the wrong lessons from the Japa­ nese experience? In my view, broadly speaking, ­there are two reasons. First, gaining access to the information was not necessarily easy. Accessibility depends on the information available in En­glish and a deep pool of economists, among other ­things. On both counts, Japan was handicapped. This essentially boils down to a language barrier prob­lem. The Bank of Japan ­adopted unconventional monetary policy far ahead of other central banks, but even ­today, I am often surprised when finding commentaries and academic papers that do not recognize this fact. Second, the Japa­nese experience was used as a con­ve­nient example to reinforce mainstream macroeconomists’ arguments in an opportunistic manner, since it seemed to fit very well with their policy implications.13 Economic theory or models are useful but in and of themselves are not real­ity. Saying this does not mean that advice coming from foreign countries is not helpful. On the contrary, looking back on my professional experiences, I recall with sincere gratitude that I have had much to learn from foreign central banks, especially from my American colleagues. Advice on troubled bank resolution and monetary policy operations ­were most valuable. I also learned a lot from the efforts of the Federal Reserve System to improve the payment and settlement system, which intensified from the mid-1980s onward. Fierce criticism from overseas colleagues on the delay in addressing the nonperforming loans prob­lem in Japan was helpful as well, though we had a hard time listening to the ruthless criticism at international meetings. What was strongly criticized was actually what we ­were feeling was necessary ourselves, but we could not move forward as we w ­ ere faced with strong po­liti­cal opposition domestically. The criticism from abroad actually became an effective driver for instituting the necessary framework to deal with troubled financial institutions and overcoming domestic po­liti­cal opposition. I learned quite a lot in the area of the conduct of monetary policy as well. A case in point is the choice of adopting the overnight interest rate as a policy rate, the announcement of the target level of policy rates, and paying interest 388 | The Roles of the Central Bank

on the current accounts held by banks at the central bank. I also learned a lot about nuts-­and-­bolts operational issues, such as central banks’ schemes to lend government securities. One of the lessons I learned from vari­ous contacts with foreign experts is that we have to have intellectual humility in making strong and concrete policy recommendations for other countries about which we have l­ imited knowledge. Bearing this lesson in mind, I always tried to strike a balance between frankness and humility when I explained about the “lessons of Japa­nese experiences.” And if ­there ­were any added value in my remarks, it would not be in the concrete policy proposal itself but in providing a perspective that might not be sufficiently recognized among the policy makers of the countries who ­were listening to my explanation. As a result, what I always stressed was that maintaining the stability of the financial system was crucially impor­tant, that ­t here was a strong feedback loop between the financial system and the real ­ ubble was quite economy, and that economic growth a­ fter the bursting of the b subdued. On the other hand, I typically refrained from giving specific recommendations on the conduct of monetary policy, based on the concern that my understanding of subtle social contracts and economic structures in other countries was ­limited.

Lessons from the Japanese Economy | 389

| CHAPTER TWENTY |

What Should We Expect of the Central Bank? Central banks have been faced with many challenges in the past, such as intermittent financial crises, high inflation or severe stagflation, but it can be said that they have eventually overcome—or at least appeared to overcome—­ these difficulties reasonably well. Indeed, the years prior to the global financial crisis (GFC) of 2007–9 ­were the heyday of the central bank. But this peaceful period was short-­lived; ­today central banks are again faced with enormous global challenges. What ­people expect from central banks has changed, and t­ here are significant differences of opinion in this regard. Some view monetary policy as in­effec­tive in the face of the zero lower bound of interest rates. ­Others view monetary policy as still effective by devising vari­ ous unconventional tools. Some pin their hopes on technocratic institutions like the central bank to play an even bigger role than in the past in stabilizing the economy. O ­ thers are increasingly questioning the legitimacy of unelected officials at the central bank to play such a big role in the economy of demo­cratic socie­ties.

FOUR CRITERIA ASSESSING THE EFFECTIVENESS OF UNCONVENTIONAL MONETARY POLICY The best way to start the discussion is to assess the effectiveness of unconventional monetary policy (UMP), which has been deployed for more than a de­ cade. Generally speaking, US economists and policy makers are relatively sanguine about the effectiveness of UMP. For example, as Ben Bernanke maintained in an address to the American Economic Association in 2020, “the new tools have proven quite effective, providing substantial additional scope for monetary policy despite the lower bound on short-­term interest rates.”1 Economists and policy makers in Asia and Eu­rope appear to be less optimistic about 390

the effectiveness of UMP compared with ­those in the United States. Japa­nese economists—in par­t ic­u ­lar, since the failure of the so-­called ­g reat monetary experiment to achieve higher inflation—­a re much less sanguine compared to both their pre­de­ces­sors and their foreign counter­parts. Both the advocates and skeptics of UMP are serious. As a longtime observer of this unsettled and sometimes acrimonious debate, and as a former central bank policy maker who was an early practitioner of UMP and experimented with many types of it, I have now come to think that my role is to ponder what produces such sharp difference of views instead of trying to give my verdict on this debate. Four questions establish natu­ral criteria for assessing the effectiveness of UMP: 1. Was UMP effective in restoring stability in the financial system or the functioning of the financial market? 2. Was UMP effective in moving financial asset prices in the intended direction? 3. Was UMP effective in stimulating real economic activity and the inflation rate? 4. Did UMP bring about benefits that outweighed their costs?

THE EFFECTS ON RESTORING FINANCIAL STABILITY Vari­ous mea­sures ­were taken by central banks in developed economies at the time of the GFC. Mea­sures like dollar swap arrangements and purchase of commercial paper and mortgage-­backed securities ­were most effective in avoiding the collapse of the financial system and maintaining the functioning of financial intermediation and market making. Th ­ ese mea­sures w ­ ere essentially the efforts of central banks to play their time-­honored role as lenders of last resort, which should not be confused with monetary policy as it is conventionally understood.

THE EFFECTS ON FINANCIAL ASSET PRICES The effect of UMP on financial asset prices differs by types of financial asset and by policy tool. When the Bank of Japan first conducted UMP between 2001 and 2006, I was of the view that compared with asset purchases, forward guidance was more effective in affecting financial asset prices. My view has changed somewhat since the GFC; I now acknowledge that asset purchases, What Should We Expect? | 391

too, if done on a ­really massive scale, can push up financial asset prices beyond their fundamental value by affecting supply and demand conditions, though it is not permanent. And if market participants come to believe that a central bank has sufficient capacity to step in to purchase for an extended period of time, the central bank can affect financial asset prices, even without actually purchasing large amounts. The degree to which the central bank can affect supply and demand conditions varies across financial assets. The efforts by the Swiss National Bank at pegging the Swiss franc exchange rate to the euro offers a good example. The bank succeeded in pegging for four years, but eventually had to abandon it in January 2015. Even though the central bank’s purchase of foreign exchange is apparently not constrained (unlike its selling, which is constrained by its holding of foreign exchange), if one takes into consideration the possibility that the bank ­will incur large-­scale losses if it has to abandon the peg, I doubt the bank has a genuine capacity to continue to purchase foreign currency without limit. In a demo­cratic society, the central bank needs po­liti­cal legitimacy to do so, and that ultimately determines its capacity to purchase without limit (see chapter 14). Since a potential supply of foreign exchange is almost limitless in the global foreign exchange market, it is questionable ­whether the central bank actually has such a capacity. By contrast, the central bank may have more power to affect supply and demand conditions in the government bond market, ­because the entity that can supply the risk-­free asset denominated in domestic currency is confined to the national government bond. On top of that, financial regulations such as minimum capital adequacy ratios and liquidity coverage ratios have the effect of increasing demand for government bonds.

THE EFFECTS ON THE REAL ECONOMY AND THE INFLATION RATE A change in financial asset prices is not the objective of monetary policy in itself. Even if the central bank succeeds in affecting financial asset prices, prices might be “detached” from the real economy. For example, if the term premium of long-­term corporate bonds is suppressed artificially by aggressive purchases, corporations ­will end up issuing long-­term bonds that are now relatively cheap, and redeem short-­term bonds, without changing their total debt levels. The assessment of UMP’s effects on the real economy is inherently inconclusive, if only b ­ ecause we do not know the counterfactuals—­what would happen without taking UMP. A methodology often employed in empirical studies is to 392 | The Roles of the Central Bank

estimate how much long-­term interest rates ­were lowered, and to plug that estimate into a standard econometric model. This is misleading, as the transmission mechanism ­after the burst of ­bubble w ­ ill often not work in the same way it works during normal periods. The difficulty of the assessment of UMP’s effect on inflation is the same as that of the effect on the real economy, ­because we do not know the counterfactuals. To me, it seems clear that UMP was not effective or at least not as effective as was desired. This is shown in the fact that the inflation rate almost consistently undershot the target in many developed economies and the g­ reat monetary experiment did not bring about a higher inflation rate. Yes, deflation was avoided, but this was another way of saying we succeeded in preventing the collapse of the financial system, and this boils down to the discussion of first criterion above.

BENEFITS VS. COSTS IN THE LONGER TERM Focusing only on the benefits is inappropriate since it neglects costs or side effects. The ultimate criteria of UMP should be its benefits net of costs or side effects, as is true of any policy mea­sure. This assessment is inherently difficult, not only ­because it takes more time for the costs or side effects of UMP to materialize fully but also ­because the view on what constitutes costs or side effects itself differs among economists and policy makers. Cost and side effects can reflect value judgments or a basic philosophy about how the economy, society, and politics should operate. ­Here I ­will examine some costs or side effects that are often discussed in this context. First, the dynamism of the competitive market might be weakened. Normally, the economic mechanism works in a way that a portion of companies created in eco­nom­ically good times go out of business during recessions. If accommodative monetary policy continues for a prolonged period of time, inefficient companies may be kept afloat due to the reduced burden of interest payments. Second, the allocative function of financial markets might be weakened due to suppressed risk premiums. Prices of financial assets are expected to reflect the investors’ views on the risks associated with the borrowers or proj­ects in question. But now, if vari­ous risk premiums are suppressed for an extended period of time by central banks’ aggressive purchases, market participants ­will rely not on their own evaluation but instead largely on the actions of the central banks and the statements of bank officials. As Henry Simons, once a well-­k nown What Should We Expect? | 393

economics professor at the University of Chicago, argued more than eighty years ago, “We must avoid a situation where e­ very business venture becomes largely a speculation on the f­ uture of monetary policy.”2 It is almost as if he was predicting t­ oday’s financial markets. Third, fiscal discipline might be weakened. If the society fails to grasp the true state of government finances b ­ ecause of suppressed borrowing costs, the possibility of a fiscal crisis ­will increase. Fourth, the possibility of undermining financial stability cannot be neglected. Monetary easing depends on the front-­loading of ­future demand, and that means an increase in debts. In addition, financial institutions squeezed by narrowing term spreads would take on more risks—­liquidity risk, credit risk, and interest rate risk. Fi­nally, t­ here w ­ ill be adverse effects on income and asset distribution. Prolonged monetary easing tends to f­ avor wealthy p ­ eople—­owners of risk assets such as stocks—as compared with average individuals who hold financial asset mainly in the form of safe assets like deposits. Monetary easing, be it conventional or unconventional, always affects the distribution of income and assets, but the usual presumption that both monetary easing and tightening are short-­lived does not hold for UMP. If monetary easing continues for a prolonged period of time, the sense of fairness ­will be eroded. Advocates of UMP argue that the pos­si­ble negative effect on distribution is more than offset by the positive effect of avoiding massive unemployment. To me this argument is not convincing b ­ ecause ­those positive effects are mainly due to the successful act of the lender of last resort rather than UMP. Advocates of UMP may say that some of the costs or side effects explained herein are not uniquely related to UMP per se and that most of them might be better viewed as that of prolonged monetary easing. But if UMP contains an internal mechanism for prolonging its use—­which is likely, in my view—­the discussions herein on costs and side effects are all relevant.

MY ASSESSMENT OF UNCONVENTIONAL MONETARY POLICY Now that many years have passed since UMP was first attempted (more than two de­cades in Japan, and more than a de­cade in other developed economies), ­there emerges reasonable consensus on its effects—at least in terms of the first and second criteria mentioned above. But we do not have a reasonable consensus yet in terms of the third and the fourth criteria of effectiveness. The answer is inherently inconclusive, simply ­because we do not know the counter394 | The Roles of the Central Bank

factuals. Even so, it is worthwhile to try to compare experiences of UMP with near counterfactuals, however imperfect they may be.3 Two episodes immediately come to my mind. One is in the Japa­nese economy a­ fter the bursting of ­bubble in the early 1990s, when UMP was not a­ dopted. A material difference is not observed between Japan in the post-­bubble period of 1990s and the American and Eu­ro­pean economies a­ fter the eruption of the GFC in terms of the path of gross domestic product (GDP) relative to a cyclical peak (see fig. 19.1 in chapter 19). The other episode is a historical one: the financial crisis as examined in the famous book by Carmen Reinhart and Kenneth Rogoff, This Time Is Dif­fer­ent.4 Based on their eight-­hundred-­year review of economic history, the authors conclude that it takes approximately eight to ten years for a country’s economic activity to recover from a significant financial crisis. The experience of the developed economies (including the United States) over the last de­cade is entirely consistent with this history. As we did no better “this time,” it is hard to conclude that the UMP pursued by the Federal Reserve Board (FRB) and o ­ thers made much difference.5 If p ­ eople in the ­future are presented without any explanation graphs showing the path of GDP ­after the GFC and prior post-­bubble episodes, they ­will likely have difficulty in recognizing the difference.

WHAT PRODUCES THE DIFFERENCE IN VIEWS? My views herein are not shared by all. What accounts for the difference? As was noted e­ arlier in this chapter, economists and policy makers in the United States are relatively sanguine about the costs of UMP. I presume this is primarily ­because US economic per­for­mance was better than that of other countries. Along ­these lines, we should or­ga­nize our thinking around the relatively good economic per­for­mance of the US economy post-­GFC, and consider how much was attributable to UMP. In my view, three f­ actors might have played some role in the better per­for­ mance of the US economy: (1) the nature of the shock and its duration, (2) the status of key international currency, and (3) the capacity of a society to manage pos­si­ble costs and side effects.

THE NATURE OF THE SHOCK AND ITS DURATION Monetary policy is essentially about smoothing out fluctuations around a potential growth path, but distinguishing mere fluctuations from a­ ctual changes What Should We Expect? | 395

in potential growth is not easy in real time. It is often the case that economic activity that was judged cyclically weak often turned out to be reflecting a decline in trend growth. Japan’s “lost de­cades” (see chapter 19) are a good example. Monetary easing could boost demand by shifting the timing of the expenditure through front-­loading of f­uture demand or shifting demand ­toward home and away from foreign countries through the exchange rate channel. This strategy works if the shock is purely a temporal demand shock or confined to a small number of countries, but it does not work if the shock is more permanent in nature or truly global. This can be explained by using the concept of the natu­ral rate of interest. The natu­ral rate of interest in the United States is relatively high, as opposed to Eu­rope and Japan, prob­ably ­because of still favorable demographics in terms of aging and population growth and an environment conducive to open innovation, such as the societal capacity to attract many talented young ­people from other parts of the world. If the natu­ral rate of interest is high or its decline has been relatively modest, ­there could be a case in which UMP is effective.

THE STATUS OF KEY INTERNATIONAL CURRENCY The United States, unlike other countries, can enjoy the privilege of issuing a key international currency, which provides the nation’s monetary easing with unique channels. First, monetary easing in the United States produces stimulus effects directly for non-­US economic agents relying on dollar funding ­because it lowers the funding cost of the dollar, which is the currency used by many companies and financial institutions around the world. Second, monetary easing in the United States has the power to induce monetary easing elsewhere, especially in emerging and developing economies. ­Those economies tend to try to avoid currency appreciation amid capital inflow, which has led to monetary easing in t­ hese countries. Third, monetary easing in the United States facilitates the adjustment of US external accounts. The United States plays a role as liquidity provider to the world, which means that most of its external liabilities are denominated in dollars. On the other hand, the external assets gained by outward foreign investment are denominated in foreign currencies. The United States, unlike Japan, is a net debtor country, and the reduction in policy interest rates ­will reduce interest payments to creditors overseas, resulting in an income transfer from overseas economies to the US economy. In other words, in terms of balance 396 | The Roles of the Central Bank

sheet adjustments, the United States has the advantage that policy interest rate reductions bring about income transfers that are favorable to the nation’s economy. Fourth, exchange rate movements resulting from monetary easing are also favorable. On the ­whole, the dollar depreciated during the GFC, and this led to improvements in the net external position of the United States in dollar terms, b ­ ecause it could enjoy exchange rate gains from external assets. In other words, the United States was in an advantageous position such that the cost of its balance sheet adjustments has been partly shouldered by foreign countries.6 ­These points demonstrate how the United States is enjoying the “exorbitant privilege” of the dollar being a key international currency.

THE CAPACITY OF A SOCIETY TO MANAGE COSTS OR SIDE EFFECTS The magnitude of the costs or side effects is dif­fer­ent across countries. It may be argued that the United States has relatively more capacity to manage side effects by utilizing its favorable demography and the flexibility of its economy. In the case of Japan, the costs or side effects of UMP tend to be larger, reflecting vari­ous social contracts that prioritize stability, especially in employment, and an unfavorable demography that leads to conservatism. The more fundamental question is how policy makers should take vari­ous social ­factors into account that might inhibit adjustment. As unelected officials, central bankers are not generally in the position to judge the validity of “social contracts.”

WHAT IS NEEDED FOR GOOD JUDGMENT IN ECONOMIC POLICY MAKING The discussion herein indicates that we need a broader perspective in order to assess the validity of specific monetary policies—­especially when views are sharply divided, as in the case of UMP. Ryutaro Komiya has described his general observation of split views concerning economic policies in the early 2000s, bearing the debate about UMP in mind. He points out five sources for split views: (1) differences in economic philosophies; (2) differences in theories, economic models, and vocabulary; (3) differences in the recognition of the quantity and scale of related economic variables, and of the magnitude of policy effects; (4) differences in the understanding of ­legal, institutional, and international frameworks that constrain economic policies; and (5) differences in the understanding of the current state of the economy, priorities among vari­ous What Should We Expect? | 397

policy objectives, and time frame. He concluded, “The weight of a theory may be only 1/3 or 1/4, and t­ hose who cannot make balanced comprehensive decisions are not qualified as ­either prac­ti­tion­ers in charge of economic policies or as policy commentators.”7 I quite agree with Komiya, though I would prob­ably not have been able to understand his argument with a lot of sympathy if I had read this when I was younger and took it for granted that the right economic theory was what was most impor­tant. Thus, I thought that if the Bank of Japan could not implement the right monetary policy, it could be just due to a lack of understanding of economics, a lack of communication efforts by the bank, or a lack of courage at the bank to act on the right economic theory. But this understanding was too simplistic. A theory can be built by focusing on the aspects of real­ity that theorists think are essential, neglecting other aspects. If we are to consider all aspects si­mul­ta­neously, a theory cannot be built upon to draw any meaningful conclusion. ­There could exist multiple theories reflecting the differences in views about which aspects are essential. What is impor­tant in policy making is the good sense to judge which theory is relevant in a par­tic­u­lar situation based on dispassionate observation of the real world.

THE SUCCESSES AND FAILURES OF MACROECONOMIC POLICY MANAGEMENT The way in which I have discussed the effectiveness of UMP is exclusively focused on the period ­after the bursting of ­bubbles. But is this the right approach? UMP was deployed in response to the deep recession ­after the autumn of 2008 due to the bursting of the credit ­bubble. Prolonged monetary easing before and aggressive monetary easing ­after the ­bubble’s burst is rooted in the same monetary strategy—­the “mop-up strategy” (see chapter 6). If so, looking at only the post-­bubble period is a bit like “missing the forest for the trees.” What we have to do is look at both periods in their entirety, examining the validity of the prevailing monetary policy strategy or, more specifically, the mop-up strategy (see chapter 6). In other words, we need a longer time frame for assessing macroeconomic policy. The next question is, What is an appropriate per­for­mance criterion from a long-­term perspective? Looking back on my experience, it is rather rare that macroeconomic policy in any specific period is rated as a success, at least in real time. When it comes to the Japa­nese economy, ­today nobody evaluates the 398 | The Roles of the Central Bank

Japa­nese ­bubble economy as a “success,” but ­people inside and outside Japan felt most confident about the Japa­nese economy during this period. Economic management in the early 1980s, prior to the b ­ ubble, was positively evaluated. As was mentioned in chapter 2, Milton Friedman highly praised the monetary policy management of the Bank of Japan during this period. What followed was the emergence of a ­bubble, then its bursting, and eventually the financial crisis. The period that is viewed with some nostalgia by many Japa­nese ­today, and rated as one of the ­great successes of macroeconomic policy management, is the high growth period from the mid-1950s to the early 1970s. But as far as I can remember, such a positive assessment was not widely shared by many during the 1960s and early 1970s, when I was in high school and university. Growth was not valued positively in ­those days as it is ­today. Newspapers ­were critical about the prob­lems of air and other environmental pollution, reporting on it almost ­every day. According to the Public Opinion Survey on the Life of the ­People, continuously conducted by the Japa­nese Cabinet Office since the early 1960s, the level of “satisfaction” of respondents during this period was not particularly high.8 Yet if we objectively look back now on the economic and social conditions of that time, t­ here is no question that the nation as a w ­ hole was steadily becoming more affluent: the standard of living was rapidly rising, the universal health care insurance system was introduced, the mortality rate declined, and the number of students ­going on to higher education increased. The survey result might be interpreted as simply showing that p ­ eople w ­ ere never satisfied with the pre­sent conditions and wanted more. In retrospect, it can be argued that the p ­ eople’s satisfaction levels actually did increase. That is one reason why ­people look back on this period with some sense of nostalgia. While the most crucial criterion for evaluating the achievement of macroeconomic policy management in the sufficiently long term is ­whether the per capita income level has or has not risen, such evaluation critically depends on ­whether p ­ eople can feel a sense of “fairness” in terms of the distribution of income and wealth across the ­whole society and that ­there are opportunities to pursue personal success.9 It is hard to distinguish the contribution of macroeconomic policy from that of private economic agents and other policy makers. But in reviewing the development of the Japa­nese economy in the past, my overall impression—as far as its success is concerned—is that macroeconomic policy What Should We Expect? | 399

played only a supporting role; it was surely not the primary actor. It cannot claim a large degree of credit for the success at that time of the Japa­nese economy. But what about the subsequent failures of macroeconomic policy management? On this question, three periods immediately come to my mind when looking back over the past fifty years. The first period is the years 1973–74, when Japan experienced double-­digit inflation. Economic activities plunged in response to strong monetary tightening to contain rampant inflation. It would be fair to say that I only have vague views on this period, as I was not actually involved in any major activities at the time. The second period is the b ­ ubble economy in the late 1980s, and the third period is that of the GFC, which immediately followed the burst of the ­bubble. In the next section I ­will focus on the role of monetary policy.

WHAT ­W ERE THE SUCCESSES AND FAILURES OF MONETARY POLICY? For this question, we need to have per­for­mance criteria. Since price stability is set as the objective of monetary policy in many countries, as a first approximation it seems natu­ral to use the inflation rate as the evaluation yardstick. For example, consumer prices increased 1.9 times during the Japa­nese high growth period of 1955–70—an average increase of 4.3 ­percent annually. The inflation rate was the highest in 1963, at 7.6 ­percent, and in that sixteen-­year period it exceeded 3 ­percent for eleven years, almost three quarters of the total period. If ­today’s standard of 2 ­percent inflation rate had been set as the evaluation yardstick back then, the Japa­nese monetary policy would definitely have been regarded as a failure. Many prob­ably do not share such an evaluation, however, due to the high economic growth during this period. What if we use the growth rate as a yardstick? It, too, does not serve well. Economic growth in the long term is basically determined by the potential growth rate—­ that is, the contribution of the increase of l­abor supply and productivity. A central bank cannot control t­ hese ­factors. Two other frequently used yardsticks are (1) the inflation gap, or deviations of a­ ctual inflation from its target level; and (2) the output gap, or deviations of ­actual GDP from potential GDP. Th ­ ese criteria not only seem intuitively plausible but also are justified from the viewpoints of social welfare, as is shown in the lit­er­a­ture of New Keynesian economics. Developed economies during the years 2004–6 performed very well in terms of this evaluation yardstick. But 400 | The Roles of the Central Bank

what followed this period was the GFC. It means that over a longer time frame, macroeconomic stability was not achieved. Why did this happen? First, our knowledge on the gaps referred to above is quite ­limited. Concerning the inflation gap, we do not know what should be the target inflation rate with any precision. As was discussed in chapter 12, the standard justification for the 2 ­percent inflation target is not so solid. The mea­sure­ ment of ­actual inflation rate is also a daunting task. The same is true for the output gap or potential growth. Second, good per­for­mance in terms of ­these gap yardsticks sometimes tends to create a false sense of stability, which brings about aggressive be­hav­ior, eventually resulting in greater instability. And last but not least, our knowledge on how monetary policy affects inflation and growth is also quite l­ imited. Even t­ oday, we are not equipped with a reliable theory of the determination of the inflation rate, as the fact that we are continuing to debate why the Phillips curve has become flatter clearly shows (chapter 9).10

FRIEDMAN’S VIEW ON THE ROLE OF MONETARY POLICY ­ ese considerations lead us to think seriously of what should be a guiding Th princi­ple of monetary policy. Is it pos­si­ble and desirable for the central bank to try to achieve an optimal control of monetary outcomes like an engineer in a factory? An idea with which I have ­great sympathy is the one expressed in Milton Friedman’s 1967 address “The Role of Monetary Policy”: The first and most impor­tant lesson that history teaches about what monetary policy can do—­and it is a lesson of the most profound importance—is that monetary policy can prevent money itself from being a major source of economic disturbance. . . . ​The monetary machine has gotten out of order even when ­there has been no central authority with anything like the power now possessed by the Fed. . . . ​­There is therefore a positive and impor­tant task for the monetary authority to suggest improvements in the machine that ­will reduce the chances that it ­will get out of order, and to use its own powers so as to keep the machine in good working order. A second t­ hing monetary policy can do is provide a stable background for the economy. . . . ​Our economic system w ­ ill work best when producers and consumers, employers and employees, can proceed with full confidence that the average level of prices ­will behave in a known way in the ­future—­preferably that it ­will be highly stable.11 What Should We Expect? | 401

When I was governor of the Bank of Japan, I often quoted t­ hese remarks.12 What did Friedman mean when he said, “prevent money itself from being a major source of economic disturbance”? It is my interpretation that he was emphasizing the importance of the lender of last resort function of a central bank, with the US situation in the 1930s in his mind. A central bank should, when faced with a truly systemic financial crisis, make ­every effort as the lender of last resort to prevent the financial system from collapsing. This is the first role of a central bank. Though I am prob­ably extending it a fair amount, how I understand Friedman’s argument is that the first priority of a central bank should be to avoid a situation in which the financial system is destabilized, leading to a financial crisis—­that is, to avoid the financial conditions that lead to an unsustainable growth path. While monetary policy cannot boost the potential growth rate, ­actual growth is certainly depressed if a central bank fails to maintain the stability of the financial system. In other words, a central bank cannot enhance medium-­to long-­term growth, but it can certainly undermine the economy if it fails to maintain financial stability. Friedman’s argument is also very illuminating in the sense that he put the function of maintaining the stability of the financial system before price stability, which is usually regarded as a primary objective of monetary policy ­today. It is also in­ter­est­ing to note that what he emphasizes is to realize a situation where “producers and consumers, employers and employees, can proceed with full confidence that the average level of prices ­will behave in a known way in the ­future—­preferably that it ­will be highly stable.”13 Price stability is understood as a sense of security that prices do not fluctuate much in the medium to long term when companies plan to make capital investment and ordinary ­people plan to buy a h ­ ouse or save for the f­ uture. This corresponds to what I meant by (long-­term) price stability in chapter 16. In my view, the fundamental role of monetary policy—to be more precise, central bank policy—­should lie in fostering a stable financial environment. Accordingly, the central bank’s per­for­mance should be evaluated on this basis.

FINE-­T UNING STRATEGY VERSUS MINIMAX STRATEGY The views of New Keynesian economics differ from Friedman’s view. The New Keynesian strategy of monetary policy—­minimizing the inflation and output gaps—­can be called an optimization strategy or a fine-­tuning strategy. This strategy sounds reasonable but, as explained herein, the real­ity is that the 402 | The Roles of the Central Bank

efforts at minimizing fluctuations themselves can sometimes be a source of bigger fluctuations l­ater on. The alternative strategy of monetary policy aims at reducing the risk of the worst-­case scenario, and this can be referred to as the minimax strategy, to borrow a term used in game theory. This minimax strategy is seemingly more modest, but in the long term it may deliver good economic per­for­mance in terms of the yardsticks mentioned above. Which is more desirable, the fine-­tuning strategy or the minimax strategy? If the central bank has the ability to do fine-­tuning well, that is definitely the first best choice. But many central banks did not have such an ability, and over the past three de­cades or so, what fine-­tuning strategies brought about was stability in the short term and instability in the long term. That is the sober real­ity. This debate ­will never end, ­because both strategies provide impor­tant viewpoints, and the choice cannot be binary. The judgment concerning short-­term stability vs. long-­term stability is, notably, s­ haped by societal value judgments. Economists’ views have changed considerably on this debate over the past ­century. A ­ fter World War II, discretionary macroeconomic policy was pursued for quite a while as Keynesian economics became increasingly accepted. Since the mid-1970s, economists have slowly come to realize that discretionary policy led to stagflation. In response, discussions gradually changed and support for discretionary policy diminished. Inflation targeting that started from the end of the 1980s originally put more emphasis on “rules” rather than on discretion. But monetary policy conduct gradually changed ­toward pursuing minimization of the two gaps and, as a result, has come to take on more of the ele­ment of discretion or fine-­tuning. This evolution is somewhat ironic, b ­ ecause inflation targeting originally started from the basic idea that too much focus on the short-­term fluctuations of output or unemployment leads to big economic fluctuations and thus monetary policy should be conducted with an aim t­ oward price stability. The fine-­tuning strategy and the minimax strategy both provide impor­tant viewpoints. What we need is to pause occasionally to check ­whether monetary policy conduct has inclined or drifted too far in ­either direction. My assessment ­today is that monetary policy conduct since the 1990s has drifted too far t­ oward the fine-­tuning strategy and we should be lean more t­ oward the minimax strategy.

THE SIGNIFICANCE OF MONETARY POLICY REGIME When it comes to monetary policy discussions, it is usually the individual policy actions of the central bank that grab most of the attention of the media What Should We Expect? | 403

and market participants. The question of monetary policy strategy is seemingly abstract, but this is far more impor­tant than ­people tend to think. I have already touched upon the issue of the Bank for International Settlements view versus the FRB view (see chapter 16). A key to this debate is not how to deal with elevated asset prices per se, but how to deal with increasing debt together with elevated asset prices. It is the monetary policy regime rather than individual monetary policy actions that is impor­tant when private economic agents decide on how much debt to bear.14 Of course, no central bank explic­itly announces its monetary policy regime. But private economic agents distill the essential ele­ments from the ­actual be­hav­ior of the central bank and the way in which monetary policy is conducted. Regarding private economic agents’ decisions about debt, three behavioral characteristics of central banks have been observed since the 1990s. First, a central bank primarily focuses on inflation in deciding monetary policy. It is envisaged that low interest rates ­will persist as long as low inflation continues even when the economy is booming. To put it differently, market participants would expect that financial imbalances w ­ ill be tolerated. Second, the central bank wants to avoid high volatility of financial asset prices. And third, when asset prices plunge, a central bank implements monetary easing. This is asymmetrical, for when asset prices are increasing, the central bank does not raise the interest rate. This is often described as the offering of a put option by a central bank, as initially expressed in the term “the Greenspan put,” named ­after onetime FRB chair Alan Greenspan. If this is the case, private economic agents would feel more secure in increasing their debts. Thus, even in the case that interest rates are increased to some extent, the effect on debts or asset prices would become l­ imited if it is regarded as a one-­off rate hike. What determines the f­ uture course of the economy and the financial markets is not a marginal change in current interest rates but a more permanent shift in how private economic agents perceive the f­uture movements of interest rates. To put it differently, it means that it is extremely difficult for a central bank to behave differently on the ground that the current regime is not appropriate, ­because it ­will bring about huge shocks to the economy and financial markets.

IS IT TIME FOR A CHANGE IN THE MONETARY POLICY REGIME? A central bank usually does not abruptly change its monetary policy regime from the fear that it would bring about a huge shock. But t­ here have been a 404 | The Roles of the Central Bank

few examples in the past. The most dramatic change of the monetary policy regime in the past fifty years can be found in the Volcker Shock of October 1979. Paul Volcker, then the chair of the FRB, implemented a drastic monetary tightening to contain inflation at that time. It is intriguing to know that Arthur Burns (who served as FRB chair before Volcker) made the following remarks in his famous lecture “The Anguish of Central Banking” on how difficult it was to tighten monetary policy just prior to the Volcker Shock: “If the United States and other industrial countries are to make real headway in the fight against inflation it ­will first be necessary to rout inflationary psy­chol­ogy. . . . ​ Such a change in national psy­chol­ogy is not likely to be accomplished by marginal adjustments of public policy. In view of the strong and wide-­spread expectations of inflation that prevail at pre­sent, I have therefore reluctantly come to believe that fairly drastic therapy ­will be needed to turn inflationary psy­ chol­ogy around.”15 Burns was making a case, with anguish, for how difficult it was to change the monetary policy regime. What he focused on was the strong inflationary psy­chol­ogy that sat deeply in the US economy and society at the time. In order to contain inflation, drastic monetary tightening was necessary, but according to his account, companies, ­labor ­unions and politicians w ­ ere all opposed to such tightening. While I do not believe that Burns foresaw what was coming soon a­ fter his lecture, what Volcker boldly did was exactly what was recommended in Burns’s speech. It is true that monetary tightening by Volcker resulted in high levels of unemployment for a considerable period. But it is the current consensus of economists that Volcker’s drastic tightening prepared the necessary foundation for positive economic developments in the United States afterward. This experience of the Volcker Shock indicates both how painful the transition period was and how impor­tant the monetary policy regime was. To me, the experience of the global economy now seems to suggest that we need comparable change in the current monetary policy regime. I have to admit we have not yet found the way in which we operationalize the change, but continuing to stick with the current regime on this ground alone is not responsible reaction. At least, we have to clearly recognize what is the problem and make serious efforts at ameliorating the current regime.

What Should We Expect? | 405

| CHAPTER TWENTY-­O NE |

The Global Cooperation of Central Banks In achieving the stability of the domestic economy, “putting one’s h ­ ouse in order” is the first princi­ple; the utmost effort of individual countries is most impor­tant in this regard. But it is becoming increasingly difficult to achieve domestic stability without the stability of the global economy and financial system. Achieving global stability is no easy task, ­because the policy makers in any individual country do not have the incentive to internalize pos­si­ble externalities when implementing domestic policies. For de­cades, central banks have made vari­ous efforts on many fronts to address this issue. The challenges are formidable, but global cooperation among central banks is vitally impor­tant.

THE GROWING INFLUENCE OF GLOBAL ­F ACTORS Looking back at the episodes of global economic turmoil since the 1990s, most of them are associated with swings of international capital flows. In the case of the Asian financial crisis of 1997–98, a large amount of capital had flowed into emerging Asian countries prior to the crisis, but capital then took flight on a massive and extremely rapid scale. In the case of the global financial crisis (GFC) of 2007–9, ­there had been a similarly massive inflow of capital to the United States from emerging economies and Eu­rope. This went t­oward government securities, mortgage-­backed securities, and complex securitized products. Through this pro­cess Eu­ro­pean banks had been increasing their leverage by borrowing short-­term funds in US dollars. This flow of capital ­stopped ­after the GFC and reversed its direction. In the case of the Eu­ro­pean debt crisis, massive amounts of funds that had been flowing into peripheral countries of the euro area suddenly shifted and rushed out. Individual countries ­were affected severely. For Japan it was exchange rate movements or, to be more precise, an exaggerated fear of yen appreciation that has provoked the most concern over the past fifty years. Cases in point are the episodes of double-­digit inflation in 406

1973–74 and the b ­ ubble economy of the late 1980s. And, as was discussed in chapter 9, the discourse on deflation in Japan since the late 1990s to a large extent reflected concerns about yen appreciation as well. The importance of global f­ actors such as international capital flows, exchange rates, and overseas economic growth should be taken into consideration not only in crisis periods but also in normal times. Monetary policy in each country affects growth and inflation by influencing domestic monetary conditions. But the real­ity is that monetary conditions in each country are increasingly determined by the collective forces of the monetary policies of many central banks—­major banks in general and the Federal Reserve Board (FRB) in par­t ic­u ­lar. The synchronization of economic cycles are evident in terms of the movements of gross domestic product (GDP). The movements of inflation are also becoming more synchronized when compared with the inflation of the past. What is notable is that the traditional linkages we have postulated between inflation, the output gap, and monetary policy at the domestic level are becoming weak. We are gradually heading into an environment where a change in the domestic inflation rate is increasingly determined by global forces. It is already debatable to what extent monetary policy can affect the domestic inflation rate but, more impor­tant, it is global monetary conditions rather than domestic monetary conditions that are becoming impor­tant determinants of the inflation rate. The central bank is no longer as “central” as its name implies. John Hicks, a Nobel Prize laureate in economics, made prophetic remarks on this possibility more than fifty years ago when he wrote, “Only in a national economy that is largely self-­contained can a national central bank be a true central bank; with the development of world market, and (especially) of world financial markets, national central banks take a step down, becoming single banks in a worldwide system, not at the ‘centre’ any longer. Thus the prob­lem that was (partially) solved by the institution of national central banks has reappeared, and is still unsolved (though we are trying to solve it), on the world level.”1

THE FAILURE TO INTERNALIZE COSTS AND BENEFITS WHEN CREATING DOMESTIC POLICIES The economy and financial markets are becoming global, while monetary policy and financial supervision and regulation are conducted at the country level by national authorities. This is what the sovereign state is all about. For the foreseeable ­future, it is unrealistic to imagine that the authorities in large Global Cooperation of Central Banks | 407

countries ­will conduct monetary policy or financial supervision and regulation for the sake of global stability. The gap between the real­ity of the global economy and the policy-­making institutions is the essential source of the prob­lem we are faced with for many de­cades to come. Since covering all issues ­ ill mainly focus on issues related to this is beyond the scope of this book, I w pertaining to central banks. Most of the prob­lems derive from the fact that (1) central banks lack the incentive to “internalize” the international spillover from their own conduct of monetary policy, (2) ­there is no global lender of last resort that is ­really worthy of that title, and (3) financial institutions tend to consume the ser­vices of financial stability excessively by not internalizing the impact of their own be­hav­ior on financial stability—­the “tragedy of the ­commons.”

THE ZERO LOWER BOUND OF THE INTEREST RATE AND THE N-1 PROB­L EM The first example showing the prob­lem of monetary policy that emanates from such externalities is the monetary policy of a country faced with low or zero interest rates (see chapter 14). Japan and Switzerland saw rapid currency appreciation when the GFC erupted, and could not pursue domestic stability as regards monetary policy. This situation corresponds to what Nobel laureate Robert Mundell discussed fifty years ago ­under the name of the “redundancy prob­lem,” or the “N-1 prob­lem.”2 This was based on the observation that if the number of economies in the world was N, ­there would be N dif­fer­ent monetary policies but only N-1 exchange rates due to the fact that the exchange rate was a price relative for two currencies. Consequently, if economies wished to pursue optimal exchange rates through the conduct of their monetary policies, t­ here would have to be one economy that could not choose its exchange rate. ­Under the Bretton Woods System of fixed currency exchange rates, which was in existence when Mundell reached this insight, it was supposed that the United States would become the Nth economy that could not choose its own exchange rate. When I first learned of Mundell’s argument many de­cades ago, I could understand what he was getting at, but it seemed quite abstract. That changed as the experience of yen appreciation during my tenure as governor of the Bank of Japan impressed on me that Mundell’s view had real-­world implications. Contrary to the original idea, the Nth economy was not the United States, but 408 | The Roles of the Central Bank

economies such as Japan and Switzerland. If e­ very economy pursued a weaker exchange rate through monetary easing of one sort or another, the world economy would practically become a zero-­sum game. And ­today many developed economies are more or less in the same situation. When one considers the spillover of domestic monetary easing and the potential reactions thereto of other economies, which would in turn affect the domestic economy, the meaning of optimal monetary policy, aiming to achieve the stability of the domestic economy, has to change. In fact, “putting one’s h ­ ouse in order” does not necessarily guarantee a global optimum but can instead result in a “currency war” type of situation (see chapter 14).

THE EXORBITANT PRIVILEGE OF THE US DOLLAR The second example of the externality prob­lem of monetary policy is related to the special status of the US dollar. The US enjoys an exorbitant privilege ­because its currency holds the status of the key international currency (see chapter 20). Even if the United States fully understands the significance of the externalities of its own policies to the global economy, it is unrealistic for the FRB to act as a global central bank, given that its constituency is the US citizenry, not global citizens. Of course, the United States may not be able to continue to enjoy this privilege forever, as evidenced by history, where the status of the key international currency shifted from UK pound sterling to the US dollar. Since a strong network effect is at work, however, a country with a key international currency can naturally pursue “its own economy first” policies for a very long time. At around the tenth anniversary of the GFC, many speeches of a soul-­searching nature ­were delivered by US policy makers and academics. One ­thing that r­ eally struck me was that t­ here was l­ ittle reference to the global implications of the dominant status of the US dollar and US financial system.

THE PITFALL OF A CORE INFLATION RATE EXCLUDING FOOD AND ENERGY A third example of the externalities of monetary policy is related to the conventional practice of focusing on the “core” inflation rate, which excludes ­fluctuations in food and energy prices, and which many central banks in developed economies use when making decisions on monetary policies. It is Global Cooperation of Central Banks | 409

j­ustifiable for each individual central bank to treat food and energy prices as exogenous factors when assessing under­lying trends in domestic inflation. But if all central banks conduct their monetary policies based on this methodology, that might risk creating overly accommodative global financial conditions, simply ­because excluded commodities are affected by global monetary conditions. This is a sort of fallacy of composition. In fact, u ­ ntil about 2008, the core inflation rate remained stable even when energy prices surged. As a result, an easing bias ended up increasing total global oil demand, inviting a further surge in oil prices. I think this global easing bias partially explains the surge in commodity prices at that time, which greatly accentuated global economic fluctuations.3

PERSPECTIVES OF EMERGING ECONOMIES Even though I have occasionally touched upon the issues unique to emerging economies, my perspective is naturally ­shaped by my own experience as a central banker from a developed economy. Prob­ably nothing is more serious than the fear of foreign currency funding in the face of a financial crisis for emerging economies. Such economies are exposed to bigger risks of capital flight when faced with difficulties ­because of “original sin”—­past experiences with balance-­of-­payment crises—­a nd the underdeveloped domestic institutional framework. For this reason, u ­ nder the current situation, with the US dollar as the key international currency, t­ here exists an asymmetry in which emerging countries tend to put more emphasis on keeping their own currencies at depreciated levels than do advanced economies. Based on the b ­ itter experience of capital outflows at the time of crises, ­those countries tend to choose the strategy of accumulating foreign reserves through foreign exchange interventions. In fact, the amount of foreign reserves held by the emerging economies of Asia surged ­a fter the Asian financial crisis. Interventions by emerging countries in foreign exchange markets are motivated not only by the perceived need for accumulating foreign reserves but also by the desire to maintain competitiveness of exports. While officials in advanced economies generally tend to have an adverse opinion concerning the accumulation of foreign reserves by emerging economies, they increasingly recognize the benefits to this strategy for the individual country as a mea­sure of self-­insurance. This is based on the recognition that swings in capital inflows and outflows are very large and have a strong impact on relatively small economies, even if the amount is not so large for 410 | The Roles of the Central Bank

big economies. In the past, policy makers in developed economies, myself included, may not have understood sufficiently the severe pains experienced by emerging countries. The Bank of Japan was able to receive unlimited amounts of US dollars at the time of Lehman B ­ rothers’ collapse by taking advantage of a swap line with the Federal Reserve Bank of New York. Yet only a ­limited number of central banks had access to this swap line. Taking this into account, we need to take the words of the then governor of the Reserve Bank of India, Duvvuri Subbarao, seriously. In his memoir he writes, “We requested a similar rupee-­dollar swap arrangement, but the Federal Reserve did not respond positively. Although they never said it in so many words, I believe their reluctance was ­either ­because the rupee is not a freely convertible currency or ­because our financial markets ­were not impor­tant from the US perspective.” 4 Reading this, I would imagine myself having held the same opinion if I had been in the position of governor of a central bank in an emerging economy. On the other hand, I would have had the same response if I had been in the ­ nder attack from position of the chair of the FRB, Ben Bernanke. The FRB was u the US Congress regarding its massive provision of liquidity to domestic financial institutions. U ­ nder such a situation, I would guess that it would be very difficult to increase the number of foreign central banks qualified for unlimited access to the US dollar. What a country facing a balance of payments crisis needs is foreign currency, and the major role of the International Monetary Fund (IMF) and other international financial institutions is to provide this. ­After the Asian financial crisis, the regional safety net framework in Asia, the Chiang Mai Initiative, was established in May 2000 as a network of reciprocal foreign currency financing schemes joined by the ten member countries of the Association of Southeast Asian Nations (ASEAN) plus China, Japan, and ­Korea. This framework was further enhanced in March 2010 in the form of a multilateral network.

INTERNATIONAL POLICY COORDINATION? How should we cope with ­these externalities or the tensions emanating from the interests of the globalized world competing with the interests of national sovereigns? This topic is often discussed u ­ nder the theme of reforms of the international monetary and financial system. To examine it in detail is far beyond the scope of this book, but I ­will focus on the global aspect of monetary policy, briefly touching on the role of lender of last resort, the payments system, and financial supervision and regulation. Global Cooperation of Central Banks | 411

One logical answer to the prob­lem of externalities is international policy coordination or cooperation. In an ideal world, each economy pursues domestic stability while internalizing any global externalities of its policies. In fact, ­there have been brief periods when international policy coordination has been tried to some extent by policy makers in the major developed economies; the Plaza Accord and Louvre Accord are good examples. For a long time I had negative feelings about the idea of international policy coordination as such b ­ ecause of Japan’s ­bitter memory of how it actually worked at the time of ­these accords. The United States was faced with the declining competitiveness of its automobile industry and exploding trade deficits, and ­these increasingly led to protectionism. The Plaza Accord was born against such a backdrop, reflecting demands from the United States to mitigate the strength of the dollar and encourage expansion of domestic demand in other developed economies so as to shrink US trade deficits. The dominance of such policy views ­under the pretext of international policy coordination contributed, at least in part through prolonged monetary easing, to the expansion ­ ubble economy in the late 1980s. This experience underlies my of the Japa­nese b basic thinking on international policy coordination as such. “Putting one’s ­house in order” should be the first princi­ple for monetary policy in each country. Yet in view of developments in the global economy following the GFC and the appreciation of the yen, I have come to be aware that t­ here may be a grain of truth in the idea of the need for international policy coordination. This grain of truth is the appropriateness of pursuing optimal policy, taking into account spillover and the feedback effects of monetary easing. On the other hand, I am keenly aware that real-­world coordination can easily degenerate into bullying from larger economies.

ENLIGHTENED SELF-­I NTEREST ­ ere is no magical solution to the tensions stemming from externalities in Th the conduct of monetary policy. What we can realistically hope for are efforts at promoting a frank and candid exchange of information and views among central banks in order to understand their true national interests—­that is, enlightened self-­interest.5 Returning to the issue of international policy coordination and international policy cooperation, ­there is a subtle difference between the two: coordination involves acting based on prior agreement on specific actions to achieve a mutually beneficial state, while cooperation involves acting without prior agreement on specific actions. The effort at knowing enlightened 412 | The Roles of the Central Bank

self-­interest corresponds to international policy cooperation, and this is what we can realistically hope for t­ oday. ­There are vari­ous venues for this cooperation. Most impor­tant are meetings at the Bank for International Settlements (BIS). The Global Economy Meeting (GEM) was the highlight of the meetings of the governors at the BIS, and of the total sixty-­one BIS member central banks, thirty attend the meeting.6 Although how the discussion at GEM was or­ga­nized differed somewhat depending on who was the chair, the United States was always the first speaker in the roundtable pre­sen­ta­t ions of each member’s economic situation, and this US pre­sen­ta­tion naturally attracted the most attention. An in­ter­est­ing observation was that “external f­ actors” ­were always mentioned in t­ hese pre­sen­ta­t ions of economic developments of each country. It is understandable for a central bank of a small country to point out external ­factors, but even ­those of major economies, including the United States, often mentioned them. Yet taking into account that the total GDP of GEM member countries amounted to more than 90 ­percent of the global GDP, if we ­were to consider ­these as one economy, ­there would be no external ­factor. What ­were seen as external ­factors ­were critically affected by global monetary conditions that emerged as a result of conduct of monetary policy on the part of each central bank. Mervyn King, governor of the Bank of ­England and onetime chair of GEM, often mentioned this point and tried to invite members’ discussions with implications for the global economy as a ­whole. One fundamental prob­lem ­here is that the theoretical models underpinning current monetary policy are still predominantly about dealing with shocks that are of a nation-­specific nature and not with global permanent shocks.

WHAT CONSTITUTES GLOBAL IMBALANCES? Discussions in the past ­were very much concentrated on the issues of current account imbalances and exchange rate adjustments. For example, current account surpluses in emerging Asian economies (especially China) and the corresponding deficit in the United States was the typical subject of many discussions during the run-up to the GFC. What was discussed in parallel at the time was the issue of the “global savings glut,” as raised by Ben Bernanke, who pointed out the possibility that US long-­term interest rates had been oppressed at a level lower than what could be reasonably explained by domestic economic ­factors due to capital inflows from emerging economies.7 If savings surpass investments in one country, its current account rec­ords a surplus, and this leads to an increase in external assets. Part of this increase is used Global Cooperation of Central Banks | 413

for purchasing US government bonds, resulting in lower longtime interest rates in the United States. Based on this line of argument, the savings glut of emerging economies is regarded by some as one of the culprits that brought about the US housing b ­ ubble and, eventually, the GFC.8 ­These discussions on global imbalances, be they related to the level of the US dollar or the savings glut, ­were predominantly focused on the current account, which is equal to the net inflow or outflow of capital movement. Such an understanding is based on the view that capital flows finance the purchase of goods and ser­vices. But financial capital moves for other reasons as well. This is evidenced by the fact that the growth of capital flows substantially surpassed that of trade in goods and ser­vices. The view focusing on the net current account balance would risk missing more impor­tant imbalances lurking in the economy. We have to be attentive to vari­ous forms of financial imbalances emanating from international gross capital flows: leverage, maturity mismatch, currency mismatch, foreign currency liquidity position, and their distribution among vari­ous entities, among other ­things. A case in point is the current account of the euro area as a ­whole, which was nearly balanced prior to the onset of the GFC. At that time, as attractive investment opportunities w ­ ere rather l­imited in Eu­rope, financial institutions in the euro area increased their investments in complex securitized products in the United States. For their funding they relied on the issuance of short-­term liabilities, including commercial papers, which in turn w ­ ere purchased by US money market mutual funds. Eu­ro­pean financial institutions ­were funding short and investing long in a foreign currency, the US dollar, and ­were taking not only price fluctuation risk but also foreign currency liquidity risk. As a result, they faced US dollar liquidity risk first and foremost when the GFC emerged. From the viewpoint of the United States (which was a recipient country of net capital inflows), although the increase in the ratio of current account deficit to GDP was not particularly large, the gross amounts of both capital inflows and outflows showed significant increases (see fig. 21.1).9

THE GROWING IMPORTANCE OF COOPERATION AMONG CENTRAL BANKS Looking at monetary policy alone, p ­ eople cannot feel optimistic about achieving global stability through international coordination or cooperation. But, as I have pointed out in chapter 16, the tasks of central banks are much broader, 414 | The Roles of the Central Bank

As a percentage of US gross domestic product 20 Gross inflows Gross outflows Current account balance

15 10 5 0 –5 –10 –15

1996

1998

2000

2002

2004

2006

2008

2010

Figure 21.1 ​Gross capital flows and the current account of the United States. Source: Borio and Disyatat (2011).

and many developments of cooperation and coordination in recent de­cades among central banks have been encouraging.10 A development has been the creation of US dollar swap lines among major central banks; without this the global financial system would have collapsed. Another is increased cooperation on the payment and settlement system. A clear example can be found in the establishment of the CLS Bank, which for its transactions eliminates the settlement risk of foreign exchange—­providing a foundation of support for the globalized economy—­due to time differences. A third development is the efforts at harmonizing standards or rules in the area of financial system stability. Many standards have been already agreed upon internationally. The Basel III accord is the most well known, but the coverage is much wider. Good practices pertaining to payment and settlement systems have been developed. For example, discussions at the first set of international meetings I attended led to the setting up of standards for payment and settlement systems, eventually embodied in the Princi­ples for Financial Market Infrastructure. The pro­gress in t­ hese areas do not grab as much media attention, but they are r­ eally impor­tant contributions to global financial stability. Last but not least, increased communication at the staff level among central banks has been an extremely valuable development. Close contact Global Cooperation of Central Banks | 415

among central bank staff has provided a rich source of knowledge of what is happening in foreign countries.

INTERNATIONAL MEETINGS AND CONTACTS WITH FOREIGN CENTRAL BANKERS It is quite impor­tant for central banks to have a frank exchange of their views; in this regard, international meetings and bilateral contacts with foreign central banks are quite impor­tant. As governor of the Bank of Japan, I attended many international meetings held at the BIS, the IMF, G7 and G20 meetings, and the Executives’ Meeting of East Asia–­Pacific Central Banks (EMEAP). In addition to in-­person meetings, ­there are quite a few telephone conferences. ­These are usually held late at night Tokyo time due to the time zone differences with other central banks.

THE BANK FOR INTERNATIONAL SETTLEMENTS Meetings at the BIS are for central banks, and their governors’ meetings are generally held bimonthly in Basel, Switzerland. The BIS was originally established to ­settle reparation payments imposed on Germany following World War I; its roles have gradually changed over the years in response to changing global economic conditions and financial markets. Currently, the BIS explains its own mission as being to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in t­ hose areas, and to act as a bank for central banks. The regular governors’ meetings, which start on a Sunday eve­ning and end on a Monday eve­ning, provide a very productive forum for promoting the candid exchange of information and views. During my tenure as governor, I did not miss any of ­these meetings. Aside from the regular governors’ meetings, vari­ous other meetings are held that are attended by governors. Besides GEM, I typically attended meetings of the Economic Consultative Committee, the All Governors Meetings, and the BIS board meeting, as well as board committees’ meetings. E ­ very meeting has its own objective and specific members. In addition, I attended meetings of the Asian Consultative Council, the Group of Governors and Heads of Supervision, and meetings with CEOs of private financial institutions when they w ­ ere held. The BIS board meetings are the equivalent of board meetings at private companies and mainly deal with issues related to governance. I had served as vice chair for the BIS board meeting 416 | The Roles of the Central Bank

­under the chairmanship of Christian Noyer (governor of the Bank of France) ­ ntil March 2013. from January 2011 u To what extent are ­t hese meetings held at the BIS carry­ing out an impor­ tant objective—to achieve enlightened self-­i nterest among central banks? One answer may be found in the several discussions where many advanced and emerging countries made rather harsh comments with regard to the pre­sen­ta­t ion of the United States when it started its second round of quantitative easing, known as QE2, in November 2011. (I myself made some remarks on several occasions, including at GEM, posing questions about QE2.) Yet my impression was that the United States had never accepted any of ­t hese criticisms. Another example can be found at the time of the Eu­ro­pean debt crisis, when countries not in the euro area ­were strongly accusing the area’s authorities of a lack of decisiveness; the United States was most aggressive in this regard. Although the criticism was directed mainly at the governments in the euro area, rather than at the Eu­ro­pean Central Bank (ECB), responses from euro area authorities, including the ECB, seemed to be quite defensive. ­After mentioning the criticisms directed at Eu­rope and the United States during the GFC and the Eu­ro­pean debt crisis, Duvvuri Subbarao, the governor of the Reserve Bank of India, gives his impressions of international meetings: “The American tendency was generally not to contest the blame. It was instead more pragmatic: ‘OK, let’s put that ­behind us and see how we should move on.’ The Eu­ro­pe­ans, in contrast, w ­ ere given to vehemently pushing back on any suggestion of blame for the spillover impact of their sovereign debt crisis or of their ineptitude in managing it. Nor did they tolerate any advice on how they could improve their policy response to mitigate the costs to them and to the rest of the world.”11 Although Subbarao’s remarks may be a ­little too harsh for Eu­rope, I do agree that this kind of general tendency existed at the time. On ­these occasions, I used to reflect upon the experience of Japan in the late 1990s, when it faced relentless criticism of its belated response to its own financial crisis, and upon how the responses of Japa­nese delegates ­were viewed by other participants in ­ ere prob­ably regarded as being as defenthe meeting. Japan’s responses then w sive as Eu­rope’s on the occasion of the Eu­ro­pean debt crisis. But I would not say that all ­those criticisms ­were meaningless. At least in the case of Japan, criticisms made at international meetings provided us with reasons to convince ­others in Japan to take necessary action; the same is likely true for t­ hose Eu­ ro­pean authorities. I did not get the sense that the Eu­ro­pean authorities w ­ ere Global Cooperation of Central Banks | 417

in denial of ­those criticisms, but instead that they ­were very much frustrated by ­others’ lack of understanding of the difficulties associated with the po­liti­ cal persuasion necessary for implementing the needed policies in the euro area. As with the case in Japan, I would imagine that t­hose criticisms prob­ably provided the rationale necessary to bring about changes in the policy course. In the case of the United States, though, I am not quite sure how seriously ­ ere taken at the FRB. I did, however, notice a subtle criticisms of the QE2 w change in remarks by the leadership at the FRB ­after receiving the criticisms in that leaders started to explain more carefully their thinking with regard to the spillover effects of QE2. The ­actual benefits of candid exchange of views among central banks may not be ideal, but they are meaningful and significant.

THE INTERNATIONAL MONETARY FUND, THE G7, AND THE G20 The atmosphere at international conferences, such as ­those of the IMF, the G7, and the G20, was a l­ittle dif­fer­ent from that of the BIS conferences. The leading actors at gatherings o ­ f the former were finance ministers, and national interests and po­liti­cal consideration ­were more vis­i­ble. Unlike the BIS meetings, joint statements would be released ­after t­ hese sessions, and this typically affected the ­nature of the gatherings. In this aspect, meetings among central banks, including ­those at the BIS, are characterized more by frankness of discussions and expert knowledge. On the other hand, meetings held at the IMF, G7, and G20 are regarded as more effective as they carry more po­liti­cal legitimacy. In short, it should be understood that both types of meetings—­those of the BIS and the more po­liti­cal ones, such as ­those associated with the IMF, G7, and G20—­are necessary for finding ways to cope with global economic and financial challenges.12

THE EXECUTIVES’ MEETING OF EAST ASIA–­PACIFIC CENTRAL BANKS International gatherings can usually be characterized as ­either of the BIS type or the IMF type. In addition, it is also pos­si­ble to characterize ­whether meetings are led by advanced economies or emerging economies. Th ­ ere are 189 member countries in the IMF and sixty countries and jurisdictions in the BIS. But, since its inception, all managing directors of the IMF have been Eu­ro­pe­ ans, and at least one deputy managing director has been an American. The BIS had been led by G10 countries, all of them advanced economies, ­until rather

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recently when it enlarged its membership to include emerging countries. ­After mentioning that an increasing number of emerging countries started to participate in international meetings ­after the GFC, Subbarao notes in his memoir, “In some sense, the advanced economies continue to run the show. Although emerging markets ­were given a seat at the t­able, t­here was no real inclusion. Typically, the advanced economies would stitch up a deal at a conclave ahead of the meeting, and pre­sent that at the formal meeting for approval, almost as a fait accompli. In other words, emerging markets had a vote, but not a voice.”13 I do not agree with Subbarao’s observation fully, but it deserves sincere consideration that t­ here exists this type of view among the emerging economies. ­Under this situation, EMEAP, which was established in 1992 with the initiative of central banks in the region—­and, in par­tic­u­lar, the Bank of Japan—­ can be regarded as having a unique value. Currently EMEAP consists of central banks and monetary authorities from eleven economies: Australia, China, Hong Kong, Indonesia, Japan, ­Korea, Malaysia, New Zealand, the Philippines, Singapore, and Thailand. Originally, the name EMEAP was only used for executives’ meetings, but it is now used more generally, referring to institutional setups for cooperation among the eleven central banks and monetary authorities in the region. It does not have any standing secretariat and in this way is dif­fer­ent from the BIS. The chair country, which rotates annually, is responsible for the management of meetings during its tenure. The Bank of Japan has devoted considerable ­human resources for supporting the activities of EMEAP even when it has not been in the chair position. In addition to annual governors’ gatherings, exchanges of views are conducted at biannual deputy governors’ meetings and meetings of working groups on vari­ous issues, ­including macroeconomic developments in the region, financial stability, payment and settlement systems, banking supervision, financial market developments, and information technology. I always felt ­there was a close and friendly atmosphere at the EMEAP governors’ meetings, where governors who had few speaking opportunities at international gatherings led by advanced economies could pre­sent their views more easily. ­There ­were also many issues to be shared among members in the same region. For example, developing domestic bond markets in member countries has been one of the major issues, and the Asian Bond Fund Initiative started in 2003 was one of EMEAP’s proj­ects. Of course, how EMEAP is run has its own challenges. Unlike the Chiang Mai Initiative, EMEAP does not have any funding scheme. From a rather cynical

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perspective, the close and friendly atmosphere at EMEAP meetings may just be reflecting a lack of ­actual power. Therefore, ­unless conscious and dedicated efforts are made, we cannot utterly deny the risk that EMEAP meetings may become merely a series of social gatherings. When EMEAP was founded in 1992, the nominal GDP of China was 13 ­percent of that of Japan. But the size of the Chinese economy surpassed ­Japan in 2010 and it became 3 times bigger in 2020. Generally speaking, if ­there is a country (such as China) with an overwhelming presence at an international meeting, this may tend to make it difficult to have frank discussions. Even so, open and honest exchanges of views have continued at EMEAP meetings.

CONTACTS WITH INDIVIDUAL CENTRAL BANKS ­ ere are periodically scheduled bilateral meetings or meetings with a small Th number of central banks. The Bank of Japan has bilateral meetings with the ECB, the FRB, and several other central banks, in such areas as bank supervision, payment and settlement systems, and information technology systems, among ­others. As for monetary policy operations, the bank has periodical trilateral meetings with the ECB and the New York Fed. Since 2009 it has also had annual trilateral meetings with the Bank of ­Korea and the P ­ eople’s Bank of China. Even when bilateral meetings have not been scheduled, the Bank of Japan has often had informative conversations over breakfast ­tables—­especially at the ­hotels in Basel when BIS meetings w ­ ere held.

THE COMRADESHIP OF CENTRAL BANKERS Ultimately, it is ­human beings who support the international financial system. It is impor­tant to expand the pool of experts who have the deep understanding of their own economy and financial markets and can share the objectives of maintaining the stability of the global economy and the financial system. Expertise is crucial when having frank exchanges of views on monetary policy or sharing knowledge on payment and settlement systems or financial regulation and supervision. What is necessary h ­ ere is not only expertise but bonds of trust. I have become friends with many of my former colleagues at foreign central banks. The exchange of views with them over the years has affected my thinking on central banking and had an enormous impact on me—­ including on the writing of this book.

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THE PROSPECT OF COOPERATION AMONG CENTRAL BANKS The state of global cooperation among central banks is less than ideal but is steadily improving. ­Going forward, ­there are many difficult challenges, including the ones stemming from the rise in pop­u­lism and a declining trend in the natu­ral rate of interest. Both are developments with profound implications for central banks. It is worrisome that the declining natu­ral rate of interest is partly caused by rapid aging and a declining population, for which we do not have answers that are effective and po­liti­cally accepted by the public at large. I am also concerned by the fact that the declining real interest rate, which is often attributed to the declining natu­ral rate of interest, is partly the result of collective monetary policy decisions by central banks. Both developments may raise expectations and pressure for central bank actions, for which an adequate response ­will be quite difficult to find. This situation could be further aggravated by a lack of global cooperation. Given the real­ity that individual countries are constrained by their domestic stability mandate, the tasks facing central banks are daunting. We need po­ liti­cal leaders in each country who understand the need for global cooperation. On the part of central banks, the mechanism on which we can pin our hope is a sense of professionalism among central bankers who understand the value of global stability and global cooperation. On top of that, we need an intellectual model that addresses the new realities of globalized economies and financial markets.

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| CHAPTER TWENTY-­T WO |

The In­de­pen­dence and Accountability of the Central Bank In the 1970s and 1980s, central banks enjoying in­de­pen­dence—­either de jure or de facto—­were relatively few. T ­ oday many central banks—at least in developed economies—­have gained in­de­pen­dence. Central banks, though their officials are unelected, have enormous powers and affect the economy—­and, for that ­matter, society and the lives of ordinary p ­ eople—­profoundly. The governing framework of central banks—­in­de­pen­dence and accountability—­worked reasonably well, but its success was rather short-­lived. The in­de­pen­dent central bank was designed as a device to address the po­liti­cal and social tendency to pursue short-­term gain, even when the long-­term consequences of the policy might be dire. But this tendency itself remains. Ironically, t­oday the governing framework has started to exert unintended consequences, undermining the objectives intended to be achieved by the in­de­pen­dent central bank. We have to think seriously about how central banks should be in­de­pen­dent and accountable in a demo­cratic society to achieve their mission of the stability of the currency.

MY ENCOUNTER WITH GOVERNMENT AND POLITICS The idea of central bank in­de­pen­dence started as in­de­pen­dence from government and politics. To avoid fiscal dominance—­where a central bank becomes a financing machine of the government—­many central banks have been prohibited from providing direct financing of the government bud­get deficit. The short-­term inclinations of the government or politicians are generated not only by the need for government finance but also by election cycles. For the Bank of Japan, the relationship with the government and politics has been a delicate issue for many years. I do not know how leadership at the bank was feeling about this delicate prob­lem in the 1970s and 1980s when I was a young staffer, but it is not so difficult to imagine. 422

My first awareness of the central bank’s difficult relationship with the government and politics was when I was in the Monetary Affairs Department as a midlevel staffer a­ fter the Plaza Accord (see chapter 2). It was 1985–88, the ­ ubble economy. The next time I became aware of the years of the Japa­nese b tension was during my years at the Financial System Department (1990–93), when the Bank of Japan wrestled with the nonperforming loan prob­lem of Japa­nese banks (see chapter 3). U ­ ntil then my contacts with politics had been rather ­limited; my direct counter­parts ­were staff at the relevant ministries of the government, and not members of the National Diet. As I took up more se­nior positions ­after 2000, I became more directly exposed to po­liti­cal developments. ­After I became governor of the bank, I had many opportunities to talk with the prime minister and finance minister directly and to answer questions at committees of the National Diet. This brought me new perspectives on the relationship between the Bank of Japan and the government and politics. I do not know to what extent my experience on t­ hese occasions when I was governor was the same as that of my pre­de­ces­sors, b ­ ecause the relationship between the bank and the government changes over time and it naturally depends on the personalities of the prime ministers, finance ministers, and governors. In terms of the po­liti­cal environment, the ruling party changed twice during my tenure, and ­there ­were frequent changes of ministers: six prime ministers and ten finance ministers over the course of only five years. The frequent changes w ­ ere quite exceptional even by the Japa­nese postwar standard characterized by a rather short stint of ministers.

EXCHANGES OF VIEWS AND INFORMATION WITH THE GOVERNMENT As for macroeconomic policy, the responsibility of monetary policy rests with the central bank, and that of fiscal policy rests with the government. It is impor­ tant for the central bank to understand the government’s thinking b ­ ehind its conduct of fiscal policy as well as other economic policies. Accordingly, close exchanges of information and views take place between the two. The institutional design varies across countries. In Japan the exchanges of views and information are conducted both at the staff and leadership levels. The ministries in charge of macroeconomic policy are the Cabinet Office and the Ministry of Finance. In the regular exchanges at the staff level between the Bank of Japan and t­ hose entities, government views on economic developments In­de­pen­dence and Accountability | 423

and its expectations for monetary policy are conveyed to bank staff. At the leadership level t­ here ­were quite a few official meetings that the governor of the bank was required to attend, such as the Council on Economic and Fiscal Policy and meetings of the Ministerial Council on the Monthly Economic Report.1 ­These meetings, though ceremonial in most cases, had the unintended benefit of creating some opportunities for me to have short one-­on-­one conversations with the ministers e­ ither before or a­ fter the meetings. But the most substantive meetings ­were the unscheduled bilateral meetings with the prime minister and finance minister. ­These meetings ­were generally useful. But sometimes, a minister’s secretary took a back seat at the meeting for note-­taking purposes. In fact, at formal meetings at the Kantei, it was a long tradition that many sat along the wall. I had to live with it, and used the meeting as a forum for informing ministers of the conditions of the economy and financial markets by showing and explaining s­ imple charts. As for monetary policy itself, a formal mechanism of the government involvement was put in place by the Bank of Japan Act. Government representatives always attended the bank’s Monetary Policy Meetings (MPMs). The representatives ­were, in most cases, ­either the vice minister, the parliamentary secretary, or an executive official from the Cabinet Office and the Ministry of Finance, but ­there ­were times when a minister himself attended the meeting. It has been a practice since the inception of the MPMs that the government representatives express their official views on economic developments and monetary policy and their conduct of vari­ous economic policies, as well as their expectations concerning monetary policy. Their remarks are published in the ­ ere are countries that allow government representaminutes of the MPMs. Th tives to attend monetary policy meetings of central banks, but it is very rare for them to express their views on monetary policies as far as developed economies are concerned.

THE GOVERNMENT’S CONSTANT CALL FOR COORDINATION While I was governor, what was most disturbing for the Bank of Japan was the constant inclination by the government to stress the importance of joint actions and coordination with the bank. The government had set beating deflation and correcting the appreciation of the yen as an impor­tant policy agenda item, and emphasized the importance of joint action and coordination in the prime minister’s general policy speech delivered at the opening of National Diet sessions, as well as in vari­ous official documents. 424 | The Roles of the Central Bank

Furthermore, it was often the case that at press conferences economic ministers routinely made nuanced and sometimes more explicit comments on monetary policy, which made the headlines in the newspapers. Media reports on anonymous remarks by high-­ranking bureaucrats had become common practice. Many argue that the government and the central bank should naturally act jointly and coordinate with each other when the economy is facing difficulties. I fully re­spect the clause of Bank of Japan Act that indicates that the bank should “always maintain close contact with the government and exchange views sufficiently” in terms of the bank’s judgment of macro­economic conditions.2 Notwithstanding t­hese communication efforts, it is not always the case that t­ hese efforts would lead to mutual agreement. What should the bank do in such cases? As stipulated in the Bank of Japan Act, “Currency and monetary control by the Bank of Japan ­shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy,” and also, “The Bank of Japan’s autonomy regarding currency and monetary control ­shall be respected.” It is obvious ­here that, at the end of the day, the bank has the final responsibility for the conduct of monetary policy. Additionally, it is stipulated that the bank “­shall endeavor to clarify to the citizens the content of its decisions, as well as its decision-­making pro­cess, regarding currency and monetary control.”3 This is, as I understand it, what in­de­pen­dence and accountability of the central bank are all about. The government publicly emphasized joint actions and coordination and expressed publicly its expectations regarding the bank’s monetary policy. This often put the Bank of Japan in a difficult situation. In case both the government and the bank ­were of the same view, the government would be seen as taking the lead on monetary policy decisions as the decisions seemed to follow prior remarks made by the government. In case both w ­ ere not of the same view, the public remark made by the government would need to be denied by the bank. Disagreement would be very clear in every­one’s eyes. In e­ ither case, confidence in each institution would be damaged and the national interest would be impaired. Exactly for the purpose of avoiding this unfortunate turn of events, the procedure to ensure accountability is stipulated in the Bank of Japan Act, which notes that the government can express its opinions at monetary policy meetings, for which minutes are published. Regrettably, the government kept relying on dif­fer­ent mechanisms from what had been clearly laid out in the act. In­de­pen­dence and Accountability | 425

PRESSURE FROM POLITICIANS I had to appear frequently before the committees of the National Diet, and se­nior staff members w ­ ere frequently called up as well. A ­ fter I took the position of governor, vari­ous groups related to monetary policy had been formed by members of the Demo­cratic Party of Japan (DPJ), the Liberal Demo­cratic Party (LDP), and sometimes bipartisan groups.4 Many of ­t hese groups published appeals and petitions, and their members often criticized the bank in the Diet. Harsh condemnations w ­ ere often made against the Bank of Japan by Diet members who believed that monetary policy was not forceful enough. To be fair to the Diet members, however, ­there ­were also criticisms made from completely opposite viewpoints, though their number was rather ­limited. One of the unforgettable Diet members of the House of Councillors was Mikishi Daimon of the Japa­nese Communist Party. Though other members of the Diet called for aggressive mea­sures in the “once-­in-­a-­millennium financial crisis,” Daimon instead criticized the mea­sures taken by the bank—­such as the purchases of asset-­backed commercial papers, corporate bonds, and equities held by banks—by ironically remarking, “The bank has gone too far” and “it is getting close to socialism” at the House of Councillors Financial Affairs Committee meeting held on April 9, 2009. Daimon also said, “I think the Bank is prob­ably ­under severe pressure to do something.”5 While I had to publicly refute his opinion on that occasion, I could not help agreeing at least in part with what he had said. Another unforgettable Diet member was the late Koichi Kato, an LDP member of the House of Representatives. A ­ fter expressing his doubts over quantitative easing (QE) at the House of Representatives Committee on Financial Affairs on September 8, 2010, he followed it with a remark that seemed more like an actor’s line than a question directed at the Diet: “I have this concern that you are becoming like Jesus Christ, who shouldered the burden of all the suffering. Are you all right? Is it dangerous if you make a firm remark as a professional that it does not make sense to do something undoable or meaningless?”6 It is hardly surprising for the central bank to be criticized by politicians with vari­ous viewpoints, and this is a healthy pro­cess in a demo­cratic society. What caused me frustration, however, was that—­with very few exceptions—­the views expressed at the National Diet ­were almost always one-­sided. Th ­ ose in ­favor of aggressive monetary policy w ­ ere quite vocal and aggressive, while other members kept s­ ilent. The views expressed w ­ ere not representative of average 426 | The Roles of the Central Bank

voters, or even of average members of the Diet. Similarly, in his memoir, the chair of the Federal Reserve Board (FRB), Ben Bernanke, has devoted quite a few pages to describing the harsh criticism against the FRB from members of the US Congress and his irritation with ­these criticisms. But impor­tant differences also exist. In the US Congress, the FRB was criticized for ­doing too much, while in the National Diet, the Bank of Japan was criticized for not ­doing enough. Given that unconventional monetary policy (UMP) was increasingly taking on the ele­ment of “quasi-­fiscal policy,” to me it was somewhat strange for the Diet to ask the bank to do more, ­because fiscal policy was within the government’s realm.

PRESSURES FROM SOCIETY ­ ere undoubtedly existed pressure from the government and politicians, but Th it did not necessarily mean that government was exerting one-­sided pressure on the central bank. What was happening was more complicated. When I had a chance to have a one-­on-­one meeting with a Diet member who was well known as a vocal advocate of aggressive monetary easing, I realized that he was actually not a true believer in this doctrine and was well aware of the need for economic and fiscal reform. The real­ity was that it was difficult for politicians who had to go through the electoral pro­cess to advocate certain mea­ sures of reform that w ­ ere unpop­u­lar. On the other hand, it was easy, with no vis­i­ble cost in the short term, to criticize the Bank of Japan given that the narrative of deflation was so facile and power­ful. It was reported that Jean-­Claude Juncker, the president of the Eu­ro­pean Commission, made a famous remark in the midst of the Eu­ro­pean debt crisis: “We all know what to do. What we do not know is how to be reelected ­after we have done what we have to do.” This holds true universally, and it is not fair to place all the blame on politicians. In a sense, it was a natu­ral action for politicians to ask a central bank to adopt aggressive monetary easing, regardless of ­whether or not they supported it ­wholeheartedly. Having lived through a tense relationship with government and politicians, I have now come to think that po­liti­cal pressures on central banks should be understood partly as po­liti­cal pressures and partly as societal pressures. If the central bank succumbs to such pressures, the objectives of central bank in­de­pen­dence are not achieved. In this fashion, I am also concerned with the “social dominance” of the central bank (see chapter 17). In­de­pen­dence and Accountability | 427

PRESSURES FROM FINANCIAL MARKETS Pressures for keeping the time frame of monetary policy short come not only from politics and society but also from financial markets. As Alan Blinder, a professor at Prince­ton University who served as vice chair of the FRB in the early 1990s, once prophetically stated, Notice the irony ­here. Perhaps the principal reason why central banks are given in­de­pen­dence from elected politicians is that the po­liti­cal pro­ cess is apt to be too shortsighted. Knowing this, politicians willingly and wisely cede day-­to-­day authority over monetary policy to a group of in­ de­pen­dent central bankers who are told to keep inflation in check. But if the central bank strives too hard to please the markets, it is likely to tacitly adopt the markets’ extremely short time horizons as its own. This can create a dangerous “dog chasing its tail” phenomenon wherein the market reacts, acts, or rather overreacts, to perceptions about what the central bank might do, and the central bank looks to the markets for guidance.7 This passage resonates with what I felt during the Japa­nese b ­ ubble. I initially had intellectual hesitation in regarding prices formed in the market as “irrational.” I might have been unconsciously afraid that the Bank of Japan would be criticized as a “conservative” central bank by giving the impression of denying the fundamental role of the market. In retrospect, the prices actually ­were sometimes irrational. Fluctuations in prices in financial markets ­were valuable sources of information, but what I have learned from vari­ous experiences since then is that it is dangerous to place absolute faith in market price and it is sensible to examine economic developments from the viewpoint of sustainability. ­There ­were slightly dif­fer­ent kinds of pressures from financial markets. During the time I was governor, whenever uncertainties in the global economy ­were heightened in the financial markets, the yen appreciated in the foreign exchange market and market participants would incorporate the expectation of further easing at the next MPM. Politicians also made remarks calling for further easing in response to the news of the yen’s appreciation and deflation, and the press would also forecast further easing at the next MPM. As a result, the bank was often cornered into a position where it did not have any other choice but to take some additional easing mea­sures due to the fear that the 428 | The Roles of the Central Bank

market would sell off in disappointment if the bank did not act as expected. Alan Blinder made this same point in an intriguing remark: “Central bankers are only h ­ uman; they want to earn high marks—­from whomever is handing out the grades. While the only verdict that r­ eally m ­ atters is the verdict of history, it takes an amazingly strong constitution to wait that long.”8 If a central bank does not have its own view on ­future economic developments, it is inevitable that it ­will become a “dog chasing its own tail.” Actions and communications by the central bank are conveyed to the public at large by media—­both traditional media and the newer social media—­a nd interpreted by financial market participants, private-­sector economists, and market analysts. But ­these actors are also constrained by a vision ­limited to the short term. For investors, what is impor­tant is their per­for­mance relative to the market; for asset man­ag­ers, it is the size of assets ­under management; and for private-­sector economists and market analysts, it is the interest of readers, whose time frame is also short.

THE INTELLECTUAL INFLUENCE OF THE SEPARATION PRINCI­P LE Pressures from the above three sources—­politics, society, and financial markets—­are all impor­tant, but they are not the ­whole story. I must add two impor­tant ele­ments: the first is intellectual influence, and the second is institutional design. ­These are not the result of overt external pressure on the central bank but are rather more spontaneous in nature. In chapter 16, I explained the separation princi­ple—­treating price stability and financial stability as distinct objectives and assigning monetary policy to the former and financial regulation and supervision to the latter. Mainstream macroeconomics has lent credence to the current practice of monetary policy characterized by the separation princi­ple. As long as monetary policy is solely assigned the task of maintaining price stability, and especially price stability over the short term, it risks neglecting financial imbalances, which threaten macroeconomic stability in the long term. The separation princi­ple is not something imposed on central banks from the outside; it is embraced by central banks themselves. The current situation is somewhat odd. Present-­day mainstream macroeconomics was born in a response to the ­bitter experiences of soaring inflation in the 1960s and 1970s. It started from a clear recognition of the trade-­off between the short term and the long term. The same is true for the idea of central bank in­de­pen­dence and inflation targeting. Ironically, t­ oday this intellectual model In­de­pen­dence and Accountability | 429

is functioning in a manner opposite to that originally intended. By separating the inseparable two facets of currency stability, the attempt to price stability—­ which unfortunately came to be understood in a relatively short term—­has become a source of the instability of currency or long-­term price stability.

THE ACCOUNTABILITY TRAP Nobody would deny that accountability is a prerequisite for in­de­pen­dence, and central banks around the globe have made efforts at enhancing their accountability. The primary objective has been set as price stability. The inflation target has been set as 2 ­percent in many developed economies. The central bank publishes regular monetary policy or inflation reports that explain its projections of inflation and growth over a two-­to three-­year time frame, as well as the transmission mechanism of its monetary policy actions. All this has contributed greatly to the success of monetary policy in many countries. Ironically, this institutional design has also had the unintended consequence of making the time frame of monetary policy short. The prob­lem has emanated from how central banks operationalize accountability and transparency. First, instability that could threaten macroeconomic stability increasingly did not take the form of inflation. In many cases, it was financial imbalance that was the primary culprit. Second, and related to the first point, it often took much longer than two to three years—­the conventional time frame of inflation targeting—­for such imbalances to cause serious economic fluctuations. Third, explaining the projections and transmission mechanisms was not easy. To take the example of economic projections, disclosing just the central tendencies was not enough. If related information w ­ ere to be disclosed, it needed to be more granular, including the path of key variables, their stochastic distribution, each member’s projections, the assumption of policy rates, and so on. But such quantitative information, however detailed, still did not satisfy all of the calls for increased transparency. How did ­those numbers come up? Disclosure of economic models was needed. But ­there exists no theoretical model that perfectly describes the a­ ctual conduct of monetary policy. The numbers are ultimately backed by judgment and intuition. I am concerned about the pos­si­ble biases that can arise if central banks act only on the bases of information that make it easy for them to be seen as fulfilling their accountabilities. ­There exist some types of impor­tant information that cannot be seen as passing the test of accountability and transparency. ­These are (1) f­ actors that are difficult to quantify; (2) f­ actors that are impor­tant 430 | The Roles of the Central Bank

but are not yet formalized in existing economic models; (3) phenomena of low probability, but with big impacts if they occur, that get insufficient attention; and (4) developments that do not affect the short-­term outlook but have big impacts in the long term. ­Bubbles and their aftermath, financial crises, rapid aging, and a decline in population are all good examples. The importance of ­these f­ actors tends to be overlooked in the current cycle of frequent monetary policy meetings. But ­these biases are not imposed on central banks from the outside. Rather, they reflect central banks’ own design of the monetary policy framework. What I have discussed herein regarding accountability is fundamentally about the choice of monetary policy strategy: a fine-­tuning strategy or a minimax strategy (see chapter 20). If we basically support the fine-­tuning strategy, we need to make only minor changes to the monetary policy framework. But if we decide that we need to move in the direction of the minimax strategy, we have to radically rethink how central banks should be held accountable.

CENTRAL BANKS AS THE ONLY GAME IN TOWN The discussion of in­de­pen­dence and accountability in this chapter has so far been framed mainly in terms of monetary policy, and especially its intertemporal trade-­offs. This is still an impor­tant consideration, but since the GFC, the situation surrounding central banks has evolved further and become more con­spic­u­ous. A very popu­lar expression used to describe the be­hav­ior of central banks in this new environment was, and still is, “the only game in town.”9 As central banks have implemented monetary easing to its limit, monetary policy mea­sures are taking on the ele­ment of quasi-­fiscal policy. ­Every time a crisis arises—­for example, geopo­liti­cal developments, natu­ral disasters, and pandemics—­people expect central banks to play the role of ­doing “what­ever it takes.” The central banks actually meet t­ hese expectations in most cases. Further, central banks are being asked to play a role in addressing pressing social prob­lems such as in­equality and climate change. Expressions such as “green QE” or “the ­people’s QE” capture the current situation. How have we arrived at this point? In my view, the most fundamental concept is that the central bank is the only institution that can quickly act to implement mea­sures that seem to have some effects, however modest that effect may be. This stands out in the current environment, where it is becoming increasingly difficult to find and implement other policy mea­sures that reasonable p ­ eople can agree on due to the fragmentation of society. In­de­pen­dence and Accountability | 431

THE FRAGMENTATION OF SOCIETY The fragmentation of society makes it increasingly difficult to forge a reasonable consensus, which is needed for conducting rational economic policy. The exact form of fragmentation is dif­fer­ent across countries. In the Japa­nese experience ­after the bursting of the ­bubble, it took the form of distrust of authorities or the fragmentation between the experts or “elites” and the general public. The b ­ ubble and the subsequent financial crisis invited distrust of policy authorities, especially at the Bank of Japan and the Ministry of Finance. Distrust of experts and the associated disrespect for professional analy­sis tended to make reasoned discussions difficult. The second form of fragmentation is the widening in­equality of income and wealth. This has occurred across many developed countries, though Japan shows up as a relatively egalitarian society in international comparisons. The third form of  fragmentation is between regular workers and nonregular workers (see chapter 9). The fourth form is increasing regional differences, and the fifth is fragmentation between the el­derly and the young. In the mid-1990s, discussions warning of social fragmentation started to intensify. But I was not able to comprehend its importance as seriously then as I do t­ oday. I recall I was still maintaining the optimistic view that once economic growth was restored, social fragmentation would be mitigated. My view has gradually changed, especially ­a fter the GFC, as I have observed transitions in other developed economies where social fragmentation exposed itself more acutely. The Occupy Wall Street movement was a clear ­ otel close to Wall Street in symbol of this widening gap. I was staying at a h New York City in December 2011 to attend an international conference, and on my way ­t here on foot I saw what remained of the movement in a park. I could not help but notice that such social fragmentation was intensifying globally. Dissatisfaction felt by the general public is ultimately reflected in politics. ­ ubble are Challenges facing the Japa­nese economy a­ fter the bursting of the b not simply t­ hose related to a temporary decline in aggregate demand but are more structural and medium-­and long-­term in nature; they include aging, low birth rates, and the incongruity of the business models of Japa­nese companies with the changing realities of the global economy. In sum, structural reform has become necessary, but efforts to change the existing social o ­ rders invite strong opposition. Against this backdrop it is natu­ral to see growing pressure or expectation for monetary easing from central banks. 432 | The Roles of the Central Bank

ACCOUNTABILITY, TRANSPARENCY, AND COMMUNICATION Transparency is an impor­tant aspect of central banks being held accountable, and good communication with constituencies is an impor­tant part of ­these accountability efforts. But communication is always challenging. Many ­people do not like complicated explanations, and they often do not have time to ­listen to them. What often is preferred is an explanation that is facile and easy to understand. That is why narratives have become so power­f ul. As I noted in chapters 9 and 10, good examples of narratives that gained near tyrannical authority in Japan have been “the Japa­nese economy is suffering from lost de­cades,” “Japan has to beat deflation,” and “deflation is a monetary phenomenon.” Central banks are faced with the challenge of not only communicating their intentions and logic to financial market participants but also countering misleading narratives in the general public and the media. A key aspect of this challenge is that it is increasingly difficulty for the general public to understand technicalities of monetary policy as UMP is ­adopted. Another challenge is the growing sharp splits in opinion. It is nothing new that opinions on economic policy and monetary policy should differ, but the development of the internet and social media has drastically changed the landscape; it has made it easier to form groups with the same opinions and become extremely aggressive ­toward ­people who do not share ­those opinions. As a result, the debate tends to become acrimonious. One of my close friends who is an academic economist told me that it has on occasion become frightening to express reasoned policy opinions lest academics became subjected to heavy attacks in the virtual community. ­Under this situation where it becomes complicated to communicate, the question arises as to how much emphasis a central bank can put on the “easy-­ to-­understand” dimension of its communication strategy. Immediately a­ fter the collapse of Lehman ­Brothers, the role of the central bank was essentially that of “the lender of last resort.” The objectives, policy mea­sures, and intended effects ­were very clear, and communication worked reasonably well. Communication of UMP has been far more difficult. I judged it critical to proceed with the Bank of Japan’s UMP by carefully reviewing and  explaining the benefits and side effects as objectively as pos­si­ble if the bank was to take on unconventional mea­sures. I thought that failing to do so would, in the end, damage the credibility of the bank. A few months a­ fter I retired as governor, one journalist friend of mine shared with me remarks by the famous Japa­nese film director, Hirokazu Koreeda, who received the In­de­pen­dence and Accountability | 433

Palme d’or d’honneur in 2018: “Intelligence sprouts ­after drawing what is difficult to u ­ nderstand which hides b ­ ehind what is regarded as easy to understand, not after making an easy-­to-­understand explanation on what is difficult to ­u nderstand.”10 Film production and the conduct of monetary policy do not have all that much in common, but I share Koreeda’s view. It becomes all the more relevant as I think of the significant impact of monetary policy and the potential power held by the central bank.

ARE CENTRAL BANKS ALMIGHTY? Where should central banks go in terms of their in­de­pen­dence and accountability? Some argue that central banks’ power is severely constrained by the zero lower bound of interest rates, and that the banks are powerless in the face of the next financial crisis or economic downturn. I disagree. First and foremost, central banks can act as the lenders of last resort. This is crucially impor­ tant for preventing a collapse of the financial system, which in turn helps to forestall the worsening of deflationary pressures. Second, while central banks are not almighty in preventing ­bubbles, they are not powerless—­particularly if they are prepared to change the monetary policy regime. Third, though this is no longer a pressing issue for developed economies, central banks can contain high inflation, as they are equipped with the tools of monetary tightening. And, last but not least, central banks can ensure an efficient and robust financial infrastructure, which is especially critical in times of crises. The perception of the “powerless central bank” is a product of the monetary policy centric view of the central bank. We should never underestimate what central banks can contribute to the economy and society. ­Others maintain that central banks are almighty, but I feel unease with this perception. Central banks are never powerless in the sense that they are equipped with the necessary technical tools to maintain stability of the currency. But this does not mean that central banks can achieve stability of currency by their own efforts alone. Such stability ultimately depends on the ­will of society, and especially the sustainability of government finances. High inflation can be technically contained by monetary tightening, but this implementation is impossible without a minimum amount of support from the government and the public at large. Technical ability is not the same as a­ ctual ability. On the back of ­these perceptions, central bank action as I have discussed it in this chapter raises the fundamental question of the role of central banks or un434 | The Roles of the Central Bank

elected officials in a demo­cratic society.11 In the old days, the central bank was an arm of the government. But ­today in­de­pen­dent central banks can act quickly ­because their power can be executed without parliamentary pro­cess. This is con­ve­nient even for politicians, who often count on central bank action. But the mea­sures taken in this context are often fiscal in nature, which is not what the original promoters of central bank in­de­pen­dence had hoped to achieve. While central banks are power­ful, they cannot solve all the prob­lems the economy is faced with. Central banks are impor­tant, but not almighty, as is assumed in some quarters. In any event, if the current trend of central banking witnessed in the past two de­cades continues unchecked, I am deeply concerned about the ­future of central bank in­de­pen­dence. Interfering with resource allocation at the microlevel and levying taxes are fiscal activities. At some point in the ­future, ­people ­will recognize such central bank activity as having overstepped the boundary between monetary and fiscal policy in a demo­cratic society. Th ­ ere could be a backlash at that point, and ­people might question the validity of the very idea of central bank in­de­pen­dence. I am a strong believer in central bank in­de­pen­dence. In order to preserve in­de­pen­dence and continue to contribute to the economy and society, central banks have to focus their efforts on their core mission, which is to maintain the stability of the currency—or, more specifically, to foster monetary and financial conditions conducive to sustainable growth: preventing the collapse ­ ubbles, containing high inflation, and of the financial system, forestalling b providing robust financial infrastructure. All this calls for at least some changes in the current accountability framework of monetary policy. It is a quite a challenging task to operationalize such a conceptual idea, and I have no concrete p ­ roposal to pre­sent. But every­thing starts with clearly recognizing where we are now.

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| CHAPTER TWENTY-­T HREE |

The Central Bank as an Organ­ization In­de­pen­dence and accountability are indispensable building blocks of the framework for governing central banks in demo­cratic socie­ties. This incentivizes the central bank to achieve the stability of the currency in the long term, but it does not necessarily guarantee the ­actual delivery of a good outcome. Ultimately, it depends on w ­ hether or not the central bank actually makes the right decisions. Of course, it is not realistic to expect the central bank to be an infallible institution; our goal should instead be to make it less susceptible to making wrong decisions. Like any other institution, the central bank is an organ­ization composed of p ­ eople and characterized by its own unique culture. ­There are many orga­nizational issues that are worthy of serious consideration.

CENTRAL BANKERS AND MEDICAL DOCTORS Alan Greenspan, the onetime chair of the Federal Reserve Board (FRB), was once described as a “maestro” (see chapter 6). This meta­phor, though quite famous, does not fit well with what I understand the central bank governor to be, ­because the word “maestro” unduly emphasizes the ­g reat talent and skill of a single individual. To state the obvious, the central bank is an organ­ization, and it is not and should not be dominated by a single person, as the knowledge and ability of a single person is inherently l­imited. Furthermore, the economy is not something that can be orchestrated freely through monetary policy. I have come across numerous meta­phors describing the job of the central banker. One example is that of an airplane pi­lot.1 When confronted with sudden trou­bles in the sky, pi­lots in the cockpit quickly need to make the right decisions. The same applies to the central banker when private financial institutions become insolvent during a financial crisis or when the functioning of financial markets is disrupted by natu­ral disasters or computer breakdowns. 436

But impor­tant differences exist between a pi­lot and the central bank governor. As for the decision by the pi­lot, the time allowed in the face of imminent danger is very short. Th ­ ere are usually no experts on the airplane other than the pi­lot and the copi­lot once it leaves the runway. As for decisions by central bankers, the time allowed is usually longer than seconds or minutes. Further, we can tap on the wisdom of experts outside the central bank. Many ­people— both experts and self-­proclaimed experts—­express their views, and some of them are quite vocal. In fact, I suspect differences of opinion among experts are much bigger as regards monetary policy. While passengers of an airplane do not have a choice other than to leave their destiny in the hand of the pi­lot, the general public does not give the central bank such carte blanche. If I w ­ ere pressed to give my favorite meta­phor for describing the job of the central banker, without hesitation I would choose that of the central banker as medical doctor.2 As doctors take care of the health of ­people, central bankers take care of the health of the economy—­both in terms of price stability and financial stability. The biggest similarity is that both jobs presuppose an enduring relationship of trust with the beneficiaries of the ser­vices in order to do the jobs properly. Patients go to their regular doctors, as they know that the doctors can be trusted through a long-­standing relationship. When we need to have surgery, doctors explain the efficacies and pos­si­ble side effects beforehand, and we give our consent as we are confident that they are making an accurate diagnosis and proposing the best treatment. The same is true for monetary policy. The public’s trust of the central bank is vitally impor­tant. What constitutes such trust is twofold: the central banker makes his or her best judgment as an expert and then implements the best policies based on this judgment. Another similarity between medical doctors and central bankers is that the level of knowledge when making recommendations is often ­limited; both the bodies of h ­ uman beings and the working of the economy and financial system are that complex. Though t­ here are many similarities between central bankers and medical doctors, one impor­tant difference exists. While patients can choose a doctor from a group of doctors, the general public cannot choose its central banker. That is why the public governance mechanism of the central bank—­in­de­pen­ dence and accountability—is put in place. In­de­pen­dence makes it pos­si­ble for the central bank to take monetary policy mea­sures that it judges to be the right ones. This is necessary but not sufficient. The central bank actually has to have the ability to make the right decisions. Other­wise, an in­de­pen­dent central bank can cause a disaster. The Central Bank as an Organ­ization | 437

THE LEGITIMACY OF CENTRAL BANK IN­D E­P EN­D ENCE In a demo­cratic society, what is the legitimacy of a group of unelected officials at the central bank conducting monetary policy? Of course, the central bank is entitled to in­de­pen­dence by law. But this legalistic answer is not complete. Central bank in­de­pen­dence can be stripped if the country’s politicians and ultimately its citizens wish to do away with it. Furthermore, ­legal in­de­pen­ dence is not the same as de facto in­de­pen­dence. In fact, the Japa­nese inflation rate was lower in the 1980s than that in West Germany with an in­de­pen­dent Deutsche Bundesbank, despite the fact that the Bank of Japan did not have l­ egal in­de­pen­dence (see chapter 4). The ­legal in­de­pen­dence of the central bank is a manifestation of the fact that ­people at large, recognizing the importance of price stability and financial stability, are prepared to delegate the task of achieving ­those goals to the central bank. Just stipulating in­de­pen­dence in the central bank law is not enough; societal support for that in­de­pen­dence is fundamentally necessary. But the public at large understandably does not bestow such societal support for the central bank without actually enjoying good macroeconomic per­ for­mance. This is a “chicken or the egg” prob­lem. In any event, the legitimacy of the in­de­pen­dent central bank depends on the public having a sense of trust that the central bank is competent and faithful in achieving its mission. The central bank is, like any other institution, formed by ­people, characterized by its unique culture, and influenced by subtle group dynamics. This means that, on top of public governance of the central bank, we have to pay sufficient attention to it from an orga­nizational or administrative perspective.

THE NECESSARY VIRTUES IN THREE DIF­F ER­E NT FIELDS OF CENTRAL BANK ACTIVITY Public discourse on monetary policy focuses overwhelmingly on what central banks should or should not do. This is an impor­tant and substantive issue, but we also have to think about how the central bank as an organ­ization can actually make the right decisions. The central bank is an organ­ization consisting of p ­ eople—­the governor, the committees, and staff—­and is characterized by its own unique institutional culture. ­Here I w ­ ill discuss three dif­fer­ent fields the central bank, which each represent necessary virtues of the of activities of 3 organ­ization.

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THE CENTRAL BANK AS AN EVER-­L EARNING INSTITUTION The first field is monetary policy and prudential policy—­both microprudential and macroprudential. In this policy area, good research and analytics play an impor­tant role; in fact, central banks have attracted talented economists. What I think is the most impor­tant virtue in this case is that the central bank is an  “ever-­learning institution.” As I have explained in this book, many policy ­mistakes are not due to s­ imple near-­term forecast errors but instead to more fundamental failures to recognize imbalances—­increasingly, financial imbalances in recent decades—­that lead to serious economic fluctuations. It is ideal if the central bank is competent enough to recognize what is happening in the economy and financial markets in real time, know what this means for the central bank, and formulate the right policy response. But it is impossible to preset an ­ ere lucky enough to find such a automatic rule for monetary policy. Even if we w rule, it would become obsolete over time. The optimal conduct of monetary policy has to adapt to changes in technology and to other fundamental conditions of the economy, the financial market, and society. And so, the public delegates the setting of monetary policy to the central bank. This requires the central bank to be an ever-­learning institution.4 Mervyn King once made a remark that is very close to my own thinking: “Since we cannot hope to describe ex ante what it is we expect to learn, and since new ideas are unlikely to be uniformly recognised and instantly accepted, it may be sensible to delegate both the immediate policy decision and the pro­cess of learning to the same institution.”5

THE CENTRAL BANK AS THE OPERATOR OF BANKING SER­V ICES The second key field of central bank activities is the provision of vari­ous banking ser­vices. One of the virtues expected in this field is efficiency. This is all the more relevant for a nonprofit organ­ization like the central bank, which tends to lack a strong incentive for enhancing efficiency. Another virtue expected in the provision of banking ser­vices is a receptiveness to innovation, ­because banking ser­vices, particularly payment ser­vices, are increasingly affected by vari­ous technological changes. At the same time, the central bank’s provision of banking ser­vices requires the bank to have a very high level of robustness and resiliency ­because it lies ­ fter the G ­ reat East at the very core of the nation’s financial infrastructure. A Japan Earthquake in 2011 (see chapter 13), all the offices of the Bank of Japan,

The Central Bank as an Organ­ization | 439

including ­those directly hit by the earthquake in Fukushima, Morioka, and Sendai, continued their business as usual, providing cash and exchanging massive amounts of damaged currency. That is, the payment and settlement system continued to function without major disruption. The continued smooth functioning of financial infrastructure is something p ­ eople do not pay attention to in normal times, but robust and resilient ser­vices of this sort cannot be provided in a catastrophic situation by competitive market forces alone. The activities in this field are often called operations. I feel slight unease with the connotations of this term for three reasons. First, the term grossly underestimates contributions to social welfare. The economic losses that ­were avoided, for example, by central banks’ efforts to reduce settlement risk does not show up in gross domestic product statistics, but the benefit is significant. It is very much a view centered on monetary policy to look at the provision of central bank banking ser­vices as secondary to that of monetary policy. An efficient, robust, and resilient payment system directly contributes to enhancing productivity in the economy in a fundamental sense. I do not know ­whether central banks’ success in this field affects public perception t­ oward central banks materially, but their failure surely affects public perception quite badly. Second, the term operations underestimates the importance of the fact that it is through such central banking ser­vices that monetary policy is executed. Without such operational knowledge, it is impossible to design optimal monetary policy, and especially so for unconventional monetary policy. Third, banking ser­vices themselves are rich sources of information and generate insights that are potentially useful for formulating monetary policy and prudential policy. For example, monitoring intraday overdrafts, which had always been a fundamental issue for the payments system, was critical when assessing funding markets during the global financial crisis (GFC) of 2007–9. Indeed, the devil is in the details: insights gained by central bank ser­vices of this nature are quite valuable.

THE CENTRAL BANK AS THE INSTITUTION OF PROBITY The third key field of central bank activities are t­ hose in which the bank is engaged to explain to the outside world what it is d ­ oing, especially in monetary policy. The more the central bank becomes influential, the more its explanations become impor­tant. This includes testimony before legislative bodies, press conferences, public speeches, the publication of papers, business contacts, 440 | The Roles of the Central Bank

outreach programs, and the like. Naturally, views about monetary policy are divided, and the central bank does not and should not expect that divergence of views to dis­appear entirely. What is impor­tant is that the public at large places its faith in the probity of the central bank, even though that public may not know the technical details of monetary policy or may not even support current monetary policy. The virtue expected is probity.6 Probity is multifaceted: to execute the right policy and to explain it well are surely impor­tant, but the central bank must be aware of potential negative feelings ­toward institutions ­ eople at the that can be perceived as elite. If the public at large thinks that p central bank do not have an understanding of or empathy for their suffering, that ­will adversely affect the basis of the bank’s conduct of monetary policy.

THE THREE PILLARS OF THE CENTRAL BANK The management and r­ unning of the central bank is no easy task. The three fields of activities discussed above are all h ­ oused in the same institution. At the same time, the central bank is neither one branch of government in charge of macroeconomic policy nor an isolated ivory tower. ­There are many books about corporate management and public management, but I do not know of a single book focused on central bank management. In fact, it is rare for such management to be explic­itly discussed, though ­there are some exceptions.7 In discussing this issue we have to take up the three pillars of the modern central bank: the policy-­making committee, the governor, and the central bank staff. I have had experience in all three, and h ­ ere I w ­ ill reflect on what the impor­tant orga­nizational issues are based both on my own experience at the Bank of Japan and my observation of central banks in general.8

CENTRAL BANK COMMITTEES Collective Decision versus the Governor’s Decision In most central banks, it is not the governor but a committee that determines monetary policy. To be sure, t­ here are some central banks where the governor is solely responsible. For example, when I was the governor of the Bank of Japan, the central banks of Canada, New Zealand, and India had this institutional setup. Even ­under this framework, however, an advisory committee to the governor, consisting of central bank officials and external experts, is put in place. ­There are pros and cons for each setup. The first rationale in f­ avor of a committee system is that it is better suited for reflecting vari­ous opinions and thus The Central Bank as an Organ­ization | 441

increasing the odds of making the right decision on average. The second rationale, related to the first, is that the committee system provides a more solid foundation for the legitimacy of central bank in­de­pen­dence ­because it relies on the collective wisdom of committee members. Other reasons are also impor­tant. Given that monetary policy affects the lives of all p ­ eople, many feel uneasy if the decision making is left to a single individual, however capable that person may be. It is natu­ral to think that ­people are more inclined to delegate decision making for monetary policy to the careful deliberation of a group of experts who are supposed to be equipped with sufficient knowledge and provide vari­ous viewpoints. To be sure, even in a case of a governor-­only system, an advisory committee is usually set up, allowing the canvassing of many expert opinions. But for such opinions to truly carry weight, it seems necessary for holders of ­these opinions to have voting powers and actually join the decision making in a formal fashion.

The Peril of Groupthink The potential strengths of the committee system as explained herein obviously presume that careful deliberation is actually made in the committee. ­Here the worst ­enemy is groupthink, through which members of the organ­ization avoid conflict and prioritize harmony and, as a result, alternative views are suppressed and bad decisions are made. If the committee is contaminated by groupthink, it ­will not function optimally. Groupthink could emerge for a number of reasons. Perhaps a group of members tends to share similar views if their backgrounds are similar. Further, if many of the staff economists providing background materials for discussion rely on the same analytical approach and similar economic models, the results of committee members’ analyses consequently tend to become similar. Another f­actor would be if the governor dominates staff economists, in which case the materials presented ­will be biased. On top of all ­these ­factors, ­human nature kicks in. ­Because ­people tend to be cautious in expressing highly speculative opinions or ideas in the nascent stages of discussion, valuable though controversial opinions may be censored. This kind of tendency may be aggravated if the members fear their remarks might exacerbate financial market volatility, though ­here the design of communication is critical. In any event, it requires considerable courage to express minority opinions in the context of ­human relations within an organ­ization, and groupthink emerges as a result of the related peer pressure. Of course, diversity of opinions is not the end in itself. If ­there are members who consider that being “vis­i­ble” is a good stepping stone in their f­ uture 442 | The Roles of the Central Bank

c­ areers and put high priority on just standing out, the inherent strength of diversity of opinions cannot be realized. The advantages of the committee system exist only when members share the common objective of making good decisions and express vari­ous opinions based on a shared sense of mission. The appointment of qualified persons as members of the committee is crucially impor­tant.

Qualifications for Members of the Committee The most critical qualification for members of the central bank policy-­making committee is, in my view, the sense of responsibility for fulfilling the mission of the central bank and the ability to make in­de­pen­dently informed judgments. What about being an economist? It is impor­tant to have a systematic understanding of economics. But that does not mean that holding a PhD in economics is absolutely necessary. If this ­were to lead to the appointment of devotees of similar economic models, the committee might inadvertently end up with groupthink. Taking account of the fact that our knowledge is inherently ­limited, the composition of members is extremely impor­tant. Notably, we now observe a kind of central bank and academic economist axis.9 Communication between the central bank and academia is quite impor­tant, but if this leads to a lack of diversity in intellectual approaches or a lack of challenges to an approach by similarly minded academics, it can come with costs. From this perspective it may be desirable to have members who have rich experience in the financial markets and at financial institutions, as well as t­ hose who have had ­actual experience in private nonfinancial business as well. Having expert knowledge on the macroeconomy and financial markets is of course impor­ tant, but an even more impor­tant qualification for members of the central bank’s monetary policy committee is the sense of responsibility for the mission of the bank and the humility and curiosity to absorb a host of new ideas. Another impor­tant consideration is the need for having board members who have deep experience in public policy in general and central banking in par­tic­u­lar. The design of the committee and the appointment of members also depends on the areas that the committee covers. In the case of the Bank of Japan, the Policy Board’s coverage is not l­imited to monetary policy but extends to all key issues, including supervision of financial institutions, operating the payment and settlement system, and the bud­geting and management of the bank. ­ ngland, its coverage is extremely wide-­ranging, and In the case of the Bank of E vari­ous discrete committees are put in place.10 As a result, the qualifications to be a member of each committee are naturally quite dif­fer­ent. It is not necessarily The Central Bank as an Organ­ization | 443

the case that an economist who excels in analyzing the macroeconomy and the conduct of monetary policy would also be competent in the management of the central bank as an organ­ization. If the committee responsible for all key issues is set up by law, as in the case of the Bank of Japan, it is impor­ tant that committee members as a ­whole can cover all the business lines of a central bank, whereby one member might excel in monetary policy and another might excel in orga­nizational management.

Who Appoints the Committee Members? Central bank in­de­pen­dence is not ensured if members are chosen based only on their loyalty to the current economic policy of the government or even the current monetary policy of the central bank. In ­these cases, the bank may be in­de­pen­dent on paper, but the potential advantages of being independent—­a neutral judgment of the correct policy prescription—­cannot be realized. In practice, how members are appointed differs by country. Notably, in many countries clever mechanisms are embedded in the framework for appointment, ­either by design or by accident, to avoid undue influence of the government and the politics of the time over the appointments. For example, in the case of the United States, seven members of the Federal Open Market Committee (FOMC) who are governors of the Board are po­liti­cal appointees—­appointed by the president, with the approval of the US Senate—­but the other five voting members are presidents of regional Federal Reserve Banks who are appointed by the boards of ­those regional banks with the approval of the chair of the FRB. In the case of the Eu­ro­pean Central Bank in appointing members of its Executive Board, including its president, recommendations are necessary by the Governing Council of the bank, which is composed of the board members and central bank governors.

THE GOVERNOR OF THE CENTRAL BANK Desired Traits The central bank is a social invention created to solve the inherent trade-­off between short-­term and long-­term stability. Thus, the job of central bankers and the governor in par­tic­u­lar is inherently unpop­u­lar. The most impor­tant trait of the governor is having a strong sense of responsibility—­the ability to say “The buck stops h ­ ere.” One issue that often comes up in discussion is w ­ hether the governor should be an economist. If by “economist” we mean an academic economist, I think 444 | The Roles of the Central Bank

the right answer is no. The talent and skill needed to be governor of a central bank is much wider than that needed to be an economist or academic economist. But the governor should be a person who appreciates the value of economics and preferably has a deep understanding of it. On top of that, the governor should be open to new ideas. What about expertise in nonmonetary policy related issues? In this re­spect, the importance of the central bank’s having a strong interest in the financial system, which Paul Volcker has emphasized, applies perfectly to the job of governor (see chapter 16). The governor should pay sufficient attention to all of the vari­ous activities the central bank is performing. If the governor is interested only in monetary policy, the morale of staff working in other fields w ­ ill decline; they might regard themselves as second-­class citizens, which w ­ ill undermine the ability of the central bank to fulfill its mission. That said, it is true that the governor is very busy. Thus, in many central banks, some kind of division of ­labor between the governor and deputy governor or other members of the board is put into place. This is a practical solution, but at a minimum, the governor should show his or her strong interest in nonmonetary policy fields. When discussion was made about the role of monetary policy in forming the ­bubble a­ fter the GFC had erupted, we often heard the argument that the b ­ ubble and financial crisis ­were due to a failure of financial supervision and regulation rather than monetary policy. As I have explained, I do not agree with this separation princi­ple, but even if this princi­ple is accepted, it is true that the governor cannot escape from responsibility for such failures ­because central banks are, in most cases, tasked with supervision and regulation in addition to monetary policy.

The Governor as Chair of the Monetary Policy Committee The functioning of the monetary policy committee depends on the governor’s style of chairing as well as the personalities of the committee’s members. ­There still exists a view in Japan that even though monetary policies are formally de­cided by the Bank of Japan’s Policy Board, it is the bank’s governor that actually makes the decisions. The reason often pointed out is that proposals from the governor as chair have always been approved by majority vote at the monetary policy meetings. However, this is b ­ ecause the chair takes note of what has emerged as a dominant view from the discussions and proposes what is likely to be approved by the majority. True, each member wants to have his or her views reflected in the decision. But if each member sticks to e­ very detail of his or her desired proposal, it may bring about a situation in which The Central Bank as an Organ­ization | 445

all proposals are denied by the majority. This applies to the governor as well. If the governor as chair sticks too much to his or her own views, this might also bring about an impasse at which no monetary policy decisions are made. Discussions at policy meetings are essentially the pro­cess of forging a reasonable consensus among the committee’s members. The chair can—to a reasonable extent, and prior to the formal decision making on key issues—­foresee topics for which opinions ­w ill be sharply divided. Accordingly, when I was governor, I tried to find a position agreeable to the policy board as a w ­ hole through one-­on-­one talks with each member at the governor’s office about pos­si­ble proposals. Given that decisions are made by the committee, it is impossible for all the members to be satisfied with ­every detail. Even as governor, I was not an exception. Yet it is impor­tant that as many board members as pos­si­ble, if not all of them, be able to have a sense of owner­ship of the decisions made. I am not quite sure if I succeeded in this objective, but at least my intention was to try to manage the meetings in this fashion. If the committee system is then viewed as better for monetary policy decision making, questions may arise about the role of the governor. Nobody thinks that the governor is just one member of the policy committee. When ­people talk about the past failures of monetary policy, the decision maker envisaged ­ eople is the governor at the time, not the committee as a in the minds of the p ­whole or the members who voted on the policy mea­sures. It is naturally viewed that the governor plays the leading role in monetary policy decision making. While I was the governor of the Bank of Japan, I fully recognized that I was the one to be blamed, and not the other members of our Monetary Policy Meetings (MPMs), even if the decision was made unanimously or I had to tweak my original position in order for the chair’s proposal to be supported by the majority at the MPM. In fact, the ­actual degree of freedom to dissent is dif­fer­ent among policy committee members. Governors and deputy governors are in a difficult position compared with other members of the committee who are relatively f­ ree to vote their own views. It is in­ter­est­ing to note how Paul Volcker voted when he was the president of the New York Federal Reserve Bank, and the ex-­officio ­ nder Arthur Burns’ chair. Being asked about this difvice chair of the FOMC u ficulty in an oral history interview, he said, “I was trying to get policy as tight as I could get it within the constraints of what Burns was willing to do. . . . ​I was the Vice Chairman of the FOMC, and I thought it was impor­tant that we not have too much overt disagreement, but I was getting pretty restless.”11 446 | The Roles of the Central Bank

Each governor has his or her own difficulty. I am not quite sure if a governor generally has the choice to hold a minority view, as t­ here are hardly any examples of that other than at the Bank of ­England. When I was governor, ­there ­were cases when the Bank of ­England’s governor, Mervyn King, was in the minority at its Monetary Policy Committee, although they ­were very rare. On such an occasion, the governor is responsible for explaining the decision of monetary policy to the public, as well as to the financial market participants, even if he or she has opposed the decision as a member of the committee. In Japan, if the governor’s view was in the minority in a decision, it would likely be regarded as a vote of no confidence in the governor. I would imagine this applies in the United States as well.12 So it appears t­ here is no s­ imple answer to the question of what the appropriate balancing act between showing leadership and building up a consensus is.

The Governor as the CEO of the Central Bank The governor is not just the commander in chief in monetary policy; he or she is the central bank’s CEO. Thus, the governor must pay due attention to ­every ­ uman resource issues. He or she usually spends aspect of the bank, including h more time on policy issues, be it monetary or financial system policy, and thus has many chances to meet with staff of policy areas. But I was fully aware that the policy function was supported by hardworking staff in nonpolicy areas of the central bank, and I intentionally set up many occasions to visit such sections both at the Bank of Japan’s headquarters and at branch offices. At the headquarters, the sections I visited for this purpose included ­those responsible for storing and shipping banknotes, exchanging damaged banknotes and coins, managing the computer center, making coupon payments of government bonds for the surviving families of the war dead, compiling statistics, setting up archives, maintaining the ser­vices of buildings, and working in the kitchens. A section that left me with a particularly strong impression was the one responsible for listening to the voices of ordinary citizens with regard to what­ ever the Bank of Japan was ­doing. ­Every day we ­were on the receiving end of many criticisms, such as the el­derly pensioner complaining that the interest rates on deposit w ­ ere too low, business o ­ wners angry that their profits w ­ ere ­ ese voices of orplunging due to the appreciation of the yen, and so forth. Th dinary citizens ­were summarized ­every month and reported to the governor. In many cases the criticisms w ­ ere made to the bank over the phone—­sometimes shouted loudly. I felt gratitude from the bottom of my heart seeing the staff so tenaciously responding to ­those angry and long phone calls. The Central Bank as an Organ­ization | 447

THE CENTRAL BANK STAFF Providing Input to the Board Members The job of the central bank staff is diverse. In the field of monetary policy, the core function is to provide the input that is necessary for the board to make right decisions.13 The board needs to be provided with sufficient information, such as the economic outlook, pos­si­ble monetary policy options, and the operational details of policy mea­sures. Good research is key, and the central bank successfully attracts many talented economists. This, though impor­tant, does not guarantee good input as regards policy decisions. Some conditions have to be met. First and foremost, a diversity of views is impor­ tant. Take the example of economic forecasting, where the operating princi­ple is that more than one forecast should be presented.14 If only one economic forecast is presented and not challenged, the policy a­ dopted might be constrained by this specific forecast. Even in cases where more than one economic forecast is presented, it is not particularly useful if multiple forecasts rely on the same approach or philosophy. What is crucial is to ensure truly diverse approaches and viewpoints. Economic and financial data is very impor­tant, but ­t here are many other valuable sources of information, such as insights gained through contacts with businesses and financial institutions or drawn from historical experience. How to efficiently or­ga­nize research activity at the central bank is an eternal and sensitive issue. ­There are two types of research at the central bank. One is research directly related to the policy decisions, or research assigned by superiors; this research tends to justify a current policy. The other type of research is more in­de­pen­dent and done at the initiative of individual economists. Both are equally impor­tant, but given ­human resource constraints, striking the balance between the two is sometimes not so easy. If the staff economists are forced explic­itly or implicitly to do the research to justify current monetary policy, the potential strength of diversity ­w ill not be realized. What is worse, this might make competent economists quit the central bank by undermining their morale. On the other hand, if central bank economists become more interested in how their published papers are evaluated in the academic community reflecting increased mobility between central bank economists and academic economists, the orientation of research at the central bank might be changed in a subtle manner. In the worst-­case scenario, central bank economists might be interested only in scholarly research that is easily manageable within the existing intellectual framework, and less interested in 448 | The Roles of the Central Bank

research that addresses policy issues of pressing need or calls for out-­of-­the-­ box thinking about the macroeconomic prob­lems of the day. Who takes the initiative for managed research of the first type can also be an issue. If each board member ­orders staff members to perform research freely according to his or her own ­will, ­human resources ­will be severely stretched. If the governor dominates the research staff, the central bank risks losing diversity in its viewpoints. If the task is delegated to the heads of research-­related departments, it might instead end up with a predominance of the views of a select few se­nior staff, and the entire board ­will risk depending on the research priorities of only t­ hose few. It is crucial to cultivate a culture that re­spects the roles of the board, the governor, and the staff. Based on my own experience at the Bank of Japan as both a staff member and a governor at dif­fer­ent times, as well as on my conversations with other governors, this is easier said than done. It is a daunting task for any central bank to strike a balance between achieving efficiency and maintaining diversity of views.

Passing On Institutional Memory What is not well recognized is the role of the central bank staff to pass on the institutional memory of the bank to its board members. The tenure of board members is not long compared with the length of an economic cycle or financial cycle. In the case of the Bank of Japan, the tenure of Policy Board members is five years. If the board members are appointed in a spread-­out fashion, the average length of remaining ser­vice of the board member at any point in time w ­ ill be as short as two and a half years. But it is crucial to have a feel for how the economy w ­ ill unfold over at least one economic cycle—­and, preferably, even one financial cycle, which is much longer than an economic cycle. From my experience, t­ here ­were periods where, ­under the influence of the conventional wisdom of the day or popu­lar narratives, a specific policy argument had an outsize influence, making it difficult for a central bank to go against it. But with the passage of time, even the fact that such a specific policy argument had been loudly voiced could be almost completely forgotten. In terms of policy debates, the degree to which a person perceives how power­ful the influence of the conventional wisdom of the day is varies, and it often depends on w ­ hether the person is actually in the driver’s seat or just a passenger. If one is exposed to changes in the macroeconomy and to public opinions in real time as a responsible policy maker at a central bank, such experiences are built up as a personal memory as well as in the institution’s overall memory. As for economic theories and policy agendas, a healthy skepticism emerges The Central Bank as an Organ­ization | 449

if a person witnesses the ebb and flow of vari­ous theoretical constructs and policy regimes. ­These tides of intellectual history are accumulated and stored as knowledge at any central bank, and they are often embodied by the staff. In terms of the importance of the length of institutional memory, it is in­ter­est­ ing to note that the Independent Evaluation Office of the International Monetary Fund (IMF) seems to attribute the difference of views—­between the central bank and the IMF staff evaluating the central bank—as due in part to the IMF staff’s high turnover on mission teams.15 Many board members of the Bank of Japan listened carefully to the personal views of the staff prior to making their own decisions. When I was a staffer, I was often invited to the rooms of board members and was asked for my personal counsel on vari­ous policy issues. What was impor­tant as a staff member on such occasions was the re­spect for the role of the board member and professional integrity. It is imperative that the relationship of trust and mutual re­ spect is established between the staff members who provide the technical materials necessary for decision making and the board members who are responsible for a­ ctual policy decisions.

Breaking a Silo Culture As with any institution, central bank staff are not immune to so-­called silo culture. It is thus critically impor­tant to foster a constructive and cooperative relationship among vari­ous departments. Of par­tic­u­lar importance is the need for breaking the silo culture that exists between the departments related to monetary policy and ­those related to financial system stability.16 The ultimate objective is to provide a stable financial environment conducive to sustainable growth. Th ­ ere is an issue of how the staff working in the area of financial stability should be involved in the pro­cess of formulating monetary policy, specifically in the regular cycle of monetary policy committee decision making. What is crucial is that vari­ous analyses with regard to financial stability are provided in a systematic and understandable manner to the board members making monetary policy. To some extent, silo culture in the central bank reflects the separation princi­ ple of price stability versus financial stability that has been dominant in the mainstream economic thinking of policy makers and academics even a­ fter the GFC. The traditional approach of the Bank of Japan is to counteract the tendency ­toward silo culture through the rotation of staff among vari­ous departments. The bank has, for example, deliberately rotated first-­class macroeconomists to the Financial System and Bank Examination Department. This was quite 450 | The Roles of the Central Bank

effective in ensuring that macroeconomists would not suffer from tunnel vision when thinking about financial stability issues.

A Sense of Satisfaction in Public Ser­vice Regardless of ­whether the organ­ization is private or public, the morale of the ­people in the workplace is crucially impor­tant. What are the work incentives of central bank staff? Pecuniary compensations are, of course, one ­factor. The levels of compensation of central bank staff relative to the average of public-­ or private-­sector employees differ across countries. ­There appears to be a general tendency t­ oward central bank staff employees being paid more compared to other public-­sector employees but less than ­those in the private sector. My casual observation is that t­ here is a global trend: the relative level of compensation of public-­sector employees, including central bank staff, is decreasing. The level of salary is not the sole determinant of motivation, but it has become an increasingly impor­tant ­factor in attracting talent with the necessary expertise in a competitive l­abor market as financial globalization progresses and the mobility of experts increases. What I want to emphasize ­here is that an impor­tant incentive of public-­ sector employees is a sense of accomplishment or satisfaction—­that they feel that their work contributes to the well-­being of the society, and further, that ­there is societal recognition of the significance of their work. I do not have sufficient knowledge about how public policies are formulated abroad, but my overall impression is that the public’s recognition of the role of public ser­vice is decreasing. For example, Japan has gone through considerable changes since the mid-1990s. An increasingly popu­lar buzzword is “politician-­led policy formulation.” The idea itself is legitimate in a demo­cratic society, but the side effect has been waning re­spect for professionalism and a decline in the morale of public-­ sector employees. I am deeply concerned about this trend. An impor­tant challenge remains to build constructive and cooperative relationships between politicians, academics, the private sector, and central bank experts. I believe that this w ­ ill determine ­whether the central bank can continue to attract young ­people who have both expertise and a high sense of the value of public ser­vice. ||||| What I have written herein is not confined to central banks or their staff. The issue is more general and carries profound implications for society characterized alarmingly by growing disintegration. Society needs to be offered solid The Central Bank as an Organ­ization | 451

policy options supported by dispassionate and professional analy­sis. Such a task is, of course, not a mono­poly of the government and should be performed by many private organ­izations and individuals. Yet I believe the responsibility of the government or public sector in this regard is huge. How society structures the public organ­ization in charge of policy and incentivizes ­people working therein is quite impor­tant. A well-­functioning intellectual infrastructure of policy formation ultimately depends on the ­will of society itself. I hope this book w ­ ill be useful for readers who are thinking seriously of the ­future of our economy and, for that m ­ atter, our society.

452 | The Roles of the Central Bank

 

Epilogue Central banks are now in a strange position. The Bank of Japan was the first central bank to find itself stuck in the “low-­for-­long” world, meaning that low interest rates persist for an extended period of time. I do not think the current equilibrium is sustainable. At some point of time in the f­ uture, the low-­for-­ long world w ­ ill inevitably be forced to change. What w ­ ill unfold might be inflation, a financial ­bubble and subsequent financial crisis, social discontent due to widening inequalities in wealth, a continuous decline in the growth rate, or some combination of ­these ­factors. Witnessing how the economy and society are now being profoundly impacted by the global pandemic of the COVID-19 virus, we certainly cannot rule out something happening that is beyond our current imagination. In any event, it seems to me that the consequences w ­ ill be dire ­unless proper actions are taken. Central banks are thus faced with enormous challenges. The current conundrum reflects under­lying po­liti­cal, social, and technological trends that are largely beyond the control of central banks. But central banks should not view themselves as innocuous. They should take the lead in reconsidering the current monetary policy framework, monetary regime, or what­ever we choose to call it. It is r­ eally a daunting task to change the current framework, for it is not without reason that we are where we are at pre­sent. Incremental monetary policy decisions leading us to the current situation have been justifiable given the logic of the current framework, but if central banks change their monetary policy framework to a meaningful extent, the impact ­w ill be huge, and that currently makes central banks cling to present-­day practices in the interests of short-­term stability. This is not a healthy long-­term approach. My observation is that quite a few ­people already recognize that just continuing with the current framework is not promising and that t­ here is a pressing need for change. I believe every­thing starts with recognizing clearly where

453

we are and where we are destined to go ­u nless we change course. If we can mobilize wisdom, I believe we w ­ ill ultimately find the appropriate alternative framework for monetary policy—or, to be more precise, the alternative framework for central bank policy. And central banks have to play an impor­tant part in the pro­cess of coming up with this framework.

454 | Epilogue

| NOTES |

PROLOGUE 1. Affiliations and titles of named individuals are as of the time of the events described. 2. I was fifty-­eight years old at the time of my appointment. Hisato Ichimada, the eigh­ teenth governor, was appointed at the age of fifty-­t wo. 3. Paulson (2010); Geithner (2014); Bernanke (2015); King (2016). 4. Subbarao (2016). 5. The only exceptions (all available in Japa­nese only) are the writings by Eigo Fukai, the thirteenth governor of the Bank of Japan (see Fukai [1928] and Fukai [1941]) and by Yasushi Mieno, the twenty-­sixth governor (see Mieno [1996] and Mieno [2000]).

CHAPTER 1 STARTING MY C­ AREER 1. Samuelson (1967). 2. Hicks (1939). Hicks would go on to receive the Nobel Prize in Economic Sciences, with Kenneth Arrow, in 1972. 3. Win­dow guidance was a moral suasion of the Bank of Japan for major commercial banks to restrain bank lending. This mea­sure was ­adopted ­a fter World War II and terminated in the early 1990s. 4. ­Today the functions of this department have been transferred to the Financial Markets Department and the Financial System and Bank Examination Department. 5. The CGFS’s name was changed from the Euro-­Currency Standing Committee in 1999.

CHAPTER 2 THE JAPA­N ESE ­B UBBLE ECONOMY 1. See Bank of Japan (2020), Chart 2. 2. In a Tankan survey, firms are asked to choose the response which best describes their judgement about pre­sent business conditions from among three pos­si­ble answers (“favorable,” “not so favorable,” and “unfavorable”), primarily in light of the firms’ profits. The Business Condition Diffusion Index denotes the percentage of “favorable” respondents minus “unfavorable” respondents. This index, though very ­simple, tracks the change in business sentiment well and is most carefully watched by many economists at home and abroad. 3. This figure reflects the aggregate of domestic lending and lending by overseas branches of Japa­nese financial institutions to domestic residents. 4. Business Week (1989).

455

5. Bank for International Settlements (2017), graph 8. On the estimated impact of cross-­holding of stocks on the P/E ratio, see McCauley (2013). 6. Shirakawa (2012b). 7. See Okina, Shirakawa, and Shiratsuka (2000); and Kosai, Shirakawa, and Okina, (2001). 8. Mori, Shiratsuka, and Taguchi (2000), chart 1; the corresponding inflation rates ­were 4.3 ­percent in Canada, 1.3 ­percent in Germany, 5.6 ­percent in Sweden, 2.1 ­percent in Switzerland, 4.1 ­percent in the United Kingdom, and 4.3 ­percent in the United States. See Bank of Japan (2006b), chart 17. 9. Friedman (1982), 4. 10. The BIS noted that the “dominant role of Japa­nese banks” was the most prominent feature of the international financial markets of the day. See Bank for International Settlements (1989), 117. 11. Bank for International Settlements (1989), 117. 12. Bank of Japan (1990b). 13. Bernanke and Gertler (1999). 14. Yamaguchi (1999). 15. Bank of Japan (1990b). 16. Bank of Japan (1990b). 17. Blanchard and Summers (2017). Bernanke (2015, 91) notes, “Could monetary policy during the early 2000s have been easy enough to achieve our employment and inflation goals while si­mul­ta­neously tight enough to significantly moderate the housing boom? It seems highly implausible. Moderately higher interest rates, as implied by ­Taylor’s rule, would have slowed the recovery while likely having only small effects on ­house prices.” 18. Mieno (2000), 195. 19. Mieno (2000), 207. 20. ­Great Moderation is used to describe a well-­performing economy characterized by declines in the volatility of output and inflation. 21. Funabashi (1989). 22. See “Joint Statement by the President and Prime Minister Noboru Takeshita of Japan on Economic Issues,” Washington, DC, January  13, 1988, The World and Japan Database, https://­worldjpn​.­g rips​.­ac​.­jp​/­documents​/­texts​/­JPUS​/­19880113​.­D1E ​.­html. 23. Bergsten and Green (2016b), 10. 24. Baker (2016), 21. 25. Group of Seven (1987), 3. 26. Shirakawa (2011a). 27. See Bergsten and Green (2016b). 28. Advisory Group on Economic Structural Adjustment for International Harmony (1986). 29. According to Komiya (1986), 59, “The U.S. current account balance is rooted in the US economy itself, and restoring balance must be achieved by correcting US economic policy. This is obvious to anyone who has had a modicum of economic training. . . . ​In spite of this, now only Japan is writing up ‘action plans’ and promising to adjust its economic structure, but the US has not made any positive commitments at all. Such a situation is indeed a serious ‘imbalance.’ ” 30. Nikkei (1989).

456 | Notes to Pages 30–46

CHAPTER 3 THE BURSTING OF THE B­ UBBLE AND THE FINANCIAL CRISIS 1. The order was reversed in the case of the United States in the early 2000s, where the decline in real estate prices preceded that of stock prices by about two years. 2. ­Today it is named the Ministry of Land, Infrastructure and Transport. 3. Bank of Japan (1990b). 4. Ahearne et al. (2002), 50–53. 5. Bank of Japan, Research and Statistics Department (1991). 6. Financial Times (1992). 7. Noguchi (2015). With regard to the changes in the Bank of Japan’s outlook on inflation, see Fujiwara et al. (2007), chart 6. 8. Shirakawa (2009a). 9. Geithner (2014), 9. 10. Policy Research Institute, Japa­nese Ministry of Finance (1993), 2. 11. A payout cost is the estimated cost that the Deposit Insurance Corporation of Japan has to bear in the resolution of a failed financial institution. Its magnitude depends on a proportion of insured deposit to total liability and loss ratio of failed bank assets, among other ­t hings. 12. Shirakawa (2012a). 13. Bank of Japan (2005), 3–4. 14. Regarding the actions of the Bank of Japan during the crisis, see Nakaso (2001). 15. Bank of Japan (2005). The credit cost ratio is the ratio of write-­offs and provisioning to the amount of loans outstanding. 16. The ratio of nonperforming loans to gross domestic product hit its peak in 2001 at around 8.5 ­percent, and the number of resolution initiatives with assistance from the Deposit Insurance Corporation crested at fifty-­six in 2001, which fell to zero the following year. 17. Ikeo (2009), 107–8. 18. Mikuriya and Nakamura (2005), 239. 19. Mori, Shiratsuka, and Taguchi (2000). 20. Ahearne et al. (2002). 21. Krugman (1998). 22. Bernanke (2015), 65. 23. Bernanke (2015), 65. 24. Shirakawa (2009a). 25. Borio (2018); Okina, Shirakawa, and Shiratsuka (2000). 26. Noguchi (2015). 27. Noguchi (2017). 28. Aoki (2014), 228.

CHAPTER 4 THE NEW BANK OF JAPAN ACT 1. Mieno (2000), 100. 2. The term stagflation refers to a case in which the economy experiences stagnation and inflation si­mul­ta­neously. 3. Proj­ect Team of the Reform of the Ministry of Finance (1996), 3. 4. Meyer (2000). Notes to Pages 48–78 | 457

5. Federal Reserve (2016), 2–3. 6. According to Arnon, Laurens and Segalotto (2006, 19), the “po­liti­cal autonomy” index of the Bank of Japan is the lowest among Organisation for Economic Co-­operation and Development peers. 7. Tucker (2018), 271. 8. U ­ nder the old Bank of Japan Act, the En­glish translation for the title of the second-­ in-­command officer was se­nior deputy governor, whereas the name of the office of two deputies of the governor u ­ nder the new act is deputy governor.

CHAPTER 5 THE ZERO INTEREST RATE POLICY AND QUANTITATIVE EASING 1. Nowadays it has become the usual practice among central banks in major economies, including the Bank of Japan, to meet eight times a year. 2. The time lag is five years for the FRB and ten years for the Bank of Japan, respectively. 3. For unconventional monetary policy during the era of QE, see Ueda (2005); and Ugai (2006). 4. Bank of Japan (2000a), 1. 5. Bank of Japan (2000b), 1. 6. Bank of Japan (2000c). 7. Since 2016, the Outlook Report has been published quarterly. 8. Bank of Japan (2000c), 3. See also Volcker (1983) and Greenspan (1994). 9. Bank of Japan (2000c), 3. 10. Council of Economic and Fiscal Policy (2001), 2. 11. Ito (2001), 48, 63, 65, 70, 71. 12. The amount was 59 trillion yen at the end of March 2001. 13. Bank of Japan (2001a). 14. Bank of Japan (2001b), emphasis added. 15. Bank of Japan (2005). 16. Bank of Japan (2002). 17. Svensson (2001). 18. As Taylor (2007, 286) notes, “By not registering strong objections to the intervention, effectively allowing it to happen, we made it easier for the Japa­nese to increase money supply.” 19. The bottom for the Tokyo Stock Price Index came on March 11, 2006. 20. Bank of Japan (2006a). 21. Ugai (2006). 22. Komiya (1976). 23. Komiya and the Japan Center for Economic Research (2002). 24. Komiya and the Japan Center for Economic Research (2002). 25. Yamaguchi (2001).

CHAPTER 6 THE ILLUSION OF THE G­ REAT MODERATION 1. For the mechanics of Japan’s high growth era, see Shirakawa (2011c). 2. Terms of trade mean how many units of overseas products can be purchased by one unit of domestic product and are conventionally expressed as the ratio of export prices to import prices.

458 | Notes to Pages 78–118

3. Bernanke (2002). 4. As Bernanke (2003) noted, “Specifically, the Bank of Japan should consider increasing still further its purchase of government debt, preferably in explicit conjunction with a program of tax cuts or other fiscal stimulus.” 5. As Greenspan (2005) explained, “Although a ‘­bubble’ in home prices for the nation as a ­whole does not appear likely, ­t here do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels.” 6. Federal Reserve System (2005). 7. Bernanke (2004). Note, however, that the phrase “the G ­ reat Moderation” was not in­ven­ted by Bernanke. 8. Bernanke (2004) points out that Japan was an exception to “the ­Great Moderation.” 9. Blinder and Reis (2005), emphasis added. 10. Blinder and Reis (2005), emphasis added. 11. Ahearne et al. (2002). 12. In his blog post on the biography of Alan Greenspan, Bernanke (2016) seems to suggest that the relatively mild economic slowdown following the bursting of the dot-­com ­bubble could have influenced the FRB’s thinking on the relations between the financial system and monetary policy: “Perhaps the financial crisis during Greenspan’s term with the greatest macroeconomic impact was the collapse of the tech ­bubble, which was the main source of the relatively mild 2001 recession. ­Whether the monetary policy response to that recession was successful is in the eye of the beholder; the relevant point is that Greenspan, the FOMC, and t­ hose who adulated Greenspan at the Jackson Hole Economic Symposium in 2005 believed that it was. The ­factors that would make the 2007 crisis so unpre­ce­dentedly catastrophic, including the collapse of key funding and securitization markets, ­were not foreseen.” 13. White (2006). 14. Tett (2015). 15. Bernanke (2004). 16. Lucas (2003), 1. 17. Woodward (2000). 18. “Borrow short and lend long” means that the maturity of borrowing is short, and that of lending is long. 19. Japan a­ dopted the standards in 2006, but the United States never implemented them.

CHAPTER 7 MY APPOINTMENT AS GOVERNOR OF THE BANK OF JAPAN 1. Bank of Japan Act, article 23 (2). It is available in the following site: http://­w ww​ .­japaneselawtranslation​.­go​.­jp​/­​?­re​= ­02. 2. Bank of Japan (2008a). 3. Bank of Japan (2007). 4. Shirakawa (2008a). 5. Bank of Japan (2008b), 3–4. 6. For a discussion of ­t hese two strategies, see chapter 6. 7. Bank of Japan (2008b), 8–9. 8. Since the Consumer Price Index is recalibrated e­ very five years, the numbers available then and ­today are dif­fer­ent. The numbers presented herein correspond to data that ­were available at the time.

Notes to Pages 119–139 | 459

9. Bank of Japan (2008c), 8. 10. Shirakawa (2008b). 11. Bank of Japan (2008d), 1. 12. U ­ ntil 1999, the committee’s name was the Euro-­Currency Standing Committee. 13. Eu­ro­pean Central Bank (2008). 14. Shirakawa (2008b). 15. Shirakawa (2008b).

CHAPTER 8 THE COLLAPSE OF LEHMAN B­ ROTHERS 1. Mishkin (2007), emphasis added. 2. Bernanke (2007), emphasis added. 3. Blanchard and Summers (2017). 4. To be precise, the entity that filed for Chapter 11 was Lehman ­Brothers Holdings Inc. 5. In Japan, unlike in the United States, many securities broker-­dealers had accounts at the Bank of Japan and ­were eligible to borrow from the bank. They ­were also subject to examination by the bank. 6. Group of Seven (2008). 7. Group of Seven (2008). 8. Bank of Japan (2008e). 9. This is according to a published financial statement of T ­ oyota’s accounts at the end of March 2017. 10. Financial Ser­v ices Regulatory Relief Act of 2006. 11. Shirakawa (2008a). 12. Cœuré (2016); Brunnermeier and Koby (2019). 13. The Bank of Japan had once (from 2003 to 2006) purchased asset-­backed CPs and securities as a time-­limited mea­sure. 14. Baxter (2013). 15. The ECB had raised its policy rate by 0.25 ­percent due to concerns over inflation. 16. Another reason for not assessing the easiness of money by comparing the size of central bank balance sheets or the increases in the monetary base is that the style of monetary operations are dif­fer­ent. Before the GFC, the FRB relied on a very small balance of required reserves, and as a result, ­actual reserves on August 1, 2007, amounted to only US$17 billion, or 0.1 ­percent of US GDP. On the other hand, within the same time frame, on July 31, 2007, current account balances at the Bank of Japan amounted to 8.8 trillion yen (US$74 billion), which was 1.7 ­percent of Japa­nese GDP. 17. This number is based on the first estimates of GDP. The final revised numbers ­were −3.1 ­percent (the fourth quarter of 2008) and −5.4 ­percent (the first quarter of 2009). 18. Bernanke, Geithner, and Paulson (2019). 19. Bernanke (2008a), emphasis added. 20. Bernanke (2008b); Bernanke (2015), 264. 21. For a detailed analy­sis based on published information, see Ball (2018). 22. Geithner (2014), pp.180. 23. Geithner (2014). 24. Shirakawa (2009c). 25. Caruana (2015). 460 | Notes to Pages 139–173

CHAPTER 9 THE INCREASING CLAMOR FOR BEATING DEFLATION 1. Group of Seven (2009a), 1. 2. Group of Seven (2009b), 1. 3. Bernanke (2015), 416. 4. Shirakawa (2009a), 6. 5. Shirakawa (2009a), 12. 6. Group of Twenty (2009), 1. 7. Bank of Japan (2009a), 2. 8. Bank of Japan (2009b), 1. 9. Bank of Japan (2009c), 1. 10. Cabinet Office (2009), 1. 11. Bank of Japan (2013b), chart 4. 12. Fujiwara et al. (2007), chart 6. 13. Ahearne et al. (2002). 14. Eu­ro­pean Central Bank (2014). 15. Bank of Japan (2009d), 4–5. 16. Bank of Japan (2009e), 9. 17. Shirakawa (2009e), 5. 18. Bank of Japan (2009f), 2. 19. Bank of Japan (2009g), 2 (emphasis added, to indicate changes from the previous Understanding). 20. Bank of Japan (2009h), 3. 21. Fisher (1933). 22. Feldstein (2015). 23. Fisher’s article was published in 1933, but the under­lying framework was already made public in 1931. 24. Volcker and Harper (2018), 227. 25. Kimura and Ueda (1997); Kuroda and Yamamoto (2006). 26. Yoshikawa (2013, 182) names the ­whole mechanism as the “Japa­nese efficiency wage hypothesis.” For relations with the “Japa­nese employment model,” see chapter 4; see also Hayakawa (2016). 27. Friedman (1963). 28. Shirakawa (2014). 29. Shirakawa (2011d). 30. Yellen (2015), 21. 31. As Ito (2001, 21) argues, “By implementing a policy of numerically targeting stable inflation, it should be pos­si­ble to stabilize . . . ​the expected rate of inflation. In short, given that the central bank sets a target, when the public has confidence in the bank, it would be natu­ral to think that ­f uture rate of inflation would coalesce around the target.” 32. Weidmann (2014). 33. For a detailed look on the bias regarding the Japa­nese CPI, see Shiratsuka (2005). 34. A detailed analy­sis can be found in Bank of Japan (2013a). 35. This point is explained in the report on price stability published by the Bank of ­Japan’s Policy Board in 2000 (Bank of Japan [2000c]) and also in Shirakawa and Momma (2001). 36. Blanchard, Dell’Ariccia, and Mauro (2010).

Notes to Pages 175–201 | 461

CHAPTER 10 DEMOGRAPHIC CHALLENGES AND RAISING PRODUCTIVITY 1. Kozo Yamamoto, remarks at the Bud­get Committee, February  16, 2010 (House of Representative (2010a, 10), translation by Shirakawa. 2. The term “crude monetarism” comes from Bernanke (2020). 3. For the Japa­nese demographic change, see Shirakawa (2012d). 4. This is based on medium variant assumptions of birth rate from the 2017 edition of Population Projections for Japan. National Institute of Population and Social Security Research (2017), 17. 5. Bank of Japan (2008). 6. The latest estimate at the time of this writing, published in October  2020, was around zero ­percent (Bank of Japan [2020]). 7. Shirakawa (2013). 8. Hayakawa (2016). 9. Shiller (2019). 10. Kimura et al. (2010). 11. Shirakawa (2017). 12. Shirakawa (2011c). 13. Shirakawa (2012e). 14. Bank of Japan (2010a), 8. 15. Jones (2020). 16. Bricker and Ibbitson (2019). 17. See, for example, Gagnon, Johannsen, and Lopez-­Salido (2016); Kim (2016); and Ferrero, Gross and Neri (2017). The March  2020 issue of the International Monetary Fund’s journal Finance & Development contains a host of papers on the impacts of demographic change on the economy. 18. Faust and Leeper (2015).

CHAPTER 11 THE EU­R O­P EAN DEBT CRISIS 1. Mundell (1961). 2. Lagarde (2011). 3. Draghi (2012). 4. In January 2015, the ECB introduced the Public Sector Purchase Programme, which enabled the bank to purchase assets, including government bonds, and was designed as QE. 5. T ­ oday the number of euro area states is nineteen. 6. Eu­ro­pean Central Bank (2010). 7. Monnet (1978).

CHAPTER 12 THE COMPREHENSIVE MONETARY EASING POLICY 1. Bank of Japan (2010b). 2. Bernanke (2015), 484. 3. Bank of Japan (2010c). 4. Bank of Japan (2010d), 2. 5. Bank of Japan (2010d), 1.

462 | Notes to Pages 203–241

6. During the Asian financial crisis, the Hong Kong Monetary Authority, which functions as the central bank in Hong Kong, purchased stocks as the agent of the Hong Kong government. This was a mea­sure in response to a financial crisis, and not conducted on the account of the Hong Kong Monetary Authority. 7. Bank of Japan (2010e), 2. 8. A ­ fter the Bank of Japan a­ dopted a negative interest rate policy in 2016, the situation became much more complicated. 9. Just before the adoption of Comprehensive Monetary Easing at the end of September 2010, the amounts outstanding in banknotes ­were 76.9 trillion yen, current account deposits w ­ ere 20.2 trillion yen, government bills and bonds w ­ ere 76.7 trillion yen, and loans ­were 36.1 trillion yen. 10. Archer and Moser-­Boehm (2013), fig. 6. Some ratios are given without names, but one can see that the figures for the ECB and the Swiss National Bank, which are in the highly capitalized group, are close to 20  ­percent, whereas the figures for the Bank of ­England and the FRB are at around 2 ­percent. While the Bank of Japan is not named in the figure, the ratio at the end of March 2010 was at 4.0 ­percent (5.7 trillion yen of capital against total assets of 142.3 trillion yen). 11. Thomas Baxter Jr., a longtime general counsel of the Federal Reserve Bank of New York, has noted (2013) that “the failure to repay rises to a more culpable malfeasance, namely the failure to be a good steward of public funds.” 12. Fukui (2003). 13. Archer and Moser-­Boehm (2013), 1. 14. Fukui (2003).

CHAPTER 13 THE ­G REAT EAST JAPAN EARTHQUAKE 1. The magnitude of the earthquake was initially estimated at 7.9, which was subsequently revised three times, eventually to 9.0. 2. The notice was posted on the bank’s website at 3:21 p.m. that after­noon. 3. Sanriku is the name of the northeast coast of Japan. 4. Bank of Japan (2011). 5. The following account is based on Endo (2013). 6. Shirakawa (2011a). 7. This is according to the World Economic Outlook database of the IMF, https://­w ww​ .­i mf​.­o rg ​/­e n​/­P ublications​/­S PROLLs​/­w orld​-­e conomic​-­o ut look​-­d atabases#sort​ =­%40imfdate%20descending. 8. Fossil-­f uel-­based electric generation had the largest share, at 60 ­percent. 9. The stricken area included Fukushima, Ibaraki, Iwate, and Miyagi Prefectures. 10. The following description owes much to Endo (2013). 11. Cabinet Office (2010), figure 1-1-1. 12. For issues highlighted by natu­ral disasters from the perspective of coping with tail risks, see Shirakawa (2011d).

CHAPTER 14 SIXFOLD SUFFERING AND THE CURRENCY WAR 1. The trade flow used in calculating the Bank for International Settlements’ effective exchange rates is manufacturing trade. Notes to Pages 241–273 | 463

2. January 2000 is chosen as a reference point to avoid any arbitrariness. The yen’s effective exchange rate at this reference point is almost average of the period up to 2012. 3. Jean-­Pierre Roth, who was the chair of the Swiss National Bank, remarked in a speech in 2004 that at the time of the inauguration of the euro, he was concerned that the disappearance of the German mark, which had absorbed the demand for safe-­haven currencies along with the Swiss franc, would result in a more acute appreciation of the franc during financial crises, especially in case of any doubts arising concerning the value of the euro; see Roth (2004). At the time of the speech, he concluded that such concerns had been proven wrong, but l­ ater, ­a fter the Eu­ro­pean debt crisis, his worries w ­ ere shown to be well founded. 4. It increased to 27.0 trillion yen in 2019. 5. Noguchi (2017), 360–70. 6. Mantega is quoted as follows: “­We’re in the midst of an international currency war, a general weakening of currency. This threatens us b ­ ecause it takes away our competitiveness.” Wheatley and Garnham (2010). 7. Bernanke (2010a). 8. Bernanke (2013). 9. On the “global savings glut,” see Bernanke (2005). 10. Bernanke (2010b). 11. Danthine (2015). 12. For further discussion of the comparison between Japan and Switzerland, see Shirakawa (2012g). 13. The ­limited size of the Swiss financial market might have caused the SNB to adopt unlimited foreign exchange market intervention, b ­ ecause this was the only option for conducting domestic quantitative easing without limit. 14. Swiss National Bank (2015), 23. 15. This is no longer true in the United States; President Donald Trump often voiced his views. 16. Bank of Japan (2012c), Chart 58. The yen’s exchange rate developments from the end of 2012 onward are explained in chapter 17 of the pre­sent volume.

CHAPTER 15 THE SUSTAINABILITY OF GOVERNMENT FINANCES 1. The IMF’s calculation includes short-­term government bonds. 2. This was typically seen in the accounts of financial institutions, which had to write off nonperforming loans from the 1990s to the early 2000s. 3. In theory, the impact should be mea­sured on using cyclically adjusted primary fiscal balances. But unadjusted primary balances are used ­here for simplicity, particularly ­because of the difficult and somewhat arbitrary challenge of estimating potential output. 4. “Bridge to nowhere” is the expression used to describe public infrastructure spending in sparsely populated regions. 5. The quarterly figures do not add up due to rounding errors. 6. Shirakawa (2011d). 7. Dornbusch (1997). 8. Shirakawa (2011b). 9. Shirakawa (2011b).

464 | Notes to Pages 273–307

10. Ito (2001, 87–88) notes that “In such a situation, one could argue that ‘Since interest rates are at zero, one cannot look to monetary policy.’ . . . ​However, Japa­nese public finances are now mired in debt and in a critical situation. . . . ​In that context, it is now impossible to support economic conditions through massive fiscal outlays, which was seen three or four years ago.” 11. For details of fiscal policy u ­ nder Takahashi, see Shizume (2009). 12. Turner (2015). As Bernanke (2003) notes, “Finance Minister Korekiyo Takahashi brilliantly rescued Japan from the ­Great Depression through reflationary policies in the early 1930s.” 13. Shirakawa (2011d). 14. Fukai (1941), 312–313.

CHAPTER 16 ENHANCING THE STABILITY OF THE FINANCIAL SYSTEM 1. Tucker (2015). 2. For details, see Shirakawa (2009f). 3. The body grew out of the Financial Stability Forum, which was established in the wake of the Asian financial crisis in April 2009. 4. Randal Quarles, vice chair of the FRB for supervision, was the chair at the time of this writing. 5. For macroprudential policies, see Shirakawa (2009g). 6. Fisher (2016) explains this point lucidly. 7. Shirakawa (2009f). See also Fisher (2016, 68): “The idea that financial stability is distinct from, and secondary to, the objectives of monetary policy puts both financial stability and price stability at risk.” 8. Win­dow guidance is a moral suasion of the Bank of Japan for major commercial banks to restrain bank lending. This mea­sure was ­adopted ­a fter World War II and terminated in early 1990s. 9. Volcker (1990). 10. Bank of Japan (2017). 11. International Monetary Fund (2017), 49.

CHAPTER 17 THE JOINT STATEMENT BY THE JAPA­N ESE GOVERNMENT AND THE BANK OF JAPAN 1. Bank of ­England (2012), 9–10. 2. Bank of Japan (2012a). 3. Bank of Japan (2009g), 2. 4. Bank of Japan (2012b), 11. 5. House of Representatives (2012), 3–4, emphasis added. 6. The interest rate applicable was the policy target rate for call money, at 0.1 ­percent, and the maximum maturity was four years. 7. Liberal Demo­cratic Party (2012), 7. 8. Bank of Japan (2012d), 8–9. 9. Cabinet Office, Ministry of Finance, and Bank of Japan (2013); Bank of Japan (2013b).

Notes to Pages 311–349 | 465

10. Cabinet Office, Ministry of Finance, and Bank of Japan (2013), art. 2. 11. Cabinet Office, Ministry of Finance, and Bank of Japan (2013), art. 2. 12. Cabinet Office, Ministry of Finance, and Bank of Japan (2013), art. 2. 13. Federal Reserve System (2012). 14. Bank of Japan (2013a), 2. 15. Komiya and the Japan Center for Economic Research (2002), 273. 16. Council on Economic and Fiscal Policy (2013), 2–3 17. Council on Economic and Fiscal Policy (2013), 3. 18. Shinzo Abe, addressing the Bud­get Committee of the House of Representatives, February 7, 2013, emphasis added. House of Representative (2013a), 13. 19. Shinzo Abe, addressing the Bud­get Committee of the House of Representatives, February 12, 2013. House of Representative (2013b), 11. 20. Cabinet Office, Ministry of Finance, and Bank of Japan (2013), art. 2. 21. According to the Cabinet Office, the peak and trough w ­ ere in March 2012 and November 2012, respectively. 22. The fluctuation in growth between the 2013 and 2014 fiscal years also reflected the front-­loading of expenditures in the run-up to the increase in the consumption tax. 23. The averages of forty private-­sector economists’ forecasts of growth ­were 2.01 ­percent and 0.25 ­percent for the 2013 and 2014 fiscal years, respectively. As to the increases in the CPI, the corresponding figures w ­ ere 0.17 ­percent and 0.45 ­percent. 24. Shirakawa (2013). 25. Bank of Japan (2013b). 8.

CHAPTER 18 THE G­ REAT MONETARY EXPERIMENT AND THE SPREAD OF JAPANIFICATION 1. Ahearne et al (2002); see also chapter 3 of the pre­sent volume. 2. Bernanke (2015), 65. 3. Wolf (2001). 4. In­de­pen­dent Evaluation Office of the International Monetary Fund (2019a), 15. 5. Bernanke (2002). 6. Nakata (2020). In the original paper, March  2013 is mentioned, but it should be April 2013. 7. Nakata (2020). 8. See Bank of Japan’s Outlook report (Bank of Japan [2020]). According to figure 46, the break-­even inflation rate in October 2020 is zero p ­ ercent. 9. In­de­pen­dent Evaluation Office of the International Monetary Fund (2019b), 25. 10. Gertler (2017), 39. 11. Gertler (2017), 40. 12. Summers and Stansbury (2019). 13. Wolf (2017). 14. Shirakawa (2010a); Shirakawa (2012a). 15. Bernanke (2020). 16. Rehn (2020). 17. In­de­pen­dent Evaluation Office of the International Monetary Fund (2019b), 25. 18. For the failure of the ­great monetary experiment and the under­lying cause of the low growth of the Japa­nese economy, see Hayakawa (2016); and Okina (2015). 466 | Notes to Pages 350–372

CHAPTER 19 LESSONS FROM THE EXPERIENCES OF THE JAPA­N ESE ECONOMY 1. Blanchard and Summers (2017). 2. Hayashi and Prescott (2001). 3. Borio (2018). 4. Powell (2018). 5. Blanchard (2013). 6. Borio et al. (2017). 7. Tett (2017). As to criminal responsibility in the Japa­nese financial crisis, forty-­four CEOs, sixty-­three non-­CEO executives, and twenty-­seven staff members from thirty-­seven failed financial institutions ­were arrested; see Okuyama and Murayama (2019), 5. 8. Bernanke (2015), 65. See also chapter 3. 9. Brunnermeier, James, and Landau (2016), 249. 10. Jones and Klenow (2016); Bernanke and Olson (2016). 11. According to the statistics compiled by OECD, per capita working time was 2,031 hours in 1990 and 1,714 hours in 2016. 12. Blanchard and Summers (2017), pp. 5. 13. Writings by Richard Koo are rare exceptions. I am basically in agreement with his emphasis on the balance-­sheet adjustment; see Koo (2003).

CHAPTER 20 WHAT SHOULD WE EXPECT OF THE CENTRAL BANK? 1. Bernanke (2020). 2. Simons (1936), 3. 3. Shirakawa (2017). 4. Reinhart and Rogoff (2009); see also Reinhart and Rogoff (2014). 5. Fisher (2019). 6. Shirakawa (2009d). 7. Komiya and the Japan Center for Economic Research (2002), 237–38. 8. This is despite the fact that Japan’s Gini coefficient decreased in this period. 9. Some of ­t hese issues are discussed u ­ nder the theme of social welfare in chapter 19. 10. For danger with numerical precision and “fine-­t uning,” see Volcker and Harper (2018), 225. 11. Friedman (1968), 12–13. 12. Shirakawa (2008c). 13. Friedman (1968), 13. 14. Shirakawa (2015). 15. Burns, Ćirović, and Polak (1979), 24.

CHAPTER 21 THE GLOBAL COOPERATION OF CENTRAL BANKS 1. Hicks (1967), 60. 2. Mundell (1969). 3. Shirakawa (2012b) points out that the imaginary “world central bank” did not satisfy the Taylor rule, which calls for raising the policy rate more than the increase in the inflation rate. 4. Subbarao (2016), 286. Notes to Pages 374–411 | 467

5. According to Wikipedia, “Enlightened self-­interest”is a philosophy in ethics which states that persons who act to further the interests of o ­ thers (or the interests of the group or groups to which they belong) ultimately serve their own self-­interest. 6. Nineteen central banks attend the meeting as observers. 7. Bernanke (2005); see also the discussion in chapter 14 of the pre­sent volume. 8. Bernanke (2005). 9. Borio (2014). 10. For many intriguing facts regarding the history of cooperation in the area of banking business among central banks, see Potter (2017). 11. Subbarao (2016), 275. 12. Tucker (2014). 13. Subbarao (2016), 290.

CHAPTER 22 THE IN­D E­P EN­D ENCE AND ACCOUNTABILITY OF THE CENTRAL BANK 1. In a period of the DPJ government, a newly created National Strategy Meeting was performing the same function. 2. Bank of Japan Act, article 4. 3. Bank of Japan Act, articles 2, 3(1), and 3(2). 4. The DPJ set up many groups, including the Diet Members’ Caucus for Beating Deflation, the Diet Members’ Caucus to Consider the Role of the Bank of Japan, the Study Group on the Yen’s Appreciation and the Eu­ro­pean Crisis, the Meeting for the Comprehensive Strategy for the Rebirth of Japan, the Emergency Meeting for Reconstruction without Tax Increases.” The LDP had such groups as the Meeting to Overcome the Yen’s Appreciation and Deflation by Revising the Bank of Japan Act, and the Meeting to Prevent the Yen’s Appreciation and Deflation. Bipartisan groups included the Meeting to Pursue Reconstruction Funding without Tax Increases, the Bipartisan Group for Revising the Bank of Japan Act, and the Diet Members’ Caucus for Achieving Reconstruction and Rebirth of Japan. 5. House of Councillors (2009), 14. 6. House of Representatives (2010b), 6. 7. Blinder (1999). 8. Blinder (1999). 9. El-­Erian (2016). 10. Kuniya (2017), 15. 11. Tucker (2018) discusses this issue extensively, and Tucker (2020) is a concise and more accessible version of this thought.

CHAPTER 23 THE CENTRAL BANK AS AN ORGAN­I ZATION 1. Komiya (1988, 60–61) uses the example of pi­lots in a jumbo jet. 2. Adam Posen, an American economist who served as a member of the Monetary Policy Committee of the Bank of ­England, once made this point by referring to the case of pharmacists, rather than doctors: “The role of a central banker, ­after all, is not so dif­fer­ent from that of a pharmacist: with a l­ imited medicine cabinet, and restricted by law from exceeding certain bounds, both must make sense of scrawled prescriptions from differing 468 | Notes to Pages 412–437

specialists, decide what side effects to take into account, and then ultimately dispense the proper dosage of medicine to their customers, all without knowing or controlling every­ thing e­ lse the patient is consuming. The best they can hope for is that the patient recovers steadily over time, with a minimum number of negative side effects.” Posen (2013, 170). 3. Shirakawa (2011e). 4. For a speech on the central bank, with a special focus on its organ­ization, see Shirakawa (2018). 5. King (2004). 6. Williamson (1999); Oritani (2019). 7. Davis and Green (2010) and Lindsey (2016) are a few exceptions. The Federal Reserve interview (2019b) with Volcker, as well as his memoir with Christine Harper (2018), contain a lot of his insightful observations about the interactions between orga­ nizational aspect of the central bank and monetary policy. 8. The analy­sis of David Lindsey (2016), who was long involved in monetary policy as a staff economist at the FRB, is in­ter­est­ing. 9. Tucker (2018), 5. He used this expression in the context of regulatory reform ­a fter the GFC. 10. ­There are four separate committees, which cover monetary policy, macroprudential policy, regulation and supervision of financial institutions, and the Bank of ­England’s own governance. 11. Federal Reserve System (2019b), 93. Gerald Corrigan expressed the same view in his oral history interview; Federal Reserve (2019a), 77. 12. Larry Meyer, who served as a member of the Board of Governors of the Federal Reserve from 1996 to 2002, mentions that three opposition votes to the chairman’s proposal “would be viewed as a sign that the FOMC is in open riot with the Chairman’s leadership.” Meyer (2004), 53. 13. Lindsey (2016) contains an in­ter­est­ing observation of research at the FRB that is more or less the same as that of the Bank of Japan. 14. Tarullo (2017) contains an in­ter­est­i ng observation about the role of staff in producing economic outlook at the FRB. 15. In­de­pen­dent Evaluation Office of the International Monetary Fund (2019b, 25) notes that “more than 50 ­percent of economists only did one mission for Article IV consultations for Japan and United Kingdom.” 16. Tett (2015).

Notes to Pages 438–450 | 469

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—­—­—­ (2011a), “­Great East Japan Earthquake: Resilience of Society and Determination to Rebuild,” remarks at the Council on Foreign Relations, New York, April 14, 2011, https://­ www​.­boj​.­or​.­jp​/­en​/­a nnouncements​/­press​/­koen​_ ­2011​/­data​/­ko110415a​.­pdf. —­—­—­(2011b), “The Transition from High Growth to Stable Growth: Japan’s Experience and Implications for Emerging Economies,” remarks at the Bank of Finland 200th Anniversary Conference, Helsinki, May 5, 2011, https://­w ww​.­boj​.­or​.­jp​/­en​/­a nnouncements​ /­press​/­koen​_­2011​/­data​/­ko110506a​.­pdf. —­—­—­(2011c), “Money, Government Securities and a Central Bank: Interde­pen­dency of Confidence,” speech at the 2011 Spring Meeting of the Japan Society of Monetary Economics, Meiji University, May 28, 2011, https://­w ww​.­boj​.­or​.­jp​/­en​/­announcements​/­press​ /­koen​_­2011​/­data​/­ko110616a​.­pdf. —­—­—­(2011d), “How to Address Tail Risks,” speech at the Annual General Meeting 2011 of the Foreign Bankers’ Association in the Netherlands, Amsterdam, June 27, 2011, https://­w ww​.­boj​.­or​.­jp​/­en​/­a nnouncements​/­press​/­koen​_ ­2011​/­data​/­ko110628a​.­pdf. —­—­—­(2011e), “Performing Public Policies,” lecture at the School of Government of Kyoto University, July 15, 2011 (in Japa­nese). —­—­—­(2012a), “Deleveraging and Growth: Is the Developed World Following Japan’s Long and Winding Road?,” lecture at the London School of Economics and Po­liti­cal Science, January 10, 2012, https://­w ww​.­boj​.­or​.­jp​/­en​/­a nnouncements​/­press​/­koen ​_ ­2012​ /­data​/­ko120111a​.­pdf. —­—­—­(2012b), “Central Banking: Before, during, and a­ fter the Crisis,” remarks at a Conference Sponsored by the Federal Reserve Board, March 24, 2012, https://­w ww​.­boj​.­or​ .­jp​/­en​/­a nnouncements​/­press​/­koen​_ ­2012​/­data​/­ko120326a1​.­pdf. —­—­—­(2012c), “Japan-­U.S. Economic Relations: What We Can Learn from Each Other,” speech at the Japan Information and Culture Center of the Embassy of Japan, Washington, DC, April 19, 2012, https://­w ww​.­boj​.­or​.­jp​/­en​/­a nnouncements​/­press​/­koen​_ ­2012​ /­data​/­ko120420a1​.­pdf. —­—­—­(2012d), “Demographic Changes and Macroeconomic Per­for­mance: Japa­nese Experiences,” opening remark at the 2012 BOJ-­IMES Conference hosted by the Bank of Japan’s Institute for Monetary and Economic Studies, Tokyo, May 30, 2012, https://­w ww​ .­boj​.­or​.­jp​/­en​/­a nnouncements​/­press​/­koen​_ ­2012​/­data​/­ko120530a1​.­pdf. —­—­—­(2012e), “Japan’s Economy and Monetary Policy,” speech at a meeting held by the Naigai Josei Chousa Kai, Tokyo, June 4, 2012, https://­w ww​.­boj​.­or​.­jp​/­en​/­announcements​ /­press​/­koen​_­2012​/­data​/­ko120604a1​.­pdf. —­—­—­(2012f), “Japan’s Economy and Monetary Policy,” speech at a meeting with business leaders, Osaka, August 24, 2012, https://­w ww​.­boj​.­or​.­jp​/­en​/­a nnouncements​/­press​ /­koen​_­2012​/­data​/­ko120824a1​.­pdf. —­—­—­(2012g), Remarks at the 30th  Anniversary Luncheon of the Swiss Chamber of Commerce and Industry in Japan, Tokyo, October 10, 2012, https://­w ww​.­boj​.­or​.­jp​/­en​ /­a nnouncements​/­press​/­koen​_­2012​/­data​/­ko121010a1​.­pdf. —­—­—­(2012h), “Sustainability of Government Debt: Preconditions for Stability in the Financial System and Prices,” Financial Stability Review 16: 169–81, https://­w ww​.­banque​-­france​ .­fr​/­sites​/­default​/­files​/­medias​/­documents​/­financial​-­stability​-­review​-­16​_­2012​-­04​.­pdf.

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| ACKNOWL­E DGMENTS |

I have come to the final stage of the long and hard work of this book—­writing the acknowl­edgments—­and this makes me reflect on what gave birth to the book. Many scenes that s­ haped my long c­ areer flash before my eyes. I am a ­career central banker who has been helped tremendously by my colleagues both at home and abroad. We worked together to accomplish tasks. Th ­ ere ­were, of course, discussions at internal meetings of the Bank of Japan, but I also learned a lot from the exchanges of views at international meetings such as ­t hose at the Bank for International Settlements (BIS). Casual conversations during coffee breaks at t­ hese meetings w ­ ere quite inspiring. It was also very illuminating to read texts of public speeches by my fellow central bankers and research papers by central bank economists, and I exchanged emails with many of them. Last but not least, I learned from other central bankers what one might call the central bankers’ spirit—­aspiring to serve the public with the tools bestowed to central banks. With all such influences in the background, this book is, in my mind, essentially a joint work of many ­people in the central banking community. I have learned a lot from conversations, dialogues, and exchanges with academics, private-­sector economists, members of the press, management personnel at financial institutions, and participants in financial markets. All of ­these are impor­tant actors when it comes to the practice of central banking and monetary policy, and their influences on me are quite apparent. I wish to express my heartfelt gratitude to every­one to whom I owe this intellectual debt; I hope they ­will forgive me for not mentioning their names, as it is impossible to include a list of all of them. This book originated from the edition written in Japa­nese and titled Cen­ tral Bank: Thirty-­Nine Years’ Experience as a Central Banker, which was published by the Japa­nese publisher Toyo Keizai in the autumn of 2018. Though the basic structure and key messages of the En­glish edition are essentially the same as the Japa­nese edition, changes and adaptations ­were made to facilitate better understanding for foreign readers of Japa­nese experiences, which are still often regarded as a sort of “enigma,” as well as to place the discussion on Japa­ nese monetary policy in a global context. 489

I am grateful to six former colleagues at the Bank of Japan who kindly read through and made countless valuable comments on manuscripts of the Japa­ nese edition. Hirohide Yamaguchi, as deputy governor, gave me dedicated support during my governorship; I always trusted his professional and impartial advice, which never left any stone unturned. Kenzo Yamamoto, who as the executive director in charge of financial stability spent numerous hours to shape the bank’s responses to the global financial crisis of 2007–9, also gave invaluable comments. Kunio Okina, who had already left the bank and was a professor at Kyoto University during most of my governorship, always provided me with insightful analyses, both privately and through his published papers and books. Takeshi Kimura, who was involved in many fields of central banking, always inspired my thinking by providing me with penetrating analy­sis; his influences can occasionally be found in my public speeches. Kosuke Aoki and Ippei Fujiwara, who are now professors—at Tokyo University and Keio University, respectively—­were always helpful in translating my nascent ideas into the language and framework of more orthodox economics. I am very fortunate that the En­glish edition of my book is being published as part of the Yale Program on Financial Stability Series. Even in the age of globalization and growing interest in central banking and monetary policy, it was still not an easy attempt for a person without prior publication in En­glish to find a publisher who would venture to publish a book focused on a par­tic­ u­lar central bank—­and especially a book with so many pages. When I was trying to find a potential publisher, Timothy F. Geithner kindly introduced me to Yale University Press. Almost three de­cades have passed since I first met him when he was a financial attaché to the US embassy in Tokyo. The publication of my book would have been impossible without strong support and a recommendation from Tim, who continues to nurture intellectual curiosity about experiences in dif­fer­ent countries. I must also thank Andrew Metrick, the director of the Program on Financial Stability of Yale School of Management, for his support of the publication of this book. The program aims to hand down accounts and analyses of the experiences of financial crises to f­uture generations, and as a member of its Advisory Board who greatly sympathizes with its ambitions, I am very honored that my book is now published as part of its series. Producing the En­glish edition started with a translation of the original Japa­ nese edition into En­glish. Satoshi Kawazoe and Jun Iwasaki, who took on this laborious task, not only translated but also made innumerable valuable com-

490 | Acknowledgments

ments. Satoshi, who was involved in many activities with me at the BIS and is now a professor at Ritsumeikan Asia Pacific University, was familiar with my thinking and writing style, not least b ­ ecause he often assisted me in crafting my speech texts at the Bank of Japan. Jun, who is also engaged in many international activities, was kind enough to spend many weekends translating while he was busy traveling to developing Asian countries for the purpose of giving technical assistance to central banks—­and all while he was also writing his own book. They both prepared what was more than the original Japa­nese edition, and I want to express the greatest of gratitude for their devoted work. Having received the initial En­glish translation, I made further changes—­ rewriting, as well as deleting and adding passages. Expressing myself in a dif­ fer­ent language helped to crystallize vari­ous aspects of my thoughts. A ­ fter I finished t­ hese revisions, I then came to feel the need for help from native En­ glish speakers who deeply understood central banking and monetary policy; I wanted them to carefully read the manuscript in order to avoid any pos­si­ble misunderstanding on the part of readers. Quite unexpectedly and fortunately, my old friends—­Peter R. Fisher and Frank Packer—­independently volunteered to do this work. I first met Peter in a meeting held at the Federal Reserve Bank of New York (or New York Fed) in 1987. Since then we have continuously discussed a wide range of issues surrounding central banking. He pointed out some fuzzy writing, raised many questions for clarification, and suggested alternative expressions. I am quite lucky in having such a friend who both passionately continues to discuss central banking issues and inspires me. I became acquainted with Frank almost twenty years ago. He worked for the New York Fed and in the private sector before joining the BIS, and is now serving as an adviser in the BIS Asian Office. On top of that, he can speak Japa­nese and has worked in Tokyo. Combining an enormous amount of knowledge of central banking with cogent observations on the Japa­nese economy, he vastly improved my manuscript both in terms of its content and its expression. I thank both Peter and Frank from the bottom of my heart for their dedicated contributions. I would also like to express my gratitude to two former central bank governors. Jacob Frenkel, a former governor of the Bank of Israel, was a teacher when I was a student at the University of Chicago. He not only gave me valuable advice on this book but also kindly wrote a recommendation letter to the publisher. Mervyn King, a former governor of the Bank of E ­ ngland, was also kind enough to write a recommendation letter. I vividly remember the conversations we had in Tokyo—­just before I left the Bank of Japan—­about the need

Acknowledgments | 491

for reconsidering the prevailing intellectual model underpinning monetary policy in many developed economies. I would also like to thank Toshitaka Sekine, former chief economist at the Bank of Japan, for having volunteered to produce many of the graphs in this book. I benefited not only from his technical support but also his keeping me abreast of the educational value of many insightful research papers, including his own. Publishing a book is a joint proj­ect of the author and editors. For the Japa­ nese edition, my special thanks go to Yuichiro Yamagata, Taketoshi Yamazaki, and Yuko Shimamura. For the En­glish edition, I want to thank Seth Ditchik, Ann-­Marie Imbornoni, and Karen Olson at Yale University Press and Melody Negron at Westchester Publishing Ser­v ices for their excellent editorial work. Without their professional and dedicated work, this book would not be born. My wife Mieko has always supported me. My life as governor at the Bank of Japan was exciting and rewarding, but at the same time not without stress. Mieko always made sure that I would leave any worries at the doorstep when I returned home. Without her taking care of me and fostering such a warm atmosphere at home over the years of our marriage, it would have been impossible for me to finish my term as governor with the sense of accomplishment that I describe in the Prologue. I am extremely grateful to her. I have two ­daughters, Sayaka Masuda and Moegi Shirakawa. Sayaka, living in Fukushima at the time of the ­Great East Japan Earthquake, was devotedly raising her two boys while I was governor. Whenever I spent time with her ­family I felt that the sustainability of the economy and society, which I continuously emphasized in policy deliberations, was never just an abstract concept. Thinking of sustainability was to imagine the ­future of Sayaka’s ­family—in par­tic­u ­lar, what would happen to the economy and society that they would be living in many years from now if necessary actions w ­ ere not taken. My ­daughter Moegi is a ­lawyer specializing in capital markets practice. It was always a joy to talk with her about the issues dealt with in this book, and her candid comments on early drafts made me aware of vari­ous aspects of issues or sensitivities that I had not considered fully before ­because of differences in our gender or generation, among other ­things. My two ­daughters both contributed greatly to this book, though their routes ­were dif­ fer­ent. I am so proud to be their ­father. My m ­ other, Ryo Shirakawa—­who is now ninety-­six years old and still enjoys composing haiku, the traditional Japa­nese poems—­read the Japa­nese edition of my book and kindly told me, to my surprise, “It’s readable.” My late ­father, Hiroshi Shirakawa, died at the age of sixty-­nine ­after fighting for five 492 | Acknowledgments

years to recover from a brain hemorrhage. I regret I did not have much time to talk with him about my job at the Bank of Japan. Recalling that he wanted me to work in public ser­vice, I often won­der what he would think of my book if he w ­ ere still alive. I would like to dedicate this book to Mieko, Sayaka, Moegi, and both of my parents, with im­mense gratitude. Masaaki Shirakawa December 2020

Acknowledgments | 493

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| INDEX |

Note: Figures and ­tables are indicated by f or t following the page number.

Abe, Shinzo and administration, 334, 345–49, 354, 356, 358, 359, 365 “Abenomics,” 365 accord: Basel, 318, 415; capital, 34; between government and Bank of Japan, 335, 338–39, 343–44, 349; Louvre, 43, 412; Plaza, 28, 37, 40, 42–45, 274, 412–13; between trea­sury and FRB, 339 accounting issues/rules, 249–50, 318–19 Act concerning Temporary Mea­sures to Facilitate Financing for SMEs, 179–80 Act for Establishment of the Cabinet Office, 94–95 Act on Emergency Mea­sures for the Revitalization of Financial Functions (Financial Revitalization Act), 63 Act on Mea­sures for Rapidly Securing the Soundness of Financial Functions (Securing Financial Soundness Act), 63 Advisory Group on Economic Structural Adjustment for International Harmony, 45–46 ageshio (“rising-­tide-­lifts-­all boats” school), 298 agricultural cooperatives: intelligence gathering from, 21; nonperforming loans by, 61–62 Amari, Akira, 349 American Economic Association, 126, 371, 390 American International Group (AIG), 151, 169

“The Anguish of Central Banking” lecture (Burns), 405 Anzen credit ­union, 61 Aoki, Masahiko, 72 Apple, 213–14 Asian Bond Fund Initiative, 419 Asian Consultative Council, 416 Asian financial crisis (1997–1998), 192, 296, 406, 410–11, 417, 463n6 (chap. 12) Aso, Taro, 152, 349, 351 asset-­backed commercial paper, 83, 102, 460n13 (chap. 8) asset-­backed securities, 102, 460n13 (chap. 8) Association of Southeast Asian Nations (ASEAN), 411 Australia: discount rate in, 177; EMEAP participation from, 419; exchange rate in, 163f, 273, 275f, 279, 356f; financial institution regulation and supervision in, 126; swap lines with, 155; target inflation rate in, 279 automotive industry: automotive financing companies and, 167; ­bubble economy and, 31; global financial crisis effects on, 154, 164, 165, 167; intelligence gathering from, 22; production and capacity in, 128, 265, 280–81; protectionist policies for, 412; sixfold suffering in, 272; subsidies and incentives for purchases from, 164; terms of trade in, 209; yen appreciation effects in, 272, 279–81 Azumi, Jun, 309

495

Baker, James, 43 Bank for International Settlements (BIS): All Governors Meetings, 416; Basel Committee on Banking Supervision, 25–26, 319–20, 321, 322; board meetings of, 416–17; on central bank finances, 253; Committee on the Global Financial System, 26, 142, 455n5 (chap. 1), 460n12 (chap. 7); Committee on Payments and Market Infrastructure, 26; donations from following ­Great East Japan Earthquake, 268; Economic Consultative Committee, 141–42, 416; financial institution regulation role of, 320; Global Economy Meeting of, 141–42, 413; governors meeting at, 141, 359, 416–18; housing b ­ ubble in US discussions at, 120; international networking at/with, 25–26, 44–45, 52, 141–42, 413, 416–18; membership in, 418; monetary policy views at, 124, 137, 404; nominal effective exchange rate calculations by, 273, 463n1 (chap. 14) banknote rule, 98 Bank of Canada, 4, 155, 441 Bank of Credit and Commerce International, 55 Bank of ­England: Asset Purchase Fa­cil­i­t y Fund, 160, 243; capital held by, 249, 463n10 (chap. 12); committees of, 443, 469n10; credit easing strategy, 102, 160; discount rate of, 156, 157; financial institution supervision by, 84, 330; Funding for Lending Scheme of, 216; G7 repre­sen­ta­tion from, 4; government relations with, 80; in­de­pen­dence and accountability of, 76, 80, 84; international networking with, 52, 413; King at, 4, 8, 337, 413, 447; monetary easing by, 141; objectives of, 82–83; payments system policy with, 24–25; swap lines with, 155 Bank of Finland, 371 Bank of France, 4, 52, 142, 417

Bank of Japan: accountability of, 81–82, 110, 113–14, 243, 336, 337, 425; appointments to, 2, 3–4, 18, 78; Bank Examination Department, 51, 153, 450; bud­get for, 79; central bank role of (see central banks); code of conduct at, 134–35; financial institution supervision by, 35, 36–37, 46, 51, 84, 126, 153, 330–31; Financial Markets Department, 18, 22, 89, 90; Financial System Department, 18, 48, 50–52, 53, 54–55, 58, 61, 67–68, 92, 324, 423, 450; Financial System Report, 332; in­de­pen­dence of, 6, 74, 76–82, 86–87, 89, 113–14, 335, 339, 346, 347–48, 359–60; Institute for Monetary and Economic Studies, 18, 89, 368; International Department, 16–17; Monetary Affairs Department, 18, 26, 27, 68, 88–89, 91–92, 423; Monthly Report of Recent Economic and Financial Developments, 91; objectives of, 77–78, 82–83; Outlook Report, 93, 136, 138–40, 186, 458n7 (chap. 5); Policy Board of (see Policy Board); Research and Statistics Department, 18, 27, 39, 206; Shirakawa’s ­career building years at (see ­c areer building years); Shirakawa’s governorship of (see governorship); wine-­a nd-­dine scandals at, 86 Bank of Japan Act (new), 74–87; accountability ­u nder, 81–82, 425; accounting rules u ­ nder, 250; asset purchases allowed ­under, 83; constitutional authorizations and, 78–79; enactment of, 85–87; ­factors under­lying revision creating, 75–77; financial system stability role u ­ nder, 83–84, 126, 321; foreign exchange market authority ­under, 84–85, 103; government relations ­u nder, 79–80, 86, 424–25; history of prior act, 74–75; in­de­pen­dence in, 74, 76–82, 86–87, 89, 347, 425; JGB purchases u ­ nder, 304–5; Joint Statement reference to, 335, 340, 345, 348; on

496 | Index

Monetary Policy Meetings, 89, 133; monetary policy ­u nder, 88–89, 347; objectives of central bank in, 77–78, 82–83; on Policy Board, 75, 78, 84, 89, 133–34; reasons for legislating, 74 Bank of Japan Act (old): history of, 74–75; revision of, 74, 75–77 (see also Bank of Japan Act (new)) Bank of Japan Research Bulletin: real estate prices report in, 35–37, 39–40; UK secondary banking crisis report in, 39 Bank of ­Korea, 268, 420 Bank of Thailand, 268 Basel Accord, 129, 318–19, 415, 459n19 (chap. 6) Basel Committee on Banking Supervision (BCBS), 25–26, 319–20, 321, 322 Baxter, Thomas, Jr., 463n11 (chap. 12) Bear Stearns, 3, 136, 149–50, 170 Becker, Gary, 19 “beggar-­t hy-­neighbor” policy, 284 Berlin Wall, fall of, 71 Bernanke, Ben: book by, 8, 168–69, 237; criticisms of Japa­nese monetary policy by, 70, 119, 364, 371, 459n4 (chap. 6); “Deflation: Making Sure ‘It’ ­Doesn’t Happen H ­ ere,” 119, 364; “Japan’s self-­induced paralysis” described by, 364; on dot-­com b ­ ubble bursting, 459n12 (chap. 6); on economic recovery, 176; on fiscal policy, 310; G7 participation of, 4; on global savings glut, 413; “The G ­ reat Moderation” speech, 121–22, 126; inflation targets u ­ nder, 335; on Japan’s self-­induced paralysis, 364; on Lehman ­Brothers’ collapse response, 169–70; on monetary base, 195; on monetary easing, 237, 284–85, 456n17; “Monetary Policy and Asset Price Volatility” by, 37; on po­liti­cal pressure, 427; on subprime mortgage crisis, 147; on swap lines, 411; on unconventional monetary policy, 390

BIS. See Bank for International Settlements Black Monday, 28, 40–41 blackout periods, 135 Blair, Tony, 76 Blanchard, Olivier, 148, 201, 374, 378, 387–88 Blinder, Alan, 122, 428, 429 BNP Paribas, 148–49, 154, 174 bonds. See corporate bonds; government bonds Borio, Claudio, 26, 124 Brazil: currency war characterization by, 284; swap lines with, 155 Bretton Woods system, 16, 17, 408 bridge bank, 60 Brunnermeier, Markus, 383 ­bubble bursting, 48–73; ­actual failure of financial institutions following, 55–56; “arms and munitions” to manage lacking, 56–57; Bank of Japan as lender of last resort following, 51, 54, 63–65; capital losses from, 30; criminal responsibility for, 467n7 (chap. 19); delayed response following, 65–67; end of financial crisis following, 65; Eu­ro­pean debt crisis comparison to, 228–29; expert opinions on, 67; financial crisis following, 10, 18, 27, 48–73; Financial System Department and, 50–52, 53, 54–55, 58, 61, 67–68; fiscal policy following, 296; framework for resolution of financial institutions following, 59–60, 62–63; interbank funding market affected by, 62, 171; international criticisms on monetary policy following, 69–70, 124; Lehman collapse compared to, 62, 64, 66, 168–72; lessons of, 72–73; “lost de­cades” narrative, 70, 211, 363; Ministry of Finance stance on, 51, 52–53, 54, 55, 59–62, 64, 66–67; monetary policy and, 49–50, 67–70, 81, 120–21, 124; nonperforming loans and, 50, 53–59, 61–62, 65–67, 457n16; overly optimistic economic

Index | 497

­ ubble bursting (cont.) b outlook and, 50; policies for financial institution failure management following, 53–55; po­liti­cal leadership on, 67; public funds for coping with financial crisis following, 57–60, 61–63, 64, 66, 67, 171–72; public opinion on responsibility for, 46–47, 380–81; real estate market and, 48–49, 49f, 457n1 (chap. 3); societal response to, 46–47, 380–81; stagnation of economy following, 70–72. See also dot-­com ­bubble ­bubble economy, 27–47; accelerating ­factors of, 33–34; ­bubble, defined, 27–28; bursting of (see ­bubble bursting); c­ areer building during, 12, 18, 27–47; current account surplus and, 32, 42–44, 45–46; ­drivers of, 30–33; exceptionally bullish expectations driving, 31–32; exchange rates and, 28, 37, 40–43, 44–45; financial crisis following, 10, 18, 27, 48–73; interest rates and, 33, 37, 40–42, 44, 46; lessons of, 46–47, 377; macroeconomic policy management and, 398–99; Maekawa Report in, 45–46; monetary easing and, 37–41, 42–44, 46, 76; monetary policy and, 6, 36–47, 76, 81; rapid credit expansion driving, 32–33, 34, 39; real estate market and, 28–30, 29f, 33–40, 46, 48, 49f, 51; unpre­c e­dented nature of, 27–30; weaknesses in mechanisms to check, 34–35. See also dot-­com b ­ ubble; global credit b ­ ubble; housing ­bubble in US Bud­get Committees, 143 Burns, Arthur, 405, 446 Business Conditions Diffusion Index, 28, 455n2 (chap. 2) business continuity planning, 259–60, 269, 318 business cycle, 20, 30, 43, 49, 136, 146 businesses and corporations: b ­ ubble bursting and changes in, 70–72; ­bubble economy effects on, 28, 30, 31–35, 39–41;

competitiveness of (see competitiveness); corporate bonds of (see corporate bonds); corporate governance in, 34–35; corporate income taxes of, 22–23, 272, 296; credit easing for, 158–60; deflation and, 184–85, 187, 189, 192–93, 205, 209 (see also deflation); employment by (see employment); Eu­ro­pean debt crisis effects on, 221, 227; financial (see financial institutions); global, ranking of, 28; global financial crisis effects on, 151–52, 154, 158–60, 164, 165, 167–68; ­Great East Japan Earthquake effects on, 263, 264–67, 269, 272; intelligence gathering from, 21–22, 263; overly optimistic economic outlook of, 50; productivity of (see productivity); reshoring of, 128, 280–81; sixfold suffering by, 272–73, 281; small-­and medium-­ size, 164, 179–80; Tankan survey of, 28, 50, 91, 107, 165, 455n2 (chap. 2); trade by (see trade); yen appreciation concerns of (see yen appreciation); zombie firms, 72, 376. See also specific industries (i.e., steel industry) call money market. See interbank funding market Canada: central bank of, 4, 155, 441; debt outstanding in, 295f; discount rate in, 177; GDP in, 387f; inflation in, 125, 456n8; social welfare in, 387f capital adequacy ratio, 249 capital gains/losses, 30, 34 capital requirements: Basel I, 318–19; Basel II, 129, 318, 459n19 (chap. 6); Basel III, 318, 415; b ­ ubble economy and, 33–34; capital adequacy ratio, 249; financial system stability and, 315, 318, 320, 321–22, 415; minimum, 24, 34, 58, 318–19, 321–22; stress tests assessing, 224 ­career building years: Bank of Japan Act revision during (see Bank of Japan Act (new)); ­bubble bursting and financial

498 | Index

crisis in (see ­bubble bursting); ­bubble economy during (see ­bubble economy); central bank value to economy in, 22–25; economic theory driving thinking in, 19–21; education and, 15–16, 19–20; executive directorship in, 18, 89, 109; in Financial Markets Department, 18, 22; in Financial System Department, 18, 48, 51, 55, 58, 61, 67–68, 92, 423; in Government Trea­sury Operations Section, 22–23; governorship founded on experience from, 7, 18–19; ­Great Moderation during (see ­Great Moderation); in Institute for Monetary and Economic Studies, 18; intelligence gathering in the field in, 21–22; in International Department, 16–17; international networking with other central banks in, 25–26, 44–45, 52; in Monetary Affairs Department, 18, 26, 27, 68, 88–89, 91–92, 423; quantitative easing during (see quantitative easing); in Research and Statistics Department, 18, 27, 39; retirement from, 18; start of, 15–26; zero interest rate policy during (see zero interest rate policy) Carney, Mark, 4 Caruana, Jaime, 253 Case-­Shiller 20-­City Composite Home Price Index, 146 central banks: accountability of, 76, 81–82, 110, 113–14, 243, 336, 337, 422, 425, 430–31, 433–34; banking ser­v ices provision by, 145, 439–40; be­hav­ior characteristics of, 404; capital of, economics perspective on role of, 251–52; committees of, 441–44; communication by, 433–34, 440–41 (see also press conferences); credibility of, 70, 86, 242, 252; in demo­cratic society, 247, 254, 438; as ever-­learning institutions, 144–45, 439; expectations for, 390–405; financial institution supervision by, 35, 36–37, 46, 51, 84, 125–26, 153, 330–31, 445; financial market pressures on, 428–29;

fragmentation of society faced by, 432; ­f uture framework for, 453–54; global cooperation of (see global cooperation of central banks); good judgment in policy making by, 397–98; government relations with, 79–80, 86, 160–61, 231–32, 422–27 (see also Joint Statement of the Government and the Bank of Japan); governorship of, 444–47 (see also governorship); in­de­pen­dence of, 6, 74, 76–82, 86–87, 89, 113–14, 335, 339, 346, 347–48, 359–60, 422–35, 437–38; intellectual influence of separation princi­ple on, 429–30; interest rate changes by (see interest rates); ­legal position in executive branch, 78–79; lending to financial institution by, 51, 54, 63–65, 84, 344, 402 (see also ­under liquidity); liquidity provided by, 51, 64, 84, 113, 153–54, 168, 171–72, 190, 195, 231–32, 242, 258, 305–6, 323; macroeconomic policy management successes and failures by, 398–400; management and ­running of, 441–51; market operations of, 24; monetary policy of (see monetary policy); negative equity at, 247–48, 250, 251–52, 463n9 (chap. 12); objectives of, 77–78, 82–83, 347 (see also price stability); as “only game in town,” 431; as organ­ izations, 436–52 (see also orga­nizational issues in central banks); payments and settlement system operated by (see payments and settlement system); politics and po­liti­cal economic influences on, 252–53, 426–27, 468n4; power of, 434–35; roles of, 10, 77–78, 402; societal pressures on, 427; staff of, 267, 448–51; value of operations to economy, 22–25. See also specific banks Central Bank Study Group report, 77, 78 CGFS (Committee on the Global Financial System), 26, 142, 455n5 (chap. 1), 460n12 (chap. 7)

Index | 499

Chase Manhattan Bank, 24 Chiang Mai Initiative, 411 China: current account in, 413; economic growth in, 5, 116–17, 420; EMEAP participation from, 419–20; Eu­ro­pean debt crisis and, 227; exchange rate in, 276; fiscal policy and economic stimulus in, 168; ­Great East Japan Earthquake supply chain effects in, 264; international meeting participation from, 142, 419–20; reciprocal foreign currency financing with, 411; yuan, not seen as safe-­haven, 274, 276 CLS Bank, 415 Coarse, Ronald, 19 code of conduct, 134–35 Coeuré, Benoit, 158 Columbia Pictures, 32 commercial paper (CP): asset-­backed, 83, 102, 460n13 (chap. 8); Bank of Japan Act allowances for purchase of, 83; as collateral, 159; Comprehensive Monetary Easing and purchase of, 241, 242, 258; credit easing and purchase of, 159–61; global financial crisis effects on, 151–52, 154, 158–60, 167 Committee on Payments and Market Infrastructure, 26, 321 Committee on the Global Financial System (CGFS), 26, 142, 455n5 (chap.1), 460n12 (chap.7) committees of central bank: appointments to, 444; collective decision making by, 441–42; groupthink perils in, 442–43; qualifications of members of, 443–44 Companies Act, 159 comparative advantage, 280 competitiveness: competition-­restraining business practices, 182–83; dynamism of competitive market, 393; Eu­ro­pean debt crisis and loss of, 226; globalization affecting, 196, 215; lower growth expectations and declining, 212–15;

prices affected by, 182–83, 192, 200, 204, 209, 212–15; product innovation and, 214–15; productivity and declining, 203; real effective exchange rate reflecting, 274; sixfold suffering affecting, 272–73, 281; trade and, 31–32, 118, 209, 212; yen appreciation effects on, 272–73, 281, 282 Comprehensive Monetary Easing, 234–54; accounting issues related to exit from, 249–50; adoption of, 239, 243; Asset Purchase Program in, 234, 241–43, 244–47, 258, 340, 342, 344, 351–53, 353f, 365–66; Bank of Japan’s views on, 252–54; central bank capital and, 249, 251–54, 463n10 (chap. 12); central bank role in demo­cratic society and, 247; enhancing monetary easing leading to, 235–37, 344; Eu­ro­pean debt crisis and, 228; exit strategy for, 242, 246–47, 249–50; foreign exchange market interventions and, 237–38; forward guidance, 237, 240; interest rate reduction in, 234, 238–41, 244, 246, 352, 463n8 (chap. 12); JGB purchases in, 234, 240, 242–43, 244–47, 249–50, 258, 352, 365; negative equity at central bank and, 247–48, 250, 251–52, 463n9 (chap. 12); reactions to, 244–46; risk premium lowering and, 239, 241, 244, 258, 303; yen appreciation and, 234–37, 238 computers, advances with, 6, 50, 71, 214–15 construction industry: b ­ ubble economy effects in, 33; global financial crisis effects on, 165, 167; lending to, 33, 49, 55 Consumer Price Index (CPI): deflation and, 96, 180, 181f, 183; economic forecast for, 357, 466n23 (chap. 17); inflation and, 37, 38f, 41, 109f, 141, 182f, 199–201, 340; monetary base and, 193, 194f; quantitative easing and, 99, 108, 109f, 111, 183; recalibration of, 459n8 (chap. 7) consumption taxes, 41, 139, 182, 222, 296, 308–10, 344–45

500 | Index

Continuous Linked Settlement, 173 “Conventional Wisdom on Japan Is Wrong” article (Wolf), 368 corporate bonds: Bank of Japan Act allowances for purchase of, 83; as collateral, 159; Comprehensive Monetary Easing and purchase of, 241, 242, 258; credit easing and purchase of, 159–61; global financial crisis effects on, 154, 158–60; government bonds yields spread with, 245, 245f; G ­ reat East Japan Earthquake effects on, 266–67; unconventional monetary policy effects on, 392; yield on, 245, 245f Corporate Reor­ga­ni­za­tion Act, 151 corporations. See businesses and corporations Corrigan, Gerald, 24, 469n11 Cosmo credit u ­ nion, 61 Council on Economic and Fiscal Policy, 94–96, 348, 354, 424 Council on Foreign Relations, 262 CP. See commercial paper CPI. See Consumer Price Index credit: ­bubble economy and rapid expansion of, 32–33, 34, 39; credit easing strategy, 102, 158–61; credit guarantee corporations supporting, 164; credit risk premiums, 100, 113, 239; global credit b ­ ubble, 107, 114, 115, 140, 173–74. See also liquidity; loans Crockett, Andrew, 124 currency war, 272, 284–85, 409 current accounts: central bank and, 23–24; domestic demand expansion effects on, 42–44, 45–46; Eu­ro­pean debt crisis and, 226; Financial Markets Department and, 90; flow of funds in, 23; foreign exchange transactions through, 24, 286; global imbalances of, 413–14, 415f; interest-­bearing reserves, 156–58, 248, 250; monetary easing and, 165, 460n16 (chap. 8); quantitative easing and, 98–100,

103–4, 112, 114; surplus, defined, 43–44; surplus/deficit and b ­ ubble economy, 32, 42–44, 45–46; yen as safe-­haven and strength of, 274 Dai-­Ichi Kangyo Bank, 28 Daimon, Mikishi, 426 debt deflation, 187–89 deflation, 175–202; academics on, 97, 206; ambiguity of term, 183–85, 202; avoiding Japanese-­style, 364–65, 371; beat deflation narrative, 180, 203, 215, 272, 359, 433; clamor for beating, 175–202; Consumer Price Index and, 96, 180, 181f, 183; debate on, 201–2, 203–4, 205–6; debt deflation, 187–89; declaration of, 96–97, 175, 180–81, 183, 187, 424; definition of, 183–86; deflationary spiral distinguished, 185–88; deflationary spiral not occurring in Japan, 188–91; Demo­cratic Party of Japan and, 175, 178–81, 343–44; demographics and, 96, 198, 203, 206–9, 211, 212–13, 217–19; employment, unemployment and wages with, 188, 189, 190–91, 192; exchange rates and, 185, 192; “expectationistas,” 204–5 on; expected rates of inf lation and, 195–98, 197f, 199, 202, 204–5, 212–13; false dawn and, 175–77; financial system collapse causing, 325; global risk of, 235; G ­ reat Depression and, 96, 119, 184, 189; Growth-­Supporting Funding Fa­cil­i­t y to address, 215–17; inflation target rates and, 97, 196, 197–98, 199–201, 202, 204–5, 461n31; Japa­nese economic recovery and, 178; long-­run trends in prices and, 181–83, 182f; lower growth expectations, declining prices, and, 212–15; “Mea­sures Aimed at Overcoming Deflation” report on, 343–44; monetary easing and, 179, 187, 191–92, 203, 428; as monetary phenomenon, 193–95, 194f, 204, 205–6, 355, 371, 433; origins of declining prices and,

Index | 501

deflation (cont.) 191–93; politics, po­liti­cal economy and, 175, 178–81, 183, 203, 204–5, 335, 343–44; power of narrative on, 209, 211–12; productivity effects of, 203; public opinion on, 183–85, 185f, 187, 205–6; public perception of prices and, 198–99; reactions to communication on declining growth potential and, 217–19; “reflationistas” on, 204–5; Understanding of Medium-­to Long-­term Price Stability revised for, 188, 199, 200; US stance on, 119, 123, 189–90, 202, 215, 364–65; yen appreciation and, 180, 184–85, 192, 203–4, 278–79; zero interest rate policy and, 91–93; zero lower bound of interest rates and, 123, 189, 195, 200–201, 378 deflationary spiral, 94, 97, 185–91, 325 “Deflation: Making Sure ‘It’ ­Doesn’t Happen ­Here” speech (Bernanke), 119, 364 Demo­cratic Party of Japan (DPJ): Bank of Japan Act amendment proposals by, 348; deputy governor appointment and, 153; fiscal policies of, 308–9, 344–45; G ­ reat East Japan Earthquake reconstruction funding proposals by, 261; monetary policy pressures from, 426, 468n4; Policy Research Council of, 343; po­liti­ cal changes with, 4–5, 178–80; po­liti­cal control by, 2, 178–80 demographics: birth rate decline, 5, 96, 117, 203, 206–9, 218, 421; ­bubble bursting and, 72; deflation and, 96, 198, 203, 206–9, 211, 212–13, 217–19; domestic market decline and, 280, 283; economic deceleration and, 117; GDP reflecting changes in, 207–8, 208f, 211, 218; governorship affected by, 4, 5, 140, 198, 203, 206–9, 211, 212–13, 217–19; life expectancy and, 300, 386, 387; lower growth expectations with declining, 212–13, 217–19, 378; rapid aging and, 5, 72, 96, 140, 198,

203, 206–9, 212–13, 217–18, 421; social security expenses and, 211, 293, 295, 300; trend growth determined by, 124; unconventional monetary policy effects and, 396, 397 Denmark: interest rate changes in, 278 Deposit Insurance Act, 59, 62–63 Deposit Insurance Corporation of Japan, 50, 53–54, 55, 56–57, 59–60, 63, 67, 457n11, 457n16 Deutsche Bundesbank, 4, 44, 86, 230 developing economies. See emerging economies Development Bank of Japan, 159 Diet. See National Diet discount rate: Bank of Japan Act changes and, 86–87; b ­ ubble bursting and, 49, 67–68, 69f; b ­ ubble economy and, 33, 41 domestic demand: demographics and decline of, 280, 283; expansion effects on current accounts, 42–44, 45–46; monetary easing to stimulate, 285, 288 Dornbusch, Rudi, 303 dot-­com b ­ ubble: bursting of, 88, 97, 115, 121, 459n12 (chap. 6); P/E ratio in, 30 Dow Jones Industrial Average, 151, 176 DPJ. See Demo­cratic Party of Japan Draghi, Mario, 185, 225, 227, 232, 319, 356 Dudley, William, 268 dynamic stochastic general equilibrium (DSGE) model, 127 Economic Consultative Committee (ECC), 141–42, 416 economic forecasts: on deflation, 186; downgrading economic outlook in, 136, 138–40, 363–64; false dawn in, 175–77, 371; on inflation, 357, 367, 367f; on interest rates, 342; Joint Statement and, 355–57, 466n23 (chap. 17); monetary policy supported by, 27; in Outlook

502 | Index

Report, 93, 136, 138–40, 186, 458n7 (chap. 5); overly optimistic, 50, 176, 371; staff contributions to, 448 Economics (Samuelson), 15 economic theory: as driver of thinking, 19–21; good judgment on application of, 398 electrical equipment industry: global financial crisis effects on, 165, 167; production and capacity increases in, 128; sixfold suffering in, 272 Electricity Business Act, 266 electronics industry: terms of trade in, 209; yen appreciation effects in, 272, 279–81, 282 EMEAP (Executives’ Meeting of East Asia–­Pacific Central Banks), 416, 418–20 Emergency Economic Stabilization Act (2008), 156 emerging economies: current accounts in, 413; discount rate in, 177; economic growth of, 5, 116, 116f, 283; exchange rate views in, 284, 285–86, 410–11; financial institution regulations in, 319; global cooperation of central banks and perspectives of, 410–11, 417, 419; monetary easing in, 396–97; production located in, 280. See also specific countries empiricism, 19–20 employment: ­bubble bursting effects on, 70–71; b ­ ubble economy and, 65; central bank objectives for, 82–83; deflation and, 188, 189, 190–91, 192; demographics of ­labor pool for (see demographics); economic recovery and improvements in, 178; employment adjustment subsidies for, 164; global financial crisis effects on, 164, 165, 166f, 382; global standard for practices, 384–85; Japa­nese employment model, 65, 107, 117, 165, 190–91, 213–14, 282, 384–85; production location affecting,

279–80; recovery from excess, 107; social welfare and working hours, 385–86, 467n11 (chap. 19); wages and, 117, 188, 190–91, 192, 213–14, 280, 283, 384–85, 384f, 451 energy: atomic, 272 (see also Fukushima Daiichi Nuclear Power Plant accident); core inflation rate excluding, 409–10; electricity shortages, 259–60, 264, 272; high prices of, 136, 138–40, 410; imports, 118; oil industry, 37, 117, 141, 180 enlightened self-­interest, 468n5 (chap. 21) ESM (Eu­ro­pean Stability Mechanism), 221, 232 ETFs (exchange-­traded funds), 234, 241, 242–43, 244, 258, 366 ethical issues: code of conduct on, 134–35; gift ac­cep­tance as, 1. See also moral ­hazard Ettin, Ed, 52 Eu­ro­pean Central Bank: appointments to Executive Board of, 444; capital held by, 249, 463n10 (chap. 12); credit easing strategy, 102, 160; on deflation, 185, 215; discount rate of, 156, 158, 460n15 (chap. 8); Eu­ro­pean debt crisis and, 221, 223–25, 229–32, 417–18, 462n4 (chap. 11); financial institution supervision by, 330; foreign exchange market authority of, 85, 238, 291; founding of, 76; G7 repre­sen­ta­tion from, 4; government bond purchase by, 221, 223, 229–31; government relations with, 80, 231–32; interest rates changes, 93, 141, 276; international networking with, 4, 417–18, 420; liquidity provision by, 231–32; Longer-­Term Refinancing Operation by, 221, 224; objectives of, 82–83; Outright Monetary Transaction by, 221, 225, 229–31, 232; press conferences by, 91; Public Sector Purchase Programme, 462n4 (chap. 11); Securities Market Programme of, 221, 223, 229–30; swap lines with, 154; Trichet at, 4, 142

Index | 503

Eu­ro­pean debt crisis, 220–33; bail outs in, 221, 222–25; Bank of Japan responses to, 227–28; central bank as lender of last resort to government in, 231–32; economic structure and social contract effects on, 382–83; effects of, 221–22; euro ideal vs. real­ity and, 225–26; euro launch and, 220; first phase of, 221, 222–23; global financial crisis distinguished, 149; government bond purchases in, 221, 223, 229–31, 462n4 (chap. 11); governorship during, 4, 5, 220–33; interest rates in, 93; international criticism of response to, 417–18; Japa­nese economy effects of, 226–27; Japa­nese experience comparison to, 228–29; private-­sector involvement and, 222–23; second phase of, 221, 223–24; social integration and, 232–33; stages of, 221, 222–25; third phase of, 221, 224–25; yen appreciation and, 226–27, 272, 274, 343, 355–56 Eu­ro­pean Economic Community, 16 Eu­ro­pean Financial Stability Mechanism, 223 Eu­ro­pean Stability Mechanism (ESM), 221, 232 Eu­ro­pean Union/euro area: central bank of (see Eu­ro­pean Central Bank); corporate-­ government bonds yields spread in, 245f; current account in, 414; debt crisis in, 4, 5, 93, 149, 220–33, 272, 274, 343, 355–57, 382–83, 417–18, 462n4 (chap. 11); euro ideal vs. real­ity and, 225–26; euro launch in, 220, 464n3 (chap. 14); exchange rate in, 16, 162, 163f, 225–27, 235, 273, 275f, 287–88, 356, 356f; GDP in, 177f, 208f, 374, 374f–76f; government bond yield in, 370; member states of, 462n5 (chap. 11); monetary base in, 193–95, 194f; monetary easing in, 288; social integration in, 232–33; Stability and Growth Pact in, 225, 226; unemployment in, 191, 382. See also specific countries

exchange rates: Bank of Japan Act on authority over, 84–85, 103; Bretton Woods system of fixed, 16, 17, 408; ­bubble economy and, 28, 37, 40–43, 44–45; communication on, 290–91; Comprehensive Monetary Easing and intervention with, 237–38; currency war over, 272, 284–85, 409; deflation and, 185, 192; emerging economies’ views of, 284, 285–86, 410–11; euro eliminating risk of, 225–26; Eu­ro­pean debt crisis and, 225, 226–27, 355–56; effect of sterilized vs. unsterilized interventions on, 104; fixed, 16, 17, 283, 408; flexible, as global standard, 385; global financial crisis and, 161–63, 162f–63f, 173; ­Great East Japan Earthquake effect on, 260–61; inflation and, 278–79, 342–43; interest rates and, 104–6, 162–63, 235, 276–78, 277f, 285–86, 288, 336; key international currency and, 396–97, 409, 410; Louvre Accord on, 43, 44–45, 286, 412; monetary base and, 103–4; monetary easing and, 37, 40–41, 234–37, 238, 276, 278, 284–85, 291–92, 409; Nixon Shock to, 17; nominal effective, 106f, 162–63, 163f, 227, 273, 275f, 283, 356, 356f, 463n1 (chap. 14); Plaza Accord on, 28, 37, 40, 42–43, 44–45, 286, 412; policy debates on, 16 (see also yen appreciation); post-2000 developments, 273–74, 275f; quantitative easing and, 102–6, 105f, 106f, 284; real effective, 274, 275f, 283; Smithsonian Agreement on, 17; yen appreciation (see yen appreciation). See also foreign exchange transactions exchange-­traded funds (ETFs), 234, 241, 242–43, 244, 258, 366 Executives’ Meeting of East Asia–­Pacific Central Banks (EMEAP), 416, 418–20 “exorbitant privilege,” 397, 409 “expectationistas,” 204–5, 239, 336 expectations: adaptive, 196; anchor inflation, 197; change inflation, 204, 365;

504 | Index

influence, 99, 206; raise inflation, 336, 421; rational, 20; work on, 359–60 exports: b ­ ubble economy and, 31–32; China’s growth of, 117; current account surplus and, 44; Eu­ro­pean debt crisis and decline in, 227; global financial crisis effects on, 165, 167; price decline in, 209, 212; purchasing power and, 118, 212; terms of trade and, 118, 118f, 209, 210f, 458n2 (chap. 6); yen appreciation effects on, 236, 237–38, 272, 279–83 Fannie Mae, 150, 171 Federal Deposit Insurance Corporation (FDIC), 52, 151, 321 Federal Open Market Committee (FOMC): appointments to, 444; deflation concerns of, 119, 365; dot-­com b ­ ubble bursting response, 97; economic forecasts of, 370; government relations and, 80; housing ­bubble and decisions by, 120–21; Japa­nese economy report to, 68 Federal Reserve Act, 170 Federal Reserve Bank of New York: credit easing mea­sures by, 161; emergency funding by, 3, 136, 149–51; Geithner at, 8; international networking with, 52, 420; liquidity provided by, 154; meeting among the Bank of E ­ ngland, the Bank of Japan, and, 24–25; swap lines with, 411; visit of se­nior officers of, 24 Federal Reserve Board (FRB): accord with US Trea­sury, 339; asset purchases by, 252, 352; Bernanke at, 4, 8, 119, 147, 195, 237, 310, 335, 411, 427; capital of, 463n10 (chap. 12); congressional reports to, 143, 146; credit easing mea­sures by, 158–59, 160; deflation response by, 189–90, 215, 364–65; economic forecasts for Japa­nese economy by, 363–64; emergency funding by, 169–71; establishment of, 321; financial institution regulatory reforms by, 330; on fiscal policy, 310; G7 repre­sen­ta­tion

from, 4; global financial crisis and, 146–47, 149–51, 156–60, 168–71, 252, 382, 395–97; global influence of, 407; Greenspan-­era monetary policy views of, 122–24, 137, 404, 459n12 (chap. 6); housing b ­ ubble and, 120, 146–47; in­de­pen­dence of, 78, 80, 87, 339; inflation target of, 335; interest-­bearing reserves, 156–57; interest rate changes by, 276, 278; international networking with, 4, 52, 417–18, 420; monetary base increases by, 195; monetary easing by, 120–21, 141, 234, 237, 276, 278, 284–85, 288, 396–97; monetary regime change at, 405; objectives of, 83; po­liti­cal pressure on, 427; price stability targets, 93; quantitative easing by, 228, 234, 284, 417, 418; response to Eu­ro­pean debt crisis, 228; study of Japa­nese economy, 68–69, 124; transcripts released by, 91, 458n2 (chap. 5); Volcker at, 93, 190, 330, 405, 445; unfeasibility of global central bank and, 409 Feldstein, Martin, 189 Financial Affairs Committees, 1, 143, 341, 426 financial crises: Asian financial crisis, 192, 296, 406, 410–11, 417, 463n6 (chap. 12); ­bubble bursting and, 10, 18, 27, 48–73; Eu­ro­pean debt crisis, 4, 5, 93, 149, 220–33, 272, 274, 343, 355–57, 382–83, 417–18, 462n4 (chap. 11); global (see global financial crisis); G ­ reat Depression (see ­Great Depression of 1930s); Lehman ­Brothers’ collapse (see Lehman ­Brothers’ collapse); Panic of 1907, 321; subprime mortgage, 4, 146–47, 149; unconventional monetary policy as response to, 395 financial imbalances: b ­ ubbles and, 28, 325 (see also ­bubble economy); buildup of, 127–30; global, 413–14, 415f; macroeconomic destabilization due to, 226, 430; monetary policy adjustments for, 78

Index | 505

financial institutions: b ­ ubble bursting and, 49–67; b ­ ubble economy and, 28, 32–40, 46; business continuity planning by, 259–60, 269, 318; capital requirements for (see capital requirements); central banks and (see central banks); deposit insurance for, 53, 55, 56, 62–63, 67, 148–49, 457n11; emergency guarantees encouraging SME lending by, 164; Eu­ro­pean debt crisis effects on, 221, 223–25; failure of, 3, 4, 50, 51–67, 139 (see also Lehman B ­ rothers’ collapse); foreign exchange transactions of (see foreign exchange transactions); framework for resolution of, 59–60, 62–63; G ­ reat East Japan Earthquake effects on, 257, 269; imbalances at, 129–30; institutional reforms in, 107, 330–31; lending by, 23, 28, 32–34, 36, 38–39, 49–50, 53–59, 61–62, 65–67, 157, 164, 167, 179–80, 315, 322; lending to, 51, 54, 57–60, 61–67, 84, 149–51, 154–55, 171–72, 216–17, 305–6, 315, 323, 344, 402 (see also interbank funding market); management and shareholder accountability for failed, 52, 54; nonbank (see nonbank financial institutions); nonperforming loans at, 50, 53–59, 61–62, 65–67, 106–8, 457n16, 464n2 (chap. 15); profitability of, 331; public funds to bail out, 57–60, 61–63, 64, 66, 67, 169–72, 382; purchase and assumption of, 3, 52, 53, 55, 59, 60, 136, 149–50, 170; quantitative easing and short-­term funding of, 100–102, 108–9, 112; regulation and supervision of, 35, 36–37, 46, 49, 51, 74, 84, 125–26, 153, 174, 314, 315, 317–31, 415, 445; in resolution, 53–65, 153, 457n16; restructuring vs. liquidation of, 53–54, 56–57, 60, 67; shadow banking and, 174, 320, 327; SME lending by, 164, 179–80; stocks held by, purchase of, 101–2, 160; stress tests for,

172, 224, 382; “too big to fail” concern for, 56, 320. See also specific entities Financial Regeneration Program (Takenaka Plan), 108 Financial Revitalization Act (Act on Emergency Mea­sures for the Revitalization of Financial Functions), 63 Financial Ser­vices Agency, 74, 129, 150, 153, 179, 319–20, 321, 329–30 Financial Stability Board (FSB), 319–20, 465n3 (chap. 16) Financial Stability Forum, 320, 465n3 (chap. 16) Financial Stability Oversight Council (FSOC), 330 Financial Supervisory Agency, 74, 321 Financial System Report, 332 financial system stability, 314–33; Bank of Japan Act on, 83–84, 126, 321; BOJ-­ Financial Ser­v ices Agency cooperation for, 329–30; ­bubble economy and, 36; capital requirements and, 315, 318, 320, 321–22, 415; central bank role in, 51, 52, 77, 155, 329–30, 402, 406, 415; enhancing, 314–33; financial crises affecting (see financial crises); fiscal sustainability and, 211, 293, 301–2, 307, 309; global cooperation of central banks for, 329–30, 406, 415; interest rate risk disclosure for, 322–23; international framework for regulatory standards for, 318–21, 329–30, 415; international institutional reforms of regulatory standards for, 330–31; intricacy of monetary policy and financial policy for, 326–27; liquidity and, 190, 315, 320, 323; macroprudential policies for, 323–25, 327, 330–31; medium­to long-­term risks to Japa­nese, 331–33; monetary policy and responsibilities for, 83–84, 102, 125–26, 338, 401–2; overview of, 314–15; payments and settlement system efficiency and resilience supporting, 317–18; price

506 | Index

stability inseparability from, 84, 125–26, 314, 325–26, 429–30; regulations and supervision for, 225, 314, 315, 317–31, 415; resilience development for, 24, 315; separation princi­ple on, intellectual under­pinnings of, 327–29; tragedy of the commons and, 316–17, 326; unconventional monetary policy effects on, 391, 394 fine-­tuning or optimization strategy, 402–3, 431 fiscal dominance, 195, 242, 293, 304, 312, 338, 359, 422 fiscal policy: BOJ’s public communication on, 305–8; changing views of on use of, 296–97, 310–11, 379–80; Eu­ro­pean debt crisis influence on, 228; exit strategy for, 312; fiscal sustainability and, 211, 293–313, 344–45, 350–51; global financial crisis and, 164, 168, 297; ­Great East Japan Earthquake reconstruction and, 261–62, 293, 297; Japa­nese economists’ views on, 310–11, 379–80; Keynesian stimulus policies as, 296–97; monetary policy crossroads with, 304–5, 311–13, 423–24, 427, 435; monetary policy vs., 113, 243; quasi-­, 160, 243, 427, 431; Takahashi Fiscal Policy, 311–13; unconventional monetary policy effects on, 394, 427; worsening fiscal condition and, 293–96, 294f–95f fiscal sustainability, 293–313; antireform camp approach to, 298–99; BOJ’s public communication on fiscal issues affecting, 305–8; changing views on fiscal policy use for, 296–97, 310–11; debt outstanding and, 293, 294f–95f, 295, 297, 298–99, 301; economic growth approach to, 298, 299, 302, 309–10; financial system stability and, 211, 293, 301–2, 307, 309; fiscal balance controversy and, 297–99; General Account situation and, 294f, 295; inflation and, 298–99, 301–2; Japa­nese

economists’ views on, 310–11; JGB low yields and, 302–3; Joint Statement and, 350–51; monetary-­fiscal policy crossroads and, 304–5, 311–13; monetary system instability and, 301–2; politics and, 297, 302, 304, 305, 308–10, 344–45, 350–51; price stability and, 293, 302, 303, 309; proreform camp approach to, 298, 299; social security and taxation reform for, 299–301, 304, 308–10, 344–45; spending reduction and, 298, 300, 302; Takahashi Fiscal Policy for, 311–13; tax revenues and, 295–96, 298, 299–301, 304, 308–10, 344–45; worsening fiscal condition and, 293–96, 294f–95f Fisher, Irving, 188–89, 325 FOMC. See Federal Open Market Committee foreign direct investment, 280, 281, 282 foreign exchange market: Bank of Japan Act on authority to intervene in, 84–85, 103; Comprehensive Monetary Easing and intervention in, 237–38; financial imbalances due to, 129–30; foreign currency liquidity risk, 128; G ­ reat East Japan Earthquake effect on, 260–61; key international currency and, 396–97, 409, 410; monetary base and, 103–4; payments and settlement system for (see payments and settlement system); quantitative easing and, 102–6, 105f, 106f; reserves and, 17, 154, 410; settlement risk, 24–25; sterilized vs. unsterilized interventions in, 104; yen appreciation (see yen appreciation). See also exchange rates forward guidance, 88, 91, 98, 100, 112, 237, 240, 292, 366, 368 Framework for the Fund-­Provisioning Mea­sure to Stimulate Bank Lending (Loan Support Program), 344 France: capital requirements in, 321; central bank of, 4, 52, 142, 417; debt crisis effects in, 223; debt outstanding

Index | 507

France (cont.) in, 295f; exchange rates with, 16; GDP in, 208f, 387f; social welfare in, 387f; Stability and Growth Pact and, 226 FRB. See Federal Reserve Board Freddie Mac, 150, 171 Friedman, Milton, 19, 20, 31, 193, 311, 399, 401–2 FSB (Financial Stability Board), 319–20, 465n3 (chap. 16) FSOC (Financial Stability Oversight Council), 330 Fuji Bank, 28 Fujii, Hirohisa, 179 Fujinawa, Kenichi, 60 Fujiwara, Sakuya, 86, 88 Fukai, Eigo, 312–13 Fukuda, Yasuo, 2–3, 153 Fukui, Toshihiko: BIS role of, 26; governorship of, 2–3, 7, 100, 102, 104, 107, 114, 119, 183, 252–54; resignation of, 86 Fukushima Daiichi Nuclear Power Plant accident, 255–71; accident details, 259; accurate communication vs. speculation following, 262–63; business continuity following, 259–60, 269; business production restoration following, 265–66; calls for BOJ financing of reconstruction following, 261–62; cash availability following, 257, 258, 269; dedication of BOJ staff following, 267; earthquake striking, 255–56, 463n1 (chap. 13); economic activity decline following, 263–65; electric com­pany corporate bond effects of, 266–67; electricity shortages following, 259–60, 264, 272; financial market response to, 260–61; financial ser­v ices provision following, 257, 269, 439–40; governorship affected by, 4, 5, 255–71, 317, 318; international support and condolences following, 268; issues highlighted by, 268–69; monetary policy mea­sures

following, 257–58; societal readiness for tail events like, 270–71 Fund-­Provisioning Mea­sure to Support Strengthening the Foundations for Economic Growth (Growth-­Supporting Funding Fa­cil­i­t y), 215–17 G7 (Group of Seven): Eu­ro­pean debt crisis addressed by, 222; financial institution regulations in, 320, 330; foreign exchange market interventions in, 260, 289; global financial crisis response by, 4, 150, 152–53, 175; international meetings and networking of, 3, 4, 141, 152–53, 175, 416, 418 G10 (Group of Ten): financial institution regulations in, 319–20; governor’s participation in, 141–42 G20 (Group of Twenty): financial institution regulations in, 319–20, 330; global financial crisis response by, 175, 177; ­Great East Japan Earthquake response of, 268; international meetings and networking of, 5, 175, 177, 416, 418 GDP. See gross domestic product Geithner, Timothy, 8, 56–57, 168, 170, 172 GEM (Global Economy Meeting), 141–42, 413 George, Eddie, 52 Germany: Berlin Wall in, fall of, 71; capital requirements in, 321; central bank of, 4, 44, 86, 230; current account of, 42; debt outstanding of, 295f; exchange rates of, 16, 276; GDP of, 165, 166f, 167, 207, 208f, 387f; government bond yield of, 162; hyperinflation of, post-­war, 27, 83, 230; inflation of, 27, 83, 86, 87t, 182, 230, 456n8; interest rates of, 41, 46; monetary policy of, 41, 42–43, 46; social welfare of, 387, 387f; Stability and Growth Pact and, 226; ten-­year trea­sury yields, 235f; terms of trade of, 209, 210f; unemployment of, 166f

508 | Index

Gertler, Mark, 368 GFC. See global financial crisis GHOS (Group of Governors and Heads of Supervision), 320, 322, 416 global cooperation of central banks, 406–21; domestic policy-­global economy gap and, 407–10; emerging economies’ perspectives and, 410–11, 417, 419; enlightened self-­interest and, 412–13, 468n5 (chap. 21); exchange rates and, 408–9, 410–11, 412; financial system stability and, 329–30, 406, 415; global central bank and, 409, 467n3 (chap. 21); global imbalances and, 413–14, 415f; growing importance of, 414–16; growing influence of global ­factors necessitating, 406–7; inflation issues and, 406–7, 409–10; international meetings and networking for, 3–5, 25–26, 44–45, 52, 141–42, 152–53, 175–77, 228–29, 237, 262, 286, 329–30, 359, 388–89, 413, 415–20; international policy cooperation and, 412–13, 415, 421; international policy coordination and, 411–12, 415; prospect of, 421; swap lines as, 154–55, 227, 411, 415; US dominance and, 409, 410–11, 413 global credit ­bubble, 107, 114, 115, 140, 173–74 Global Economy Meeting (GEM), 141–42, 413 global financial crisis (GFC, 2007–2009): asset purchases in response to, 252; Bank of Japan’s response to, 153–60; Bear Stearns acquisition and, 3, 136, 149–50, 170; BNP Paribas and, 148–49, 154, 174; ­bubble prevention efforts and, 173–74; coordinated rate cuts in, 163–64; credit easing mea­sures in, 158–61; defined, 149; def lation following, 185, 192, 235; deteriorating economic conditions and higher inflation just a­ fter the onset of, 140–41; discount rate reduction in, 155–58, 163–64; economic activity contraction

in, 165–67, 166f; exchange rate changes in, 161–63, 162f–63f, 173; false dawn following, 175–77, 234–35; financial imbalances buildup before, 127–30; fiscal policy and, 164, 168, 297; G7 meetings on, 4, 150, 152–53, 175; global economy prior to, 115–18, 116f; government-­central bank division of ­labor in, 160–61; differing societal responses to, 381; government initiatives in, 164, 168; governorship affected by, 5, 149–74; G ­ reat Depression compared to, 152, 167–68; interest-­bearing reserves in, 156–58; Japa­nese financial market stability in, 164–65; Lehman ­Brothers’ collapse and (see Lehman ­Brothers’ collapse); liquidity needs in, 151–52, 154–55, 323; mainstream macroeconomic thinking before, 124–26; origins of, 4; payments and settlement system and, 153, 173; stress tests for financial institutions in, 172, 382; subprime mortgage crisis and, 4, 146–47, 149; US authorities’ response to Lehman collapse and, 168–71, 382, 395–97; yen appreciation in, 161–63, 162f, 274, 276 globalization: competition increased with, 196, 215; exchange rates and, 283; international framework for regulatory standards reflecting, 318; Japa­nese economic stagnation in face of, 71; monetary policy challenges with, 6; production location with, 279–80 global standard, 109, 199, 318, 383–85 Goldman Sachs, 8 government bills: Comprehensive Monetary Easing and, 248, 258, 463n9 (chap. 12); foreign exchange market interventions and, 104 government-­BOJ Joint Statement. See Joint Statement of the Government and the Bank of Japan

Index | 509

government bonds: corporate bonds yields spread with, 245, 245f; Eu­ro­pean debt crisis and purchase of, 221, 223, 229–31, 462n4 (chap. 11); Eu­ro­pean debt crisis and yields on, 223, 224, 226; Japa­nese (see Japa­nese Government Bonds) Government Deposit Bureau, 312 governorship: accidental nature of, 2–4; appointment to, 3–4, 18, 78, 86, 133–45, 455n2(pro); book on, 8–12; central bank committees working with, 441–44; as CEO of central bank, 447; code of conduct for, 134–35; Comprehensive Monetary Easing during (see Comprehensive Monetary Easing); Council on Economic and Fiscal Policy participation, 95, 348, 354, 424; deflation during (see deflation); demographic challenges during (see demographics); deputy, 2–3, 18, 78, 86, 133, 153, 357–58, 445, 458n8 (chap. 4); desired traits and qualifications for, 444–45; deteriorating economic conditions and higher inflation in, 140–41; enhancing financial system stability during, 314–33; ethical issues for, 1, 134–35; Eu­ro­pean debt crisis during (see Eu­ro­pean debt crisis); experience as foundation for, 7, 18–19; final month of, 357–60; fiscal sustainability during (see fiscal sustainability); G ­ reat East Japan Earthquake during (see ­Great East Japan Earthquake); international meeting attendance and networking in, 3, 4, 5, 141–42, 152–53, 175–77, 228–29, 237, 262, 286, 329–30, 359, 388–89, 416–20; Joint Statement of the Government and the Bank of Japan during, 334–60; leadership role in, 6–7, 133–37, 445–47; Lehman ­Brothers’ collapse during (see Lehman ­Brothers’ collapse); Monetary Policy Meetings chair, 3, 90, 135–37, 445–47; National Diet relations with, 142–43, 144, 335, 423; Policy Board leadership,

6–7, 133–34, 445–47; productivity issues during (see productivity); public speaking and visitation in, 143–45; resignation and retirement from, 1, 18, 357–58; turbulence during, 4–5; yen appreciation during (see yen appreciation) ­Great Depression of 1930s: book on, 8; deflation and, 96, 119, 184, 189; financial institution regulation following, 321; global financial crisis compared to, 152, 167–68; historical significance of, 27, 83, 184 ­Great East Japan Earthquake, 255–71; accurate communication vs. speculation following, 262–63; business continuity following, 259–60, 269; calls for BOJ financing of reconstruction following, 261–62; cash availability following, 257, 258, 269; death and damage from, 263–64 (see also Fukushima Daiichi Nuclear Power Plant accident); dedication of BOJ staff following, 267; earthquake striking, 255–56, 463n1 (chap. 13); economic activity decline following, 263–65; effects of, generally, 4; electric com­pany corporate bond effects of, 266–67; electricity shortages following, 259–60, 264, 272; financial market response to, 260–61; financial ser­v ices provision following, 257, 269, 439–40; fiscal policy and, 261–62, 293, 297; governorship affected by, 4, 5, 255–71, 317, 318; international support and condolences following, 268; issues highlighted by, 268–69; monetary policy mea­sures following, 257–58; payments and settlement system following, 256, 317, 318, 440; production restoration following, 265–66; societal readiness for tail events like, 270–71 “­Great East Japan Earthquake: Resilience of Society and Determination to Rebuild” speech, 262–63

510 | Index

­ reat Hanshin Earthquake, 257 G ­Great Moderation, 115–30; ­bubble economy and, 31, 41; confidence of power of monetary policy in, 126–27; definition of, 456n20; deflation concerns in US during, 119, 123; financial imbalances buildup during, 127–30; financial institution imbalances in, 129–30; global economy in, 115–18, 116f; “The ­Great Moderation” speech (Bernanke), 121–22, 126; Greenspan-­era monetary policy views in, 122–24, 126–27, 459n12 (chap. 6); housing b ­ ubble in US during, 120–21; illusion of, 115–30; mainstream macroeconomic thinking in, 124–26; reshoring in Japan during, 128; terms of trade in, 118, 118f; Tokyo real estate mini-­bubble in, 128–29; zero interest rate policy in, 88, 123 ­great monetary experiment, 363–72; “Abenomics” and, 365; central bank balance sheet expansion in, 365–66, 366f; deflation avoidance and, 364–65, 371; economic forecasts and assessments of, 363–64, 367–72, 367f; inflation and, 365–72, 367f; Japanification and, 363, 370–71, 372; lessons learned from, 371–72; productivity decline and, 368, 369f; quantitative and qualitative easing in, 365–67 Greece: debt crisis in, 4, 220, 221, 222–23, 228 Greenspan, Alan, 93, 120, 122–23, 127, 404, 436, 459n5 (chap. 6), 459n12 (chap. 6) “The Greenspan Era: Lessons for the ­Future,” 122 gross domestic product (GDP): ­bubble bursting and decline of, 49; capital gains relative to, 30; central bank balance sheet relative to, 366, 366f; current account relative to, 32, 100, 415f, 460n16 (chap. 8); debt relative to, 293, 294f–95f, 295, 297, 298; demographic

changes reflected in, 207–8, 208f, 211, 218; economic forecasts for, 177f; fiscal condition relative to, 293, 294f–95f, 295, 297; global financial crisis and decline of, 165–67, 166f, 375, 375f–76f; ­Great East Japan Earthquake effects on, 264, 265; monetary base relative to, 194f; net international investment relative to, 274; nonperforming loans ratio to, 457n16; per capita, 207–8, 208f, 211, 218, 376f, 387f; purchasing power relative to, 118; real growth rates, 369f, 370, 374–75, 374f–76f; size of economies relative to, 116; social welfare and, 385–87, 387f Group Advocating Reconstruction Financing without Tax Hikes, 261 Group of 7, 10 and 20. See G7; G10; G20 Group of Governors and Heads of Supervision (GHOS), 320, 322, 416 groupthink, 442–43 Growth-­Supporting Funding Fa­cil­i­t y (Fund-­Provisioning Mea­sure to Support Strengthening the Foundations for Economic Growth), 215–17 growth theory, 180 Hashimoto, Ryutaro, 77, 94 Hatoyama, Yukio, 178, 179, 308 Hayakawa, Hideo, 206 Hayami, Masaru, 7, 86, 88, 95, 100, 104, 183 Hayashi, Fumio, 376 Heckman, James, 19 “he­li­cop­ter money,” 119 Herstatt Bank, 321 Hicks, John, 16, 407, 455n2 (chap. 1) Hildebrand, Philipp, 278 Hokkaido Takushoku Bank, 62 Homma, Masaaki, 95 Homma, Tadayo, 51–52, 54, 61 Hong Kong: EMEAP participation from, 419; Hong Kong Monetary Authority stock purchases, 463n6 (chap. 12) Hosokawa, Morihiro, 178

Index | 511

House of Councillors: Bank of Japan appointment approval by, 2, 3, 78; Bud­get Committee of, 143; Financial Affairs Committee of, 143, 426; fiscal policies before, 310, 345; Joint Statement and, 339; monetary policy pressure from, 426; Policy Board member approvals by, 134; po­liti­cal party controlling, 2, 308; Rules and Administration Committee of, 2, 3 House of Representatives: Bank of Japan appointment approval by, 2, 3, 78; Bud­get Committee of, 143; deflation views in, 203; dissolution of, 344–46; Financial Affairs Committee of, 1, 143, 341, 426; fiscal policies before, 310, 344–45; Joint Statement enforceability and, 339; monetary policy pressure from, 426; Policy Board member approvals by, 134; po­liti­cal party controlling, 2, 178, 308, 334; Rules and Administration Committee of, 2, 3 housing b ­ ubble in US, 120–21, 146–47, 174, 459n5 (chap. 6) housing market. See real estate market Hyogo Bank, 61 hysteresis, 71, 72 Ichimada, Hisato, 455n2(pro) Ikeo, Kazuhito, 66–67 IMF. See International Monetary Fund imports: current account surplus and, 44; deflation and falling prices of, 192–93; purchasing power and, 118, 212; terms of trade and, 118, 118f, 458n2 (chap. 6); yen appreciation effects on, 283 incentives or subsidies: for central bank staff, 451; economic theory consideration of, 19; global financial crisis and government provision of, 164; Growth-­ Supporting Funding Fa­cil­i­t y provision of, 216–17; tax breaks as, 297 income: income and asset distribution, 386, 394, 399, 432; per capital, 399;

wages as, 117, 188, 190–91, 192, 213–14, 280, 283, 384–85, 384f, 451 India, central bank of. See Reserve Bank of India Indonesia: EMEAP participation from, 419 Industrial Bank of Japan, 28 Industrial Production Index, 264 industry. See businesses and corporations; specific industries (i.e., steel industry) inflation: ­bubble economy and, 31, 33, 36, 37–41; central bank in­de­pen­dence and, 81, 86; central bank successes and failures with, 400; Consumer Price Index and, 37, 38f, 41, 109f, 141, 182f, 199–201, 340; core rate of, 409–10; deteriorating economic conditions and higher, 140–41; determinants of expected rates of, 195–96, 197f; downgrading economic outlook and, 138–40; economic forecasts on, 357, 367, 367f; exchange rates and, 278–79, 342–43; expected rates of, 195–98, 197f, 199, 202, 204–5, 212–13, 213f, 336; fiscal sustainability and, 298–99, 301–2; German post-­war hyperinflation, 27, 83, 230; global influences on, 406–7, 409–10; global standard for the debate of, 384–85; ­great monetary experiment and, 365–72, 367f; inflation gap, 400–401; interest rates and, 37, 41, 336; international comparison of, 87t; Joint Statement and, 335–43, 345, 348, 350–51, 354–55; long-­term trend of, 181–82, 182f; monetary base and, 195, 198; monetary policy and, 41, 76, 81, 196, 198, 335–43, 345, 348, 350–51, 354–55, 365–72, 393, 400–401, 402–3, 405; per capita potential growth correlation with, 212–13, 213f; price stability and, 93–94, 110, 125, 139, 196, 335, 338, 339–40, 342–43, 350, 354, 400, 430; target rates of (see inflation targets); unconventional monetary policy effects on, 393 Inflation Target Policy (Ito), 97

512 | Index

inflation targets: anchoring expectations to, 197–98, 205; deflation and, 97, 196, 197–98, 199–201, 202, 204–5, 461n31; fine-­tuning vs. minimax strategy and, 403; fiscal policy and, 298, 309–10; global standard for, 109, 199, 384–85; goal vs. target terminology for, 341–42; ­great monetary experiment and, 365–68, 370–71; inflation gap and, 401; Joint Statement and, 335–43, 345, 348, 350–51, 354–55; one-­percent, 340, 357; price stability and, 93–94, 110, 125, 196, 335, 338, 339–40, 342–43, 350, 354, 430; quantitative easing termination and, 109–10; time frame for reaching, 109, 341, 350–51, 354–55; two-­percent, 109–10, 199–201, 335, 337, 340, 345, 348, 350–51, 354–55, 365–67, 370–71, 384–85, 401; yen appreciation and, 279, 342–43 information and communications technology advances, 6, 50, 71, 214–15 interbank funding market: b ­ ubble bursting effects in, 62, 171; central bank influence on, 23–24; defined, 23; discount rate in (see discount rate); global financial crisis and, 147–48, 151, 154–58; Libor-­OIS spread, 147–48, 148f, 151, 154, 164; overnight interest rate in, 23–24, 90, 91, 108, 157, 241 interest-­bearing reserves, 156–58, 248, 250 interest rates: b ­ ubble bursting and, 49–50, 67–68, 69f; b ­ ubble economy and, 33, 37, 40–42, 44, 46; Comprehensive Monetary Easing lowering, 234, 238–41, 244, 246, 352, 463n8 (chap. 12); coordinated rate cuts in developed countries, 163–64; differentials in, 104–5, 162–63, 235, 239, 240, 276–78, 277f, 288, 336; discount rate, 33, 41, 49, 67–68, 69f, 86–87, 136, 141, 155–58, 163–64, 177; exchange rates and, 104–6, 162–63, 235, 276–78, 277f, 285–86, 288, 336; forecasts on, 342; global determination of, 44, 413–14;

housing b ­ ubble in US and, 120; inflation and, 37, 41, 336; interest rate margins, 331–32; on JGBs (see ­under Japa­nese Government Bonds); monetary policy and setting of, 24, 40–42, 49–50, 67–68, 69f, 100–101, 276, 278, 322, 370 (see also Comprehensive Monetary Easing; zero interest rate policy); natu­r al rate of interest, 218, 303, 379, 396, 421; negative, 276, 278, 332, 366, 378–79, 463n8 (chap. 12); negative equity and, 248; overnight, 23–24, 90, 91, 108, 157, 241; quantitative easing and, 98–101, 104–6, 108, 112; risk disclosure, 322–23; risk-­free, 239, 240; risk premiums and, 100, 113, 239, 241, 244, 258, 303, 393; yen appreciation and differentials in, 162–63, 235, 276–78, 277f, 288, 336; zero interest rate policy, 68, 88, 91–93, 98–99, 108, 112, 123, 240–41, 278, 352; zero lower bound of (see zero lower bound (ZLB) of interest rates) international cooperation. See global cooperation of central banks International Monetary Fund (IMF): Article IV Consultations, 37; Bank of Japan’s International Department tracking, 16; economic forecasts and assessment of Japa­nese economy by, 364, 367–68, 372; Eu­ro­pean debt crisis and, 221, 222–23; foreign currency provision by, 411; Global Financial Stability Report, 332–33; government debt calculations by, 295; governor’s participation in meetings of, 176–77, 262; In­de­pen­dent Evaluation Office of, 364, 367–68, 372, 450; international meetings and networking at/by, 176–77, 262, 416, 418; member countries of, 418 international policy coordination, 33, 42, 46, 411–12 iPhone, cost structure of, 213–14 Ireland: debt crisis in, 4, 221, 223 Ishikawa, Tomoko, 360

Index | 513

Issing, Otmar, 198 Issues in the Debates on Monetary Policy (Komiya et al.), 113 Italy: debt crisis in, 4, 221, 223, 224; debt outstanding of, 295, 295f; exchange rates of, 16; GDP of, 387f; social welfare of, 387f Ito, Takatoshi, 97 Iyo Bank, 55 Jackson Hole Economic Symposium, 37, 122–24, 223, 237, 284 James, Harold, 383 Japan: b ­ ubble economy in (see ­bubble bursting; b ­ ubble economy); central bank of (see Bank of Japan); Constitution of, 78–79; demographics of (see demographics); earthquake in (see ­Great East Japan Earthquake); fiscal policy of (see fiscal policy); GDP of (see gross domestic product); inflation vs. deflation in (see deflation; inflation); lessons from economic experiences in (see Japa­nese economic experiences); Ministries in (see Ministry entries); monetary policy in (see monetary policy); po­l iti­c al situation in (see politics and po­liti­cal economy; specific parties) Japan Business Federation, 282, 358 Japan Center for Economic Research, 113 Japa­nese Communist Party, 426 Japa­nese Constitution, 78–79 Japa­nese economic experiences, 373–89; ­bubble economy effects on, 377 (see also ­bubble bursting; b ­ ubble economy); demographics and, 378, 386, 387; employment and wages in, 384–86, 384f; fiscal policy solutions and, 379–80; global standards and, 383–85; gross domestic product comparisons and, 374–75, 374f–76f; knowledge limitations on changing nature of economy as, 377–78; lessons from, 10, 27, 111, 176, 228,

337, 360, 363, 371–73, 377, 380, 388–89; long-­term growth determinants and, 377–78; “lost de­c ades” narrative of, 373–75, 385; roles of economic structure and social contract in interpreting, 382–83, 385; root c­ auses of declining growth trend, 375–76, 378; social welfare and GDP in interpreting, 385–87, 387f, 467n11 (chap. 19); societal responses and, 380–81; zero lower bound of interest rates and, 378–80 Japa­nese Government Bonds (JGBs): accounting issues for central bank holding of, 249–50; Bank of Japan Act on, 304–5; Comprehensive Monetary Easing and purchase of, 234, 240, 242–43, 244–47, 249–50, 258, 352, 365; defaulting on, 301; fiscal sustainability and, 301–5, 311–13, 345; inflation targeting and purchase of, 338; loss of confidence in, 211; monetary base and purchases of, 195; as perpetual bonds, 304–5; prices of, unconventional monetary policy effects on, 392; quantitative easing and, 97, 98, 100–101, 114; settlement of, 153, 260, 261–62; swapping maturing for newly issued, 304–5; yield on, 92, 136, 162, 235f, 239, 245, 245f, 260, 261–62, 302–3, 370 Japa­nese Meteorological Society, 255 Japanification, 10, 363, 370–71, 372, 380 Japan National Press Club, 139, 144 “Japan on the Brink” article (Wolf), 364 Japan Real Estate Institute, 48 Japan Society of Monetary Economics, 119, 252–53, 307 Japan-­US Structural Impediments Initiative, 296 JGBs. See Japa­nese Government Bonds Joint Statement of the Government and the Bank of Japan, 334–60; Abe cabinet and, 346–49; accord on policy via, 338–39; Bank of Japan’s princi­ples

514 | Index

expressed in, 349–51; central bank accountability and, 336, 337; central bank in­de­pen­dence and, 335, 339, 347–48; communication about, 349, 354–55; deflation and, 335, 343–44, 350, 355; developments following, 354–55; economic and price outlook at time of, 355–57, 466n23 (chap. 17); final month following, 357–60; foreign exchange market reaction and, 342–43; general election and po­liti­cal changes affecting, 344–46; inflation targeting and, 335–43, 345, 348, 350–51, 354–55; monetary easing and, 340, 342, 344, 351–53, 354–55; parties to, 339; pro­cess leading to, 334–38; reactions to, 351; time frame for inflation targeting in, 341, 350–51, 354–55; yen depreciation and, 342–43 Jojima, Koriki, 344 Jones, Charles, 218 JPMorgan Chase, 3, 136, 149–50, 170 Juncker, Jean-­Claude, 427 jusen (housing finance companies), 55–56, 61, 64, 171 Kamaishi Shinkin Bank, 55 Kamezaki, Hidetoshi, 134 Kan, Naoto, 179, 222, 236, 256, 259, 308 Kansas City, Federal Reserve Bank, 237 Kato, Koichi, 426 key international currency, 396–97, 409, 410 Kim Choongsoo, 268 King, Mervyn, 4, 8, 337, 413, 439, 447 Kiuchi, Takahide, 349 Kizu credit u ­ nion, 61 Knight, Frank, 258 knowledge: of central bank committee members, 443–44, 444–45; central banks as ever-­learning institutions gathering, 144–45, 439; garnering in the field, 21–22, 263; limitations of, on changing nature of economy, 377–78 Koishikawa Botanical Garden, 1

Koizumi, Junichiro, 296, 335 Komeito Party, 344–45 Komiya, Ryutaro, 16, 46, 112–13, 353, 397–98 ­Korea. See South K ­ orea Koreeda, Hirokazu, 433–34 Krugman, Paul, 378 Kyoto University School of Government, 18 ­labor issues. See employment Lagarde, Christine, 223 Landau, Jean-­Pierre, 383 land prices. See real estate market Laspeyres index, 199 LDP. See Liberal Demo­cratic Party lean-­against-­t he-­w ind stratergy, 124,137 Lehman ­Brothers’ collapse, 146–74; Bank of Japan’s response to, 153–60; bankruptcy filing, 150–51; Bear Stearns acquisition and, 149–50, 170; b ­ ubble prevention efforts and, 173–74; coordinated rate cuts following, 163–64; credit easing mea­sures following, 158–61; economic activity contraction following, 165–67, 166f; economic recovery following, 72; economic turmoil following, 139, 146, 151–52; exchange rates following, 161–63, 162f–63f, 173; G7 response to, 4, 150, 152–53, 175; global financial markets in wake of, 151–52; government-­central bank division of ­labor following, 160–61; government initiatives following, 164, 168; governorship during/after, 4, 139, 146–74; ­Great Depression repeat avoidance following, 167–68; housing ­bubble bursting and, 146–47; interest-­ bearing reserves following, 156–58; Japa­nese ­bubble bursting compared to, 62, 64, 66, 168–72; Japa­nese financial market stability following, 164–65; Japa­nese securities h ­ ouses’ failure vs., 171–72; liquidity needs following, 151–52, 154–55, 323; payments and settlement system following, 153, 173; public funds

Index | 515

Lehman ­Brothers’ collapse (cont.) not provided in the ­handling of, 169–71, 382; stress tests for financial institutions following, 172, 382; subprime mortgage crisis and, 146–47, 149; US authorities’ response to, 168–71, 382, 395–97; yen appreciation following, 161–63, 162f lenders’ responsibility princi­ple, 61 lessons from Japa­nese experiences. See Japa­nese economic experiences leverage, 127–28 Liberal Demo­cratic Party (LDP): Bank of Japan Act amendment proposals by, 348; on deflation, 180, 203; fiscal policies of, 308–10, 344–45; inflation targeting stance of, 345; monetary policy stance in, 345, 346, 426, 468n4; Monetary Policy Subcommittee, 111; po­l iti­c al control by, 2, 334 Libor-­OIS spread, 147–48, 148f, 151, 154, 164 life expectancy, 300, 386, 387 liquidity: central bank providing, 51, 64, 84, 113, 153–54, 168, 171–72, 190, 195, 231–32, 242, 258, 305–6, 323; financial system stability and, 190, 315, 320, 323; foreign currency liquidity risk, 128; global financial crisis and shortage of, 151–52, 154–55, 323; Liquidity Coverage Ratio, 323; quantitative easing and, 323; swap lines for, 154–55, 227, 411, 415 loans: emergency guarantees for, 164; financial institutions providing, 23, 28, 32–34, 36, 38–39, 49–50, 53–59, 61–62, 65–67, 157, 164, 167, 179–80, 315, 322; financial institutions receiving, 51, 54, 57–60, 61–67, 84, 149–51, 154–55, 171–72, 216–17, 305–6, 315, 323, 344, 402 (see also interbank funding market); global financial crisis effects on, 157, 164, 167; nonperforming, 50, 53–59, 61–62, 65–67, 106–8, 457n16, 464n2 (chap. 15); to SMEs, 164, 179–80; subprime

mortgage, 4, 146–47, 149. See also credit; liquidity Loan Support Program (Framework for the Fund-­Provisioning Mea­sure to Stimulate Bank Lending), 344 Longer-­Term Refinancing Operation (LTRO), 221, 224 Long-­Term Credit Bank of Japan (LTCB), 63, 381 “lost de­cades” narrative, 70, 204, 211, 363, 373–75, 385, 433 Louvre Accord, 43, 44–45, 286, 412 lower ­house. See House of Representatives Lucas, Robert, Jr., 19–20, 126–27 Maastricht Treaty, 76, 220–21 macroeconomics: mainstream, 42, 195–97, 205, 328, 336, 373, 429; New Keynesian, 127 macroeconomic slide formula, 300 macroeconomy: ­bubble economy and, 32, 398–99; exchange rates and, 44; financial imbalances destabilizing, 226, 430; financial institution stock purchases stabilizing, 102; inflation of (see inflation); mainstream thinking on, 124–26, 336, 429–30; monetary policy and, 40, 42, 124–26; nonperforming loans and, 57, 58–59, 66; successes and failures of policy management for, 398–400 macroprudential policies and perspective, 57, 323–25, 327, 330–31, 398–400 Made in Amer­i­ca (Dertouzos, Solow, Lester), 32 Maehara, Seiji, 343–44 Maekawa, Haruo, 45 Maekawa Report, 45–46 Maestro (Woodward), 127 Malaysia, 419 Mantega, Guido, 284 Matsushita, Junichi, 60 Matsushita, Yasuo, 86 maturity transformation, 23, 323

516 | Index

“Mea­sures Aimed at Overcoming Deflation” report, 343–44 Mexico: international meeting participation from, 142; swap lines with, 155 Meyer, Larry, 469n12 microprudential policy, 125, 324 Midori Bank, 64 Mieno, Yasushi: on Bank of Japan Act, 75; ­bubble bursting response of, 51, 53, 61, 68; ­bubble economy response of, 40, 41; governorship advice of, 3 military expenditures, 312 minimax strategy, 403, 431 minimum capital requirements, 24, 34, 58, 318–19, 321–22. See also capital requirements Ministerial Council on the Monthly Economic Report, 424 Ministry of Construction (now Ministry of Land, Infrastructure and Transport), 48, 457n2 (chap. 3) Ministry of Economic and Fiscal Policy: Council on Economic and Fiscal Policy participation, 95; deflation stance in, 343; Joint Statement involvement of, 335, 349; monetary policy and, 89 Ministry of Economy, Trade and Industry, 259, 266 Ministry of Finance: Banking Bureau of, 35, 49, 52–53, 54, 84; Bank of Japan bud­get approval by, 79; central bank in­de­pen­ dence and, 76, 81, 423–24; Comprehensive Monetary Easing and, 253; Council on Economic and Fiscal Policy participation, 95; discount rate and, 41; financial institution failure response of, 51, 52–53, 54, 55, 59–62, 64, 66–67; financial institution regulation and supervision by, 46, 49, 51, 74, 84; Financial System Research Council, 51, 77, 78; financial system stability role of, 319; foreign exchange market intervention authority of, 85, 103, 238, 287, 290–91; ­Great East

Japan Earthquake response of, 260; international financial system ­under, 17; JGB issuance by, 305; Joint Statement involvement of, 349, 351; monetary policy role and, 89; Policy Research Institute, 59; taxes u ­ nder (see taxes); wine-­a nd-­dine scandals at, 76, 86; yen appreciation response of, 236 Mishkin, Frederick, 146–47 Mitchell, Wesley, 20 Mitsubishi Estate, 32 Miyazawa, Kiichi, 58, 61, 67 Mizuno, Atsushi, 134 Modern Monetary Policy in Theory and Practice (Shirakawa), 137 Momma, Kazuo, 206 Monet, Jean, 232 monetary base, 90, 103–4, 112, 193–95, 194f, 198, 206, 335, 365, 366f monetary easing: Bank of Japan Act and, 76, 80, 81, 87; ­bubble bursting and, 68–69, 120–21; b ­ ubble economy and, 37–41, 42–44, 46, 76; current accounts and, 165, 460n16 (chap. 8); deflation and, 179, 187, 191–92, 203, 428; essential mechanisms of, 379; exchange rates and, 37, 40–41, 234–37, 238, 276, 278, 284–85, 291–92, 409; financial system stability and, 322, 327–29, 331–32; fiscal sustainability and, 299, 303, 310; a­ fter ­Great East Japan Earthquake, 258; inflation targeting and, 336, 338, 340, 345; Joint Statement and, 340, 342, 344, 351–53, 354–55; key international currency and, 396–97; longer-­term benefits vs. costs of, 393–94; in United States, 120–21, 141, 234, 237, 276, 278, 284–85, 288, 396–97; yen appreciation and, 37, 40–41, 234–37, 238, 276, 278, 284–85, 291–92, 428; zero lower bound of interest rates and, 113, 284, 340, 379–80. See also Comprehensive Monetary Easing

Index | 517

monetary policy: ­under Bank of Japan Act, 88–89, 347; b ­ ubble bursting and, 49–50, 67–70, 81, 120–21, 124; ­bubble economy and, 6, 36–47, 76, 81; challenges to selecting best, 6; change of policy regime, 404–5; communication of, 114, 205–6, 433–34, 440–41 (see also press conferences); critique of, 204–5 (see also international criticisms subentry); economic forecasts supporting, 27; financial system stability responsibilities and, 83–84, 102, 125–26, 338, 401–2; fine-­tuning or optimization strategy for, 402–3, 431; fiscal policy crossroads with, 304–5, 311–13, 423–24, 427, 435; fiscal policy vs., 113, 243; Friedman’s view on role of, 401–2; global cooperation on (see global cooperation of central banks); good judgment in policy making, 397–98; as ­great monetary experiment, 363–72; inflation and, 41, 76, 81, 196, 198, 335–43, 345, 348, 350–51, 354–55, 365–72, 393, 400–401, 402–3, 405; interest rates and, 24, 40–42, 49–50, 67–68, 69f, 100–101, 276, 278, 322, 370 (see also Comprehensive Monetary Easing; zero interest rate policy); international coordination of, 411–12; international criticisms on, 69–70, 119, 124, 147, 363–65, 371–72, 388, 417–18, 459n4 (chap. 6); intricacy of financial policy and, 326–27; Joint Statement on (see Joint Statement of the Government and the Bank of Japan); lessons from Japa­nese experiences with (see Japa­nese economic experiences); meetings on (see Monetary Policy Meetings); minimax strategy for, 403, 431; Monetary Affairs Department and, 18, 27; monetary easing as (see monetary easing); monetary tightening in, 21, 37, 40, 46, 49–50, 81, 198, 405; money multiplier and, 23, 193; objectives of, 77–78, 82–83, 347 (see also

price stability); politics, po­liti­cal economy and, 179–80, 203, 204–5, 236, 237, 306, 468n4 (see also Joint Statement of the Government and the Bank of Japan); quantitative and qualitative easing as, 365–67; quantitative easing as (see quantitative easing); role of, 401–2; structural reform and, 113–14; successes and failures of, 400–401; two perspectives approach to, 111; unconventional (see unconventional monetary policy; specific policies) “Monetary Policy and Asset Price Volatility” (Bernanke), 37 Monetary Policy Meetings (MPMs): Bank of Japan Act and, 89, 133; blackout periods for, 135; Comprehensive Monetary Easing and, 236, 237, 239, 344, 351–53; deflation addressed in, 187–88, 205, 215–16; downgrading economic outlook in, 136, 138–40; economic recovery assessment at, 178; function of, 135; global financial crisis decisions in, 155, 156, 159–60; governor as chair of, 3, 90, 135–37, 445–47; G ­ reat East Japan Earthquake addressed in, 256; Joint Statement raised in, 335, 349, 351; minutes and transcripts of, publication of, 82, 90–91, 458n2 (chap. 5); participants in, 89, 424–25; on quantitative easing, 98, 101–2, 108–9, 111; ­running of, 89–91, 458n1 (chap. 5); yen appreciation addressed in, 276, 278; on zero interest rate policy, 91–92 “Money, Government Securities and a Central Bank: Interde­pen­dency of Confidence” speech, 307 “mop-up strategy,” 124, 137, 398 Monthly Report of Recent Economic and Financial Developments, 91 moral ­hazard, 53–54, 57 Moreau, Émile, 313 MPMs. See Monetary Policy Meetings Mundell, Robert, 408

518 | Index

Murakami, Yasusuke, 15–16 Muto, Toshiro, 2 N-1 prob­lem, 408–9 Nakagawa, Shoichi, 152 Nakahara, Nobuyuki, 99 Nakamura, Seiji, 134 Nakata, Taisuke, 365–67 Nambara, Akira, 39 National Bureau of Economic Research, 20 National Diet: Bank of Japan accountability to, 82; Bank of Japan Act approved by, 75, 77, 86; Comprehensive Monetary Easing stance in, 245; deflation stance in, 209; financial institution failure response in, 62, 63; fiscal policy before, 243, 308–9, 344–45; governorship relations with, 142–43, 144, 335, 423; G ­ reat East Japan Earthquake response bud­get passed in, 261; House of Councilors of (see House of Councilors); House of Representatives of (see House of Representatives); Joint Statement before, 339, 354–55; monetary policy pressure from, 203, 204, 306, 335, 426–27, 468n4; yen appreciation concerns of, 236, 237, 279 National Institute of Population and Social Security Research, 207 natu­ral rate of interest, 218, 303, 379, 396, 421 negative equity, 53–54, 64, 247–48, 250, 251–52, 463n9 (chap. 12) Netherlands Bank, 52 New Keynesian economics, 127, 297, 400, 402–3 New Komeito Party, 310 New York Fed. See Federal Reserve Bank of New York New Zealand: central bank structure in, 441; EMEAP participation from, 419; inflation targets in, 125; swap lines with, 155 Nikkei Index: Black Monday effects on, 28, 40–41; ­bubble bursting and, 48; ­bubble economy and, 28, 40–41;

economic recovery from low of, 178; ­Great East Japan Earthquake effect on, 260; rebounding of, 107, 357 Nippon Telegraph and Telephone, 28 Nishimura, Kiyohiko, 2, 134 Nixon Shock, 17 Noda, Tadao, 134 Noda, Yoshihiko, 236, 260, 309–10, 343, 344–45 nonbank financial institutions: jusen as, 55–56, 61, 64, 171; lending to, 33, 49, 55–56, 64; resolution of, 61–62, 64 Northern Rock, 148–49 Norway: swap lines with, 155 Noyer, Christian, 4, 417 nuclear accident. See Fukushima Daiichi Nuclear Power Plant accident Nuclear and Industrial Safety Agency, 259 Nukaga, Fukushiro, 3 Occupy Wall Street movement, 432 oil industry: ­f utures market prices, 141, 180; reverse oil shock in, 37 Okina, Kunio, 30 OMT (Outright Monetary Transaction), 221, 225, 229–31, 232 “only game in town, the,” 431 Onogi, Katsunobu, 381 Organisation for Economic Co-­operation and Development, 386 orga­nizational issues in central banks, 436–52; banking ser­v ices provision as, 145, 439–40; committee structure as, 441–44; ever-­learning nature of central banks as, 144–45, 439; governorship as, 444–47; in­de­pen­dence as, 437–38; institution of probity role as, 440–41; legitimacy of in­de­pen­dence as, 438; meta­phors for central banker role, 436–37, 468–69n2 (chap. 23); necessary virtues of central bank as, 438–41; staff roles and contributions as, 448–51; three pillars of central bank, 441–51

Index | 519

Outlook and Risk Assessment of the Economy and Prices report, 93, 136, 138–40, 186, 458n7 (chap. 5) output gap, 28, 37, 148, 195–96, 202, 357, 400–401, 402–3, 407 Outright Monetary Transaction (OMT), 221, 225, 229–31, 232 overnight interest rates: central bank’s operational target, 23–24; Financial Markets Department and, 90; quantitative easing and, 108, 157; zero interest rate policy and, 91, 108, 241 P&A. See purchase and assumption Panic of 1907, 321 Patrikis, Ernest, 52 Paulson, Hank, Jr., 4, 8, 150, 152, 168, 170 payments and settlement system: BOJ-­NET for, 153, 256, 317; central bank policy on, 24–25, 84; Financial System Department addressing, 51; financial system stability with efficient and resilient, 317–18; global cooperation of central banks on, 415; global financial crisis and, 153, 173; ­Great East Japan Earthquake and, 256, 317, 318, 440 ­People’s Bank of China, 420 ­People’s New Party, 178 P/E (price-­to-­earnings) ratio, 30 Personal Consumption Expenditure (PCE) deflator, 335 Philippines: EMEAP participation from, 419 Phillips curve, 195–96, 202, 401 Plaza Accord: b ­ ubble economy and, 28, 37, 40, 42–43, 44–45; foreign exchange market interventions following, 286; as international policy coordination, 412 Policy Board: appointment to, 78; Bank of Japan Act on, 75, 78, 84, 89, 133–34; code of conduct for, 134–35; function of, 133–34, 443; governor’s leadership of, 6–7, 133–34, 445–47; Joint Statement with, 339, 348, 349, 351; membership of, 133, 134;

Monetary Affairs Department supporting, 18; monetary policy decisions (see monetary policy); Monetary Policy Meetings of (see Monetary Policy Meetings); price stability defined by, 93–94; tenure of members on, 449 policy duration effect, 91 policy rate: coordinated rate cuts in developed countries, 163–64; deteriorating economic conditions and, 141; economic recovery and changes to, 177; global financial crisis and reduction of, 155–58, 163–64 politics and po­liti­cal economy: b ­ ubble bursting response and, 67; b ­ ubble economy and, 30, 35, 41–42; central bank in­de­pen­dence and, 76, 422–23, 426–27, 468n4; central bank influenced by, 252–53, 426–27, 468n4; deflation and, 175, 178–81, 183, 203, 204–5, 335, 343–44; Eu­ro­pean Union and, 220, 228; exchange rate policies subject to, 289–90; fiscal sustainability and, 297, 302, 304, 305, 308–10, 344–45, 350–51; general election in, 344–46; governorship and, 2–3, 5, 9, 153, 178–79, 426–27; ­Great East Japan Earthquake reconstruction influenced by, 261; “Joint Statement” pressures from (see Joint Statement of the Government and the Bank of Japan); monetary policy and, 179–80, 203, 204–5, 236, 237, 306, 468n4 (see also Joint Statement of the Government and the Bank of Japan); po­liti­cal autonomy index, 458n6 (chap. 4); societal pressures influencing, 427, 432. See also House of Councilors; House of Representatives; National Diet; specific parties population changes. See demographics Portugal: debt crisis in, 4, 223 Posen, Adam, 468–69n2 (chap. 23) positive supply shock, 192

520 | Index

Powell, Jerome, 377–78 Prescott, Edward, 376 press conferences: Bank of Japan accountability via, 82; central bank in­de­pen­dence addressed in, 346; deflation addressed in, 185, 187, 202, 215–16; government comments on monetary policy in, 425; governor’s final, 1, 359–60; governor’s first, 3; governor’s resignation addressed in, 358; governor’s responsibility for, 144; ­Great East Japan Earthquake response addressed in, 260; inf lation targeting addressed in, 340; Joint Statement addressed in, 349, 354; monetary base addressed at, 195; Monetary Policy Meeting outcomes at, 90–91, 136–37, 140, 345–46 prices: competitiveness affecting, 182–83, 192, 200, 204, 209, 212–15; consumer (see Consumer Price Index); deflation of (see deflation); of exports, 209, 210f, 212; financial asset, unconventional monetary policy effects on, 391–92; inflation of (see inf lation); long-­r un trends in Japa­nese, 181–83, 182f; lower growth expectations and declining, 212–15; oil industry ­futures market, 141, 180; origins of declining, in Japan, 191–93; Outlook Report on, 93, 136, 138–40, 186, 458n7 (chap. 5); public perception of, 198–99; real estate, reports on, 35–37, 39–40, 48; stability of (see price stability) price stability: achievement of, 86; b ­ ubble economy and, 36; defining, 93–94, 335; financial system stability inseparability from, 84, 125–26, 314, 325–26, 429–30; fiscal sustainability and, 293, 302, 303, 309; inflation and, 93–94, 110, 125, 139, 196, 335, 338, 339–40, 342–43, 350, 354, 400, 430; mainstream thinking on, 124–26; monetary policy objective of, 24, 42, 76, 77–78, 80, 82–84, 110, 122, 124–26, 225, 303, 326, 338, 347, 400, 430;

“The Price Stability Goal in the Medium to Long Term” report on, 339–40; Understanding of Medium-­to Long-­ term, 110, 139, 188, 199, 200, 240 “The Price Stability Goal in the Medium to Long Term” report, 339–40 price theory, 19 price-­to-­earnings (P/E) ratio, 30 Princi­ples for Financial Market Infrastructure, 415 probity, central bank as institution of, 440–41 productivity: ­bubble bursting, adaptations of businesses and, 32, 72; deflation effects on, 203; demographic decline affecting, 217–18, 300; g­ reat monetary experiment and, 368, 369f; raising of, 203, 214, 217; reshoring and, 128, 280–81; restoration of post-­Great East Japan Earthquake, 265–66; root c­ auses of decline in, 376; standard growth theory on, 180; trend growth determined by, 124; Public Finance Act, 304 Public Opinion Survey on the Life of the ­People, 399 punctuality, 386 purchase and assumption (P&A): emergency funding for, 3, 60, 136, 149–50, 170; of failed financial institutions, 3, 52, 53, 55, 59, 60, 170 quantitative and qualitative easing (QQE), 365–67 quantitative easing (QE), 97–114; adoption of, 97–98; Bank’s view of quantity and, 98–100, 352–53; central bank accountability and in­de­pen­dence issues with, 110, 113–14; Comprehensive Monetary Easing distinguished, 244; Consumer Price Index and, 99, 108, 109f, 111, 183; costs and benefits of, 112–13; current accounts and, 98–100, 103–4, 112, 114; economic and monetary conditions

Index | 521

quantitative easing (QE) (cont.) during the period of, 106–8; effectiveness of, 100–102, 112; efforts to increase effectiveness of, 100–102; exchange rates and, 102–6, 105f, 106f, 284; foreign exchange market and, 102–6, 105f, 106f; global financial crisis response from experience with, 157; international criticism of, 417, 418; JGB purchases and, 97, 98, 100–101, 114; liquidity and, 323; monetary base and, 103–4, 112; overview of, 88; pillars of, 98; reactions to termination of, 111; Securities Market Programme distinguished, 223; termination of, 108–10, 111, 129, 158; yen carry trade and, 105–6; zero interest rate policy and, 98–99, 108, 112 Quarles, Randal, 465n4 (chap. 16) quasi-­fiscal policy, 160, 243, 427, 432 Quarterly Japa­nese Economic Model, 127 rational expectation, theory of, 20 Reagan, Ronald, 42 real economy, unconventional monetary policy effects on, 392–93 real estate market: Bank of Japan report on, 35–37, 39–40; ­bubble bursting and, 48–49, 49f, 457n1 (chap. 3); ­bubble economy and, 28–30, 29f, 33–40, 46, 48, 49f, 51; housing b ­ ubble in US, 120–21, 146–47, 174, 459n5 (chap. 6); housing finance companies and, 55–56, 61, 64, 171; lending to, 33, 49, 55, 61; real estate investment trusts, 241, 242–43, 244, 258; rebounding of, 107; subprime mortgages in, 4, 146–47, 149; taxes on, 34; Tokyo mini-­bubble in, 128–29 “Recent Increases in Japa­nese Real Estate Prices and Their Consequences” report, 35–37, 39–40 redundancy prob­lem, 408–9 “reflationistas” (rifure-­ha), 204–5, 239, 242–43, 309, 336

Rehn, Olli, 371 Reinhart, Carmen, 395 Reis, Ricardo, 122 Renesas Electronics, 265, 269 Reserve Bank of Australia, 279 Reserve Bank of India: international meeting participation from, 142; structure of, 441; Subbarao leading, 8, 411, 417, 419; swap lines with, 411 reshoring, 128, 280–81 Resolution and Collection Corporation, 60 Resolution Trust Corporation, 52 rifure-­ha (“reflationistas”), 204–5, 239, 242–43, 309, 336 “rising-­tide-­lifts-­a ll boats” school (ageshio), 298 risk assets, 234, 370 Rocke­fel­ler Center, 32 Rogoff, Kenneth, 395 rokujuku (sixfold suffering), 272–73, 281 “The Role of Monetary Policy” speech (Friedman), 401–2 Roth, Jean-­Pierre, 464n3 (chap. 14) Rules and Administration Committees, 2, 3 safe-­haven currency, 163, 226, 274, 276, 288, 343 Samuelson, Paul, 15 Sanyo Securities, 62, 171–72 Sato, Takehiro, 349 savings rate, 191, 286, 413–14 Schiller, Robert, 30, 209 Schulz, Theodore, 19 “The Secondary Banking Crisis in the United Kingdom in the Early 1970s” report, 39 Securing Financial Soundness Act (Act on Mea­sures for Rapidly Securing the Soundness of Financial Functions), 63 Securities Market Programme (SMP), 221, 223, 229–30 Securitization Market Forum, 102 seigniorage, 248, 251–52

522 | Index

Semiannual Report on Currency and Monetary Control, 82 semiconductor industry, 31 separation princi­ple, 84, 125–26, 314, 325–29, 429–30, 450 Seventy Years in Retrospect (Fukai), 312–13 shadow banking, 174, 320, 327 Shirakawa, Masaaki: ­career building years of (see ­career building years); education of, 15–16, 19–20; ­family of, 20; governorship of (see governorship) Shiratsuka, Shigenori, 30 Simons, Henry, 393–94 Singapore: EMEAP participation from, 419; swap lines with, 155 sixfold suffering (rokujuku), 272–73, 281 small-­and medium-­size enterprises (SMEs), lending to, 164, 179–80 Smithsonian Agreement, 17 SMP (Securities Market Programme), 221, 223, 229–30 SNB. See Swiss National Bank social contracts, 215, 233, 301, 382–83, 385, 397 Social Demo­cratic Party, 178 social dominance, 359, 427 social fragmentation, 432 social security: demographics and expenses for, 211, 293, 295, 300; macroeconomic slide formula for, 300; reform of, 299–301, 304, 308–10, 344 social welfare, 385–87, 387f, 399, 400–401, 440, 467n11 (chap. 19) societal issues: capacity to manage costs or side effects of UMP, 397; Eu­ro­pean Union social integration as, 232–33; exchange rate policies creating, 290; fiscal sustainability and, 300–301, 302; fragmentation as, 432; income and asset distribution as, 386, 394, 399, 432; social contracts as, 215, 233, 301, 382–83, 385, 397; social dominance as, 359, 427; social welfare as, 385–87, 399, 400–401, 440, 467n11

(chap. 19); societal pressures on central banks as, 427; societal readiness for tail events as, 270–71; societal responses ­a fter ­bubble bursting as, 46–47, 380–81 Solow, Robert, 32 “Some Thought on Monetary Policy in Japan” speech, 119 Sony, 32 South K ­ orea: central bank of, 268, 420; EMEAP participation from, 419; exchange rate in, 162, 163f, 275f, 356f; reciprocal foreign currency financing with, 411; swap lines with, 155 Spain: debt crisis in, 4, 221, 223, 224–25 Special Funds-­Supplying Operations to Facilitate Corporate Financing, 159 sponsors’ responsibility princi­ple, 61 Stability and Growth Pact, 225, 226 staff of central bank: breaking silo culture among, 450–51; compensation of, 451; dedication of, following ­Great East Japan Earthquake, 267; input to board members from, 448–49; institutional memory of, 449–50; satisfaction in public ser­v ice of, 451; Shirakawa as (see ­career building years) stagflation, 76, 141, 181–82, 403, 457n2 (chap. 4) stagnation of economy, 70–72, 121, 174, 183, 227, 293, 296, 368. See also “lost de­cades” narrative Stansbury, Anna, 368 steel industry, 21–22, 168 Stigler, George, 19 stock market: Black Monday effects on, 28, 40–41; ­bubble bursting and, 48, 55, 457n1 (chap. 3); b ­ ubble economy and, 28, 30, 35–36, 40–41; economic recovery from low of, 178; global financial crisis effects on, 151, 164–65, 176; ­Great East Japan Earthquake effect on, 260, 262; rebounding of, 107, 357 Stress Test (Geithner), 172

Index | 523

stress tests, 172, 224, 382 Subbarao, Duvvuri, 8, 411, 417, 419 subprime mortgage crisis, 4, 146–47, 149 subsidies. See incentives or subsidies Suda, Miyako, 134, 247 Sumitomo Bank, 28 Summers, Lawrence “Larry,” 148, 368, 374, 387–88 sustainability of government finances. See fiscal sustainability Svensson, Lars, 102 swap lines, 154–55, 227, 411, 415 Sweden: b ­ ubble economy in, 30; central bank of, 93, 155, 278; inflation in, 456n8; swap lines with, 155 Swedish Riksbank: interest rates changes, 93, 278; swap lines with, 155 Swiss National Bank (SNB): capital of, 463n10 (chap. 12); foreign exchange market authority of, 85; franc appreciation experiment by, 288–90, 392, 464n13 (chap. 14); interest rates of, 278, 288; swap lines with, 154 Switzerland: capital requirements in, 321; central bank of (see Swiss National Bank); exchange rate in, 162, 163f, 273, 275f, 276, 287, 288–90, 356f, 392, 408–9; franc, as safe-­haven currency, 273, 276, 278, 288, 464n3 (chap. 14); inflation in, 456n8; terms of trade in, 209 Tachi, Ryuichiro, 77 Takahashi, Korekiyo, 311–12 Takahashi Fiscal Policy, 311–13 Takenaka, Heizo, 108, 335 Takenaka Plan (Financial Regeneration Program), 108 Takeshita, Noboru, 42, 43 Tamaki, Takashi, 56 Tanigaki, Teiichi, 345 Tankan survey, 28, 50, 91, 107, 165, 455n2 (chap. 2)

target rate of inf lation. See inf lation targets taxes: bank losses and, 66; b ­ ubble economy affected by, 34; capital gains, 34; consumption, 41, 139, 182, 222, 296, 308–10, 344–45; corporate income, 22–23, 272, 296; effect on fiscal sustainability through change in receipt of, 295–96, 298, 299–301, 304, 308–10, 344–45; Eu­ro­pean debt crisis and receipts of, 221; flow through central bank account, 22–23; incentives via tax breaks, 297; personal withholding, 23; real estate, 34; reform of taxation, 299–301, 304, 308–10, 344–45 Taylor, Bill, 52 Taylor rule, 68, 467n3 (chap. 21) technology advances, 6, 50, 71, 196, 214–15, 299, 376, 439 TEPCO (Tokyo Electric Power Com­pany), 259–60, 264, 266–67 terms of trade, 118, 118f, 209, 210f, 212, 458n2 (chap. 6) Tett, Gillian, 126, 381 Thailand: central bank of, 268; EMEAP participation from, 419 This Time Is Dif­fer­ent (Reinhart and Rogoff), 395 Tietmeyer, Hans, 44–45 Tohoku Electric Power Com­pany, 264 Toho Sogo Bank, 55 Tokuyo City Bank, 62 Tokyo District Court, 153 Tokyo Electric Power Com­pany (TEPCO), 259–60, 264, 266–67 Tokyo Kyodo Bank, 60, 61, 64 Tokyo Kyowa credit ­union, 61 Tokyo Stock Exchange, 262 “­Toward Strengthening the Competitiveness and Growth Potential of Japan’s Economy” speech, 358–59 Toyo Shinkin Bank, 55 ­Toyota, 154

524 | Index

trade: exports (see exports); global financial crisis contraction of, 165, 167; ­Great East Japan Earthquake effects on, 264, 265–66; imports, 44, 118, 192–93, 212, 283, 458n2 (chap. 6); protectionist policies and, 32, 43, 44, 412; terms of, 118, 118f, 209, 210f, 212, 458n2 (chap. 6) tragedy of the commons, 316–17, 326 train ser­v ice, punctuality of, 386 transparency, 82, 90–91, 342, 430–31, 433–34 Treaty of Maastricht, 76, 220–21 Trichet, Jean-­Claude, 4, 142 Troubled Asset Relief Program, 382 Tsuchida, Masaaki, 53 tsunami. See Fukushima Daiichi Nuclear Power Plant accident Tucker, Paul, 86 Ueda, Kazuo, 99 unconventional monetary policy (UMP): communication of, 433–34; criteria for assessing effectiveness of, 390–94; definition of, 91; exit mechanisms for, 242; financial asset price effects of, 391–92; financial system stability effects of, 391, 394; fiscal policy and, 394, 427; key international currency and, 396–97; legitimacy of central bank’s implementing, 247, 392; longer-­term benefits vs. costs of, 393–94; nature and duration of shock affecting the effect of, 395–96; origins and adoption of, 88, 388; real economy and inflation rate effects of, 392–93; reasons for differing views on, 395–97; Shirakawa’s assessment of, 394–95; societal capacity to manage costs or side effects of, 397. See also Comprehensive Monetary Easing; forward guidance; ­great monetary experiment; quantitative easing; zero interest rate policy Understanding of Medium-­to Long-­term Price Stability, 110, 139, 188, 199, 200, 240

“Understanding the Greenspan Standard” (Blinder and Reis), 122 unelected officials, 383, 390, 397, 438 unemployment: deflation and, 188, 189, 191, 192; economic recovery and lowering of, 178; employment adjustment subsidies for avoiding, 164; Eu­ro­pean debt crisis effects on, 221; global financial crisis and, 164, 165, 166f, 382 United Kingdom: capital requirements of, 321; central bank of (see Bank of ­England); debt outstanding of, 295f; exchange rate of, 162, 163f, 275f, 356f; financial institution regulation and supervision of, 84, 126, 330; Financial Ser­vices Authority, 84, 330; GDP of, 166f, 208f, 374, 374f–76f, 387f; inflation of, 86, 87t, 456n8; Northern Rock bank run in, 148–49; payments system policy with, 24–25; report on secondary banking crisis in, 39; social welfare of, 387f; ten-­year trea­sury yields, 235f; unemployment of, 166f United States: capital requirements of, 321, 459n19 (chap. 6); confidence of power of monetary policy in, 126–27; corporate-­ government bonds yields spread in, 245f; criticisms of Japa­nese monetary policy in, 70, 119, 364, 371, 459n4 (chap. 6); current account of, 42, 45–46, 413–14, 415f, 456n29, 460n16 (chap. 8); debt outstanding of, 295f; deflation and deflation stance in, 119, 123, 189–90, 202, 215, 364–65; demographics of, 396, 397; dollar as key international currency, 396–97, 409, 410; dot-­com b ­ ubble in, 30, 88, 97, 115, 121, 459n12 (chap. 6); employment practices and wages in, 384–85, 384f; exchange rates in relation to US dollar, 16, 17, 41–43, 44, 103, 105f, 162, 162f–63f, 235, 275f, 283–88, 356f, 396–97, 408–9; Federal Reserve of (see Federal Reserve Board); financial institution regulatory reforms in, 330; fiscal policy of, 310;

Index | 525

United States (cont.) FOMC of (see Federal Open Market Committee); foreign exchange market authority in, 85, 238, 291, 464n15 (chap. 14); GDP of, 165, 166f, 177f, 208f, 374–75, 374f–76f, 386–87, 387f; global influence of, 407, 409, 410–11, 413; government bond yield of, 162, 245f, 370; G ­ reat Depression in (see ­Great Depression of 1930s); ­Great East Japan Earthquake supply chain effects in, 264; G ­ reat Moderation in, 41, 119–27; housing ­bubble in, 120–21, 146–47, 174, 459n5 (chap. 6); inflation in, 86, 87t, 405, 456n8; interest rates in, 41, 46, 120, 123, 123f, 246, 276, 278, 285–86, 396, 413–14; Iraq invasion by, 100; Japa­nese economic relations with, 32, 42, 44; Japa ­nese industry vs., 31–32; Japa­nese views of economy in, 139; Lehman ­Brothers’ collapse in (see Lehman ­Brothers’ collapse); methodology for financial institution failure in, 52, 53, 149–50; monetary base in, 193–95, 194f; protectionist policies in, 32, 43, 44, 412; response to Eu­ro­pean debt crisis, 228, 383; social welfare of, 387, 387f; subprime mortgage crisis in, 4, 146–47, 149; terms of trade of, 210f; Trea­sury Department of (see United States Trea­sury); unconventional monetary policy in, 395–97; unemployment of, 166f, 191, 382 United States Trea­sury: Baker at, 43; credit easing mea­sures by, 161; foreign exchange market authority of, 85, 238, 291, 464n15 (chap. 14); FRB accord with, 339; FRB in­de­pen­dence from, 87, 339; FSOC headed by Secretary of, 330; Geithner at, 8, 56–57; global financial crisis response by, 168–71; Paulson at, 4, 8, 150, 152; securities of, 285, 339; Summers at, 368; temporary guarantee scheme by, 151; ten-­year trea­sury yields, 235, 235f. See also specific Secretaries

University of Chicago, 19–20 University of Tokyo, 15–16 upper ­house. See House of Councilors Value and Capital (Hicks), 16 Volcker, Paul, 93, 190, 330, 405, 445, 446 wages. See ­under employment Washington Mutual, 151 “Way Out of Economic and Financial Crisis: Lessons and Policy Actions” speech, 176 Weber, Axel, 4 Weidmann, Jens, 198 West Germany: Berlin Wall in, fall of, 71; central bank of, 4, 44, 86, 230; current account of, 42; inflation of, 86, 87t, 182; interest rates in, 41, 46; monetary policy of, 41, 42–43, 46. See also Germany West Texas Intermediate (WTI) crude oil ­f utures index, 180 White, William, 124 win­dow guidance, 327, 455n3 (chap. 1), 465n8 (chap. 16) wine-­a nd-­dine scandals, 76, 86 Wolf, Martin, 364, 368 Woodward, Bob, 127 World Bank, 176, 262 Yamaguchi, Hirohide, 101, 134, 153, 237, 256, 259, 263, 349 Yamaguchi, Yutaka, 26, 37, 68, 86, 89, 99, 101 Yamaichi Securities, 62, 64, 171–72 Yamamoto, Kenzo, 256 Yamamoto, Kozo, 111, 341 Yellen, Janet, 196 yen appreciation, 272–92; in ­bubble economy, 37, 40–43; communication on, 290–91; Comprehensive Monetary Easing and, 234–37, 238; deflation and, 180, 184–85, 192, 203–4, 278–79; developed economies’ views of, 284, 286–88; economic activity contraction and,

526 | Index

165–66; economic “hollowing out” concerns with, 279–81; emerging economies’ views of, 284, 285–86; Eu­ro­pean debt crisis and, 226–27, 272, 274, 343, 355–56; foreign exchange market interventions on, 238, 260, 284; global financial crisis and, 161–63, 162f, 274, 276; inflation targeting and, 279, 342–43; interest rate differentials and, 162–63, 235, 276–78, 277f, 288, 336; Lehman B ­ rothers’ collapse and, 161–63, 162f; Louvre Accord and, 43; manufacturing business frustration with, 281–82; monetary easing and, 37, 40–41, 234–37, 238, 276, 278, 284–85, 291–92, 428; monetary policy critique for, 204, 236, 279; Plaza Accord and, 37, 40, 42–43; policy proposals for halting, 291–92; post-2000 exchange rate developments and, 273–74, 275f; public opinion on, 282–83; purchasing power parity and, 278–79; sixfold suffering with, 272–73, 281; Smithsonian Agreement and, 17; Swiss franc appreciation response applicability to, 288–90; yen as safe-­haven currency and, 162–63, 226–27, 274, 276, 278, 288, 343, 355

yen carry trade, 105–6 Yosano, Kaoru, 153, 309 Zengin System, 317 zero interest rate policy, 91–93; adoption of, 91–92; ­bubble bursting lead to, 68; Comprehensive Monetary Easing and, 240–41, 352; overview of, 88; quantitative easing and, 98–99, 108, 112; termination of, 92–93; in US, 123, 123f; yen appreciation and, 278 zero lower bound (ZLB) of interest rates, deflation and, 123, 189, 195, 200–201, 378; exchange rate implications of, 276–78, 284–85, 408; foreign exchange market interventions and, 85; inflation targeting and, 336; interest rate margins and, 332; lessons from Japa­nese economic experiences with, 378–80; monetary easing and, 113, 284, 340, 379–80; as monetary policy constraint, 378–79; N-1 or redundancy prob­lem and, 408–9; yen appreciation and, 276, 278, 284; zero interest rate policy and, 90, 91 zombie firms, 72, 376

Index | 527