Monetary Policies in the Age of Uncertainty (SpringerBriefs in Economics) 9811641455, 9789811641459

Table of contents :
Preface
Acknowledgments
Contents
About the Authors
1 Effects of Unconventional Monetary Policy and Inflation Target
1.1 Introduction
1.2 Quantitative and Qualitative Monetary Easing (QQE)
1.3 Inflation Target
1.4 Conclusion
References
2 Central Bank Independence in a Changing Environment
2.1 Introduction
2.2 Central Bank Independence in the 1990s
2.3 Changing Environment
2.3.1 Deflation
2.3.2 Relationship with Fiscal Policy
2.3.3 Fiscal Dominance
2.3.4 Reassigning Responsibility for Financial Stability
2.3.5 Politicized Economy
2.4 Proposal of Constitutional Model
2.4.1 Constitutional Model
2.4.2 Central Bank Independence and Democracy
2.4.3 Active, Not Passive, Independence
2.4.4 Constitutional Reform as History
2.4.5 Practices of Central Banking in a Constitutional Model
2.5 The Central Bank Independence: Japanese Case
2.5.1 Unfortunate Start
2.5.2 Deflation
2.5.3 Abenomics
2.5.4 Proposal for Restoration of Independence Under Abenomics
2.6 Conclusion: Future of the Central Bank
Appendix A: Culture, Democracy and Central Banking
Introduction
What is a Central Bank?
The Market Economy and Democracy
Central Bank Culture
Constitutions and Central Banks
Constitutions and Central Banks
Conclusion
Appendix B: The Historical Development of the Bank of Japan Law: A Political Economics Analysis
Introduction
Period of the Former Bank of Japan Laws
Period of the Former Bank of Japan Act
The Current Bank of Japan Law
Problems with the Current Bank of Japan Law
References
3 Japanese Experiences and an International Comparison
3.1 Introduction
3.2 Quantitative and Qualitative Monetary Easing (QQE)
3.2.1 Quantitative Versus Qualitative
3.2.2 Central Bank Balance Sheet Size or Quantitative Easing
3.2.3 Composition of Central Bank Balance Sheets (Qualitative Easing)
3.3 Negative Nominal Interest Rates
3.3.1 Forward-Looking Monetary Policy
3.3.2 Nominal and Real Interest Rates
3.3.3 Japanese Problem (1): Low Labor Productivity
3.3.4 Japanese Problem (2): An Increasing Number of Non-regular Workers
3.4 Yield Curve Control
3.4.1 The Yield Curve
3.4.2 Yield Curve Control (YCC)
3.4.3 An International Comparison of Yield Curve Control
3.5 Concluding Remarks
References
Afterword

Citation preview

SPRINGER BRIEFS IN ECONOMICS KOBE UNIVERSIT Y SOCIAL SCIENCE RESEARCH SERIES

Yoichi Matsubayashi Tamotsu Nakamura Kosuke Aoki Wataru Takahashi

Monetary Policies in the Age of Uncertainty

SpringerBriefs in Economics Kobe University Social Science Research Series

Series Editors Yunfang Hu, Kobe University Graduate School of Economics, Kobe, Japan Shigeyuki Hamori, Kobe University Graduate School of Economics, Kobe, Japan Editorial Board Masahiro Enomoto, Kobe University RIEB, Kobe, Japan Yoshihide Fujioka, Kobe University Graduate School of Economics, Kobe, Japan Yuka Kaneko, Kobe University Graduate School of International Cooperation Studies, Kobe, Japan Kazumi Suzuki, Kobe University Graduate School of Business Administration, Kobe, Japan Kenji Yamamoto, Kobe University Graduate School of Law, Kobe, Japan

The Kobe University Social Science Research Series has been established as a subseries of the SpringerBrief in Economics Series, but in fact this exciting interdisciplinary collection encompasses scholarly research not only in the economics but also in law, political science, business and management, accounting, international relations, and other subdisciplines within the social sciences. As a national university with a special strength in the social sciences, Kobe University actively promotes interdisciplinary research. This series is not limited only to research emerging from Kobe University’s faculties of social sciences but also welcomes cross-disciplinary research that integrates studies in the arts and sciences. Kobe University, founded in 1902, is the second oldest national higher education institution for commerce in Japan and is now a preeminent institution for social science research and education in the country. Currently, the social sciences section includes four faculties — Law, Economics, Business Administration, and International Cooperation Studies — and the Research Institute for Economics and Business Administration (RIEB). There are some 230-plus researchers who belong to these faculties and conduct joint research through the Center for Social Systems Innovation and the Organization for Advanced and Integrated Research, Kobe University. This book series comprises academic works by researchers in the social sciences at Kobe University as well as their collaborators at affiliated institutions, Kobe University alumni and their colleagues, and renowned scholars from around the world who have worked with academic staff at Kobe University. Although traditionally the research of Japanese scholars has been publicized mainly in the Japanese language, Kobe University strives to promote publication and dissemination of works in English in order to further contribute to the global academic community.

More information about this subseries at http://www.springer.com/series/15423

Yoichi Matsubayashi · Tamotsu Nakamura · Kosuke Aoki · Wataru Takahashi

Monetary Policies in the Age of Uncertainty

Yoichi Matsubayashi Graduate School of Economics Kobe University Kobe, Japan

Tamotsu Nakamura Graduate School of Economics Kobe University Kobe, Japan

Kosuke Aoki Graduate School of Economics University of Tokyo Tokyo, Japan

Wataru Takahashi Faculty of Economics Osaka University of Economics Osaka, Japan

ISSN 2191-5504 ISSN 2191-5512 (electronic) SpringerBriefs in Economics ISSN 2520-1697 ISSN 2520-1700 (electronic) Kobe University Social Science Research Series ISBN 978-981-16-4145-9 ISBN 978-981-16-4146-6 (eBook) https://doi.org/10.1007/978-981-16-4146-6 © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2021 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Singapore Pte Ltd. The registered company address is: 152 Beach Road, #21-01/04 Gateway East, Singapore 189721, Singapore

Preface

In the autumn of 2017, 40 years after the appearance of John Kenneth Galbraith’s “The Age of Uncertainty” in 1977, Bruegel and the Graduate School of Economics, Kobe University, co-hosted an international conference in Brussels, Belgium, titled “Japan and Europe: Monetary Policies in the Age of Uncertainty.” The one-day conference was very successful not only in the sense that it was attended online and onsite by many economists, policymakers, practitioners, and others, but also in the sense that useful and fruitful discussions were deeply and broadly developed. A number of these discussions and exchanges addressed the challenges faced by Europe and Japan in the age of uncertainty and will no doubt be invaluable assets not only for academia but also for government and industry. The conference consisted of three main sessions: Session I—Assessment of unconventional monetary policies on macro and finance, Session II—New monetary policy instruments and challenges in Europe and Japan, and Session III—Revisiting central bank governance. In each session, a first-class Japanese expert participated as the main speaker. One of the experts is a leading macro and monetary economist in Japanese academia, one is a well-established and internationally renowned practitioner at the forefront of monetary policy, and the third is a monetary economist with extensive experience and a proven track record of analysis. Combining their discussions into a single publication would result in a unique volume of close collaboration between the leading scholars and best practitioners. The three experts kindly and willingly agreed that they would document the content of their talks and discussions in new independent papers and contribute them as chapters of a book. However, because one of them now has significant influence on Japanese monetary policy and, consequently, the world economy, we asked the two academic professionals to contribute to this book. In addition, we developed an additional chapter that aims to help readers better understand their contributions. As their coauthors, we are grateful to the two contributors. We are also certain that many people in academia and practice will learn a great deal from this volume about monetary policies in the age of uncertainty. This small but important book focuses on Japanese experiences. To understand monetary policies and their consequences, three solid pillars are crucially important: v

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theory, institutions, and experience; these form the basis of this book. Without theory, no policies will be formulated or implemented, while implementation crucially depends on institutions. Insight into experience enriches theory and deepens our understanding of institutions. Chapter 1 provides a clear theoretical background for unconventional monetary policies and inflation targeting. Chapter 2 intensively explores the meaning and desirability of central bank independence. Chapter 3 reviews the consequences of Japanese monetary policies in the last decades compared to those in other advanced economies. Readers might think that this volume is a bit out of date because several years have passed since the conference; however, this is not the case. We have lived in an era of uncertainty since, or perhaps even before, Galbraith pointed it out. Uncertainties have not only continued to grow in recent days, but also continued to spread worldwide in the current environment of globalization: Uncertainty in one region is quickly transmitted to other regions. Risks and uncertainties, of course, exist not only in the economy, but in other areas of our lives. A typical example is the global spread of the new coronavirus, or COVID-19, that we have recently experienced. Although freedom of mobility is an essential human right, it is now one of the main causes of the worldwide challenge. Needless to say, capital and funds are much more mobile than human beings, which implies that financial uncertainties and risks can spread faster and wider than infectious diseases. Hence, it is always of great importance to share the financial crisis experiences of individual countries and prepare concrete measures to prevent their spread. Finally, because the authors are members of different institutions, we would like to take this opportunity to note that the views expressed in this volume are those of the authors and do not necessarily reflect the views of their institutions. Kobe, Japan

Yoichi Matsubayashi Tamotsu Nakamura

Acknowledgments

The international conference series of Bruegel and the Graduate School of Economics, Kobe University, which began in 2013, was the inspiration for this volume. Due to incredible effort on both sides, the series has been very successful so far. Hence, our special thanks go to the director of Bruegel, Dr. Guntram Wolff. We are also grateful for the effort of every single staff member in both institutions. The series was made possible by human and financial support from various public and private organizations. We are especially grateful to the Japanese Ministry of Foreign Affairs for its financial assistance. In addition to its financial support, the Japanese Foreign Ministry has made unparalleled human contributions to the conference over time. We also thankfully acknowledge the support provided to the conference series by JETRO, the Japanese External Trade Organization. We greatly appreciate the continued and generous financial assistance of the Toshiba International Foundation, Shizen Research Institute, and Rokkodai Foundation, the alumni association of Kobe University’s social science colleges. Yoichi Matsubayashi and Tamotsu Nakamura would like to thank our graduate student, Yoshitaka Ogisu. Without his excellent assistance, the publication of this volume would have been considerably delayed. Last but not least, our thanks are also due to Prof. Takeshi Yanagawa of Setsunan University, the former editor of this brief series, who has encouraged us to publish our findings as part of the series.

vii

Contents

1 Effects of Unconventional Monetary Policy and Inflation Target . . . . . 1 Kosuke Aoki 1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1.2 Quantitative and Qualitative Monetary Easing (QQE) . . . . . . . . . . . . . 3 1.3 Inflation Target . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 1.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 2 Central Bank Independence in a Changing Environment . . . . . . . . . . . . Wataru Takahashi 2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Central Bank Independence in the 1990s . . . . . . . . . . . . . . . . . . . . . . . . 2.3 Changing Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 Deflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.2 Relationship with Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.3 Fiscal Dominance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.4 Reassigning Responsibility for Financial Stability . . . . . . . . . 2.3.5 Politicized Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4 Proposal of Constitutional Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4.1 Constitutional Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4.2 Central Bank Independence and Democracy . . . . . . . . . . . . . . 2.4.3 Active, Not Passive, Independence . . . . . . . . . . . . . . . . . . . . . . . 2.4.4 Constitutional Reform as History . . . . . . . . . . . . . . . . . . . . . . . . 2.4.5 Practices of Central Banking in a Constitutional Model . . . . . 2.5 The Central Bank Independence: Japanese Case . . . . . . . . . . . . . . . . . 2.5.1 Unfortunate Start . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.2 Deflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.3 Abenomics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.4 Proposal for Restoration of Independence Under Abenomics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13 13 14 15 15 16 17 18 18 19 19 20 20 21 21 23 23 24 24 25

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2.6 Conclusion: Future of the Central Bank . . . . . . . . . . . . . . . . . . . . . . . . . Appendix A: Culture, Democracy and Central Banking . . . . . . . . . . . . . . . . Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . What is a Central Bank? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Market Economy and Democracy . . . . . . . . . . . . . . . . . . . . . . . . . . . . Central Bank Culture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Constitutions and Central Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Constitutions and Central Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Appendix B: The Historical Development of the Bank of Japan Law: A Political Economics Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Period of the Former Bank of Japan Laws . . . . . . . . . . . . . . . . . . . . . . . . . Period of the Former Bank of Japan Act . . . . . . . . . . . . . . . . . . . . . . . . . . . The Current Bank of Japan Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Problems with the Current Bank of Japan Law . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Japanese Experiences and an International Comparison . . . . . . . . . . . . Yoichi Matsubayashi and Tamotsu Nakamura 3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Quantitative and Qualitative Monetary Easing (QQE) . . . . . . . . . . . . . 3.2.1 Quantitative Versus Qualitative . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.2 Central Bank Balance Sheet Size or Quantitative Easing . . . . 3.2.3 Composition of Central Bank Balance Sheets (Qualitative Easing) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3 Negative Nominal Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1 Forward-Looking Monetary Policy . . . . . . . . . . . . . . . . . . . . . . 3.3.2 Nominal and Real Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . 3.3.3 Japanese Problem (1): Low Labor Productivity . . . . . . . . . . . . 3.3.4 Japanese Problem (2): An Increasing Number of Non-regular Workers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4 Yield Curve Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.1 The Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.2 Yield Curve Control (YCC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.3 An International Comparison of Yield Curve Control . . . . . . . 3.5 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

26 27 27 28 29 29 30 31 31 32 32 33 34 37 39 40 43 43 45 45 46 47 48 48 49 51 52 52 52 54 56 56 57

Afterword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

About the Authors

Yoichi Matsubayashi has been Dean of the Graduate School of Economics at Kobe University since 2020 and Professor there since 2003. He is also Senior Fellow at the Japanese Ministry of Finance’s Policy Research Institute and Visiting Fellow at the Bank of Japan’s Institute for Monetary and Economic Studies. He obtained his M.A. and Ph.D. in economics from Kobe University. He was previously Visiting Scholar at Harvard University and the Bruegel Institute. Tamotsu Nakamura has been Executive Vice President of Kobe University since 2021 and Professor there since 2003. He is Adjunct Professor of economics at Xiamen University in China. He was also Visiting Professor of Economics at the University of British Columbia in Canada. He received his M.A. and Ph.D. from Kobe University. Kosuke Aoki is Professor in the Graduate School of Economics at the University of Tokyo. He also serves as Advisor for the Research and Statistics Department of the Bank of Japan. His employment includes the London School of Economics, CREI-Universitat Pompeu Fabra, the Bank of England, and Kobe University. In 2014, he received the Japanese Economic Association (JEA) Nakahara Prize, which was established in 1995 to honor economics researchers under the age of 45 who have made significant internationally recognized contributions. He obtained his Ph.D. in economics from Princeton University and his M.A. in economics from Kobe University. Wataru Takahashi is Professor in the Department of Economics, Osaka University of Economics, and Research Fellow at the Research Institute of Economics and Business Administration (RIEB), Kobe University. He obtained his MPhil in economics from Oxford University in 1984. Previously, he worked at the Bank of Japan for 35 years, including as Advisor to the Governor for international affairs from 2002 through 2006; in this position, he was responsible for financial cooperation between the central banks in East Asia and performed economic research on the global economy. He was also Director-General of the Bank of Japan think tank, the Institute for Monetary and Economic Studies. xi

Chapter 1

Effects of Unconventional Monetary Policy and Inflation Target Kosuke Aoki

1.1 Introduction It is a great pleasure to talk at this prestigious conference and I would like to thank Professor Yoichi Matsubayashi for giving me this opportunity. The theme of the conference is “Europe and Japan: Monetary policies in the age of uncertainty,” and the title of this session is “Assessment of unconventional monetary policies on macro and finance.” As Mr. Darvas requested, my presentation focuses on the following two topics: (1) how unconventional monetary policy affects bank lending and (2) the inflation target of 2%. Before discussing those two issues, let me briefly summarize the inflation dynamics in Japan and the series of unconventional monetary policy measures conducted by the Bank of Japan. The Japanese economy experienced the emergence and collapse of asset price bubbles from the late 1980s to the early 1990s, followed by the 1997 banking crisis. Figure 1.1 shows Japan’s yearly Consumer Price Index (CPI) inflation rates from 1985 to 2016. The blue line plots the inflation rate of all items in CPI, and the orange line plots the inflation rate of the CPI excluding food and energy. Figure 1.1 shows that CPI inflation in Japan was already low in the 1980s. This was partly caused by the sharp appreciation of the Japanese yen following the Plaza Accord in 1985. Inflation was below 2% during most of the sample period. The highest inflation rate is slightly above 3% (1990 and 1991). After the collapse of the asset price bubbles, CPI inflation began declining and became negative in 1995. Interest rates declined due to the Bank of Japan’s attempts to stimulate aggregate demand. Figure 1.2 shows the overnight call rate and 10-year Japanese government bond (JGB) yield from 1989 to 2018. The Bank sets its call rate target at 0.15% in February 1999, which was the beginning of the zero interest rate policy. Thus, the Bank faced the zero lower bound on the nominal interest rate much earlier than other major central banks did. To overcome this serious constraint, the Bank of Japan introduced various unconventional monetary policy measures in the late 1990s and early 2000s, long before © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2021 Y. Matsubayashi et al., Monetary Policies in the Age of Uncertainty, Kobe University Social Science Research Series, https://doi.org/10.1007/978-981-16-4146-6_1

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the global financial crisis of 2008. The Bank introduced its first forward guidance policy in April 1999 when Governor Hayami announced that “I think that the Bank will maintain the zero interest rate policy until deflationary concerns are dispelled.”1 Quantitative easing was first introduced in March 2001 and lasted until March 2006. The Bank changed its main operation target from the call rate to the current account balance. In addition to this, the Bank committed to maintaining its policy until core CPI inflation is expected to stabilize at more than zero percent. More specifically, in its policy statement on March 19, 2001, the Bank announced that “the quantitative easing policy continues to be in place until the core CPI registers stably zero percent or an increase year on year.” The Bank of Japan ended its first quantitative easing policy in March 2006 and raised the policy target rate to 0.25% in July of the same year. Following the global financial crisis in 2008, the Bank began “Comprehensive Monetary Easing” in October 2010. Under Comprehensive Monetary Easing, the Bank purchased a variety of assets including exchange-traded funds (ETFs) and Japan Real Estate Investment Trusts (J-REITs) as well as JGBs. In April 2013, the Bank introduced “Quantitative and Qualitative Monetary Easing (QQE),” under which it started purchasing massive amounts of JGBs to increase the monetary base, including bonds with longer maturities. In January 2016, the Bank introduced negative interest rates (introduction of QQE with a negative interest rate), and then, in September 2016, the Bank decided to introduce a new policy framework of “Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control” by strengthening the two previous policy frameworks, QQE and QQE with a Negative Interest Rate.

1.2 Quantitative and Qualitative Monetary Easing (QQE) The Bank of Japan’s forward guidance and various kinds of asset purchase policy have a common transmission mechanism through which they affect the economy’s aggregate demand. Those policy measures affect aggregate demand by decreasing long-term nominal interest rates. As long as a decline in nominal interest rates is not totally offset by a decline in inflation expectations, unconventional monetary policy lowers long-term real interest rates to stimulate aggregate spending through intertemporal substitution of spending such as consumption and equipment investment. Intuitively, savers save by less because returns on saving decline, and borrowers borrow more to spend on durables such as houses and cars. Firms borrow more to invest in equipment. Commercial banks play an important role in this monetary policy transmission channel. While large firms have access to equity markets and corporate bond markets to finance their payments for wages and equipment investment, small firms and households do not. They instead rely on bank loans. Therefore, whether they can

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increase their spending in response to a decline in interest rates depends on whether commercial banks increase their loan supply. Do commercial banks increase their loan supply in response to a decrease in longterm nominal interest rates? An answer to this question is not necessarily obvious from a theoretical point of view. Consider a situation in which banks hold as their assets both long term government bonds and loans to firms. Suppose that the interest rates of long-term government bonds decline relative to loan rates. Since government bonds become less attractive than loans, banks try to reduce their holdings of government bonds and increase loans. This simple argument implies that a decline in long-term government bond interest rates stimulate bank loans. However, this is not the only channel through which a decline in long-term interest rates affects bank loan supply. There has been concern that extremely low levels of nominal interest rates may negatively affect banks’ loan supply. Bank profitability depends on the spread between short- and long-term nominal interest rates. On one hand, banks’ cost of funding is the interest paid on deposits and the cost to manage deposit accounts. Deposit rates are strongly affected by short-term government bond interest rates and the interbank market rate. In recent periods, those short-term interest rates have been at the effective zero lower bound. On the other hand, bank revenues depend on loan rates, which move in line with the interest rates of long-term government bonds. Therefore, banks’ profitability depends positively on the spread between short- and long-term interest rates. Because the deposit rate is subject to a lower bound, a decline in long-term interest rates may imply a decline in the deposit-lending spread, reducing bank profitability. If bank profitability is kept low for a considerable period of time, their capital may decrease, which might force them to cut their loan supply to maintain a high enough capital ratio to meet regulatory requirements. Consequently, unconventional monetary policy may have a negative impact on aggregate demand by reducing bank profitability, an argument is made by advocators of the so-called “reversal interest rate.” According to Brunnermeier and Koby (2019), the reversal interest rate is the rate at which an accommodative monetary policy becomes contractionary for lending. They construct a theoretical model of banks subject to credit frictions to show that the reversal rate does exist and that its level can be above zero. Some empirical studies indeed show that the level of nominal interest rates and bank profits are positively related. For example, Classens et al. (2018) use micro banking data from 47 countries to show that a decline in nominal interest rates leads to a decline in banks’ net interest margin and profits. Heider et al. (2017) study how lowered interest rates affected bank lending in the Euro area. They show that when the European Central Bank reduced the Deposit Facility Rate from 0 to −0.10% in June 2014, banks that rely more on deposit funding decreased their lending relative to those that rely less on deposit funding. Do Japanese banks increase their loan supply to firms? Whether banks in Japan increase their loan supply in response to declining long-term interest rates on Japanese government bonds is an empirical question. Ono et al. (2018) investigate this issue using a firm-bank loan-level panel dataset for 2002–2014. They focus their analysis

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on two transmission channels through which lower interest rates increase loan supply. The first is called the portfolio balance channel; this channel depends on the trade-off between the substitution effect and income effect. When monetary easing decreases the interest rates of long-term government bonds, the bonds become less attractive to banks. Therefore, banks reduce their holdings of government bonds to increase loan supply to firms, which is called the substitution effect. On the other hand, a decrease in income from government bond holdings decreases bank net worth. When banks are subject to capital constraints, a reduction in net worth leads to a decrease in their loan supply, which is referred to as the income effect. According to the portfolio balance channel, the net effect of lower interest rates on loan supply depends on the relative size of these two effects. The second channel is called the bank balance sheet channel. When interest rates fall and bond prices increase, capital gains on the bonds banks hold increase their net worth. An increase in net worth allows banks to increase their loan supply. Ono et al. (2018) show that a 1 percentage point reduction in long-term interest rates increases the growth rate of a bank’s loan supply by 1.6 percentage points. This suggests that the substitution effect of the portfolio balance channel is larger than the income effect. They also show that banks that enjoy larger capital gains on their bond holdings increase their loan supply, which provides evidence of the bank balance sheet channel. Overall, their findings suggest that Japanese banks did increase their loan supply when the Bank of Japan’s monetary easing policy decreased the interest rates on Japanese government bonds.

1.3 Inflation Target Let me move on to the second topic—whether it is desirable for a central bank to have an inflation target of 2%. As is discussed in Blinder et al. (2008), an independent central bank should be given a clearly defined mandate by its government. An inflation target is one such example. Many central banks, including the Bank of Japan, adopt an inflation target of around 2%. The inflation targets of the Bank of England and the Federal Reserve Bank is also 2%, while the European Central Bank aims to keep inflation below but close to 2% over the medium term. From a theoretical point of view, adopting a numerical inflation target can anchor private sector expectations about inflation in the medium and long term. Many empirical studies show that this is indeed the case. For example, Gurkaynak et al. (2010) compare inflation expectations of inflation targeting countries (Sweden and the United Kingdom) and the United States, which was at that time a non inflationtargeting country. They show that the long-term inflation expectations of Sweden and the UK are less responsive to macroeconomic news than those of the United States. Their finding implies that adopting a numerical inflation target can anchor long-term inflation expectations. In Japan, inflation has been below 2% for more than 10 years. The Bank of Japan introduced its inflation target in 2013, but had never achieved its target until January

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2019. One may wonder whether it makes any sense to have a target inflation rate that has never been achieved. To answer this question, we need to address the following two issues. First, in which sense is 2% inflation regarded as desirable? Is 2% optimal from a theoretical point of view? Second, how bad, in terms of economic welfare, it is to have inflation less than 2%? Let me start with the first issue. The important question is whether a 2% inflation target is justified from a welfare point of view, especially since economic theory hardly shows that 2% inflation is optimal. The most famous and classic theoretical study of the optimal inflation rate is Friedman (1969), who shows that it is optimal from a social welfare point of view to target a negative inflation rate that is consistent with the lowest level of the nominal interest rate. This is called the Friedman rule. This argument may seem unrealistic to the reader, but the intuition behind it is very simple, and it is very robust against variations in model assumptions. Here is the intuition. The two key concepts for understanding the Friedman rule are: (1) the opportunity cost of holding fiat money (i.e., notes and coins) and (2) the Fisher equation that relates the nominal interest rate to the inflation rate. People hold fiat money because it provides them with transaction services (as a medium of exchange) and also because it serves as a store of value. However, fiat money does not provide interest income while other nominal assets, such as government bonds, do. Therefore, the opportunity cost of holding fiat money is the foregone interest income from holding money rather than interest-bearing nominal assets. This opportunity cost is lower as the nominal interest rate is lower. The opportunity cost is minimized when the nominal interest rate is made as low as possible, typically, zero. According to the Fisher equation, the nominal interest rate is equal to the sum of the real interest rate plus the expected inflation rate. If we assume that the expected inflation rate is equal to the realized inflation rate on average, which is roughly true in the long run, a zero nominal interest rate implies deflation, which is equal to the negative of the real interest rate. For example, if the real interest rate is 1%, then the optimal inflation rate is minus 1%. Friedman’s rule focuses on the roles of money as a store of value and medium of exchange. Another benchmark monetary model, the New Keynesian model, focuses on money as a unit of account and leads to a different optimal inflation rate. The New Keynesian model starts with the observation that nominal price adjustments by firms are sluggish and are not synchronized across firms. Firms’ price adjustments become infrequent when adjustment incurs some cost. Those costs include costs of changing price tags and menus, as well as costs of analyzing the optimal prices that maximize firm profits. If firms incur costs when they change their prices, it is not optimal for them to change prices frequently. The fact that price adjustments are infrequent and not synchronized has an important implication for the optimal rate of inflation. For example, suppose that firm A has a chance to adjust its product price today, while firm B does not. In such an environment, suppose that the inflation rate is positive. Firm A adjusts its price in response to inflation. Typically, it increases its price to keep its price relative to the prices of other goods at the optimal level. However, firm B cannot do so. Thus, the price of firm A’s product relative to that of firm B becomes too high from the social point of view. This is because the relative prices of

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firm A’s product relative to firm B’s product should reflect either consumers’ relative preference for product A compared to product B, or the relative production levels of firm A and B. More precisely, product A’s price should be higher than product B’s price only if either consumers prefer product A to product B or firm A’s technology level is lower than that of firm B. Therefore, in general, changes in the relative prices of goods that are caused by inflation are inefficient from a welfare point of view. This welfare distortion is called the “relative-price distortion” in the New Keynesian literature. This distortion is minimized when inflation is equal to zero. Therefore, according to the New Keynesian literature, the optimal inflation rate is equal to zero. The Friedman rule and New Keynesian model are the two standard theoretical benchmarks for the optimal rate of inflation. Neither of the two justifies a 2% inflation rate as the optimal rate. Therefore, why do policy makers in the real world tend to think that a zero inflation rate (New Keynesian) or one that is slightly negative (the Friedman rule) is not socially optimal? There are several reasons why it is beneficial to target a positive inflation rate. One reason is that inflation that is too low constrains conduct of monetary policy over business cycles because the nominal interest rate cannot be far below zero. This is called the zero lower bound, or the effective lower bound, on the nominal interest rate. According to the Fisher equation, the nominal interest rate is the sum of the real rate and the expected inflation rate. When the inflation rate is on average close to its target rate, a low inflation target rate implies a low expected inflation rate, and therefore implies a low nominal interest rate on average. Since the instrument of monetary policy is the short-term nominal interest rate, a average nominal interest rate that is too low can constrain monetary policy during recessions when the central bank needs to decrease the nominal interest rate. When the nominal interest rate is at its zero lower bound, the central bank cannot decrease the interest rate further to stimulate aggregate demand. This problem can be avoided by keeping the average level of the nominal interest rate high enough. The central bank can accomplish this by targeting a higher rate of inflation. In other words, the bank needs a “buffer.” This idea goes back to Summers (1991). The size of the buffer, that is, the target rate of inflation, depends on certain economic factors. One factor is the average rate of economic growth. If a country’s average growth rate is high, then its real interest rate tends to be high. This allows keeping the nominal interest rate high enough even if the average inflation rate is low. Therefore, a growing economy does not need a high inflation target. Another factor is economic volatility. When a country is more likely to be hit by large negative economic shocks, then that country’ central bank more often needs to decrease its nominal interest rate, largely to offset the effects of adverse shocks, and therefore the chance of hitting the zero bound is high. The inflation target rate of such a country should be high to maintain a large enough buffer. The second reason a positive inflation target can be justified is because downward nominal wage rigidity exists. In some countries, workers and labor unions are extremely reluctant to accept nominal wage cuts. It is not clear from a theoretical point of view why workers care about nominal wages rather than real wages. However, there is some clear evidence for downward nominal wage rigidity, and

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this rigidity has a cost because real wages cannot decrease to clear labor markets. Typically, nominal wage rigidity results in high unemployment rates. When downward nominal wage rigidity exists, it is argued that positive inflation helps adjust labor markets. Suppose that workers resist nominal wage cuts, but nominal wages are not perfectly indexed to inflation. Then, positive inflation can decrease real wages as long as the rate of increase in nominal wages is lower than the rate of inflation. A more flexible real wage helps the labor market clear. Therefore, a positive inflation target can reduce unemployment caused by downward nominal rigidity, particularly during recessions. This idea goes back to Tobin (1972). The third reason is the upward measurement bias in the consumer price index (CPI). The CPI is designed to measure the cost of living. There are several reasons for why changes in CPI do not accurately measure changes in the cost of living. For example, the CPI in Japan is a Laspeyres Index that measures changes in the cost of living by assuming that a representative consumer consumption basket is kept fixed when prices change from one period to the next. However, in reality, consumers change their consumption basket in response to changes in the prices of goods, introduction of new goods, and discontinuation of old product models. Also, the quality of goods improves over time, but it is not easy to perfectly measure improvements in quality. For these reasons, it is widely known that CPI measures have upward biases. Shiratsuka (1998) reports that an estimate of the upward bias in the Japanese CPI (at the time this paper was written) was 0.9%. The existence of an upward bias implies that the true inflation rate may be lower than the measured CPI inflation rate. For example, if the bias in the CPI inflation rate is 1%, targeting a CPI inflation rate of 0% may actually mean targeting a deflation rate of 1%. Facing a bias of this kind, it may be better to target a positive inflation rate. So far, I have reviewed some theoretical studies of the optimal inflation rate. The literature has shown that the optimal inflation rate is low—zero or negative. I have also reviewed some practical reasons why it makes sense to target a positive inflation rate—the zero lower bound on the nominal interest rate, downward nominal wage rigidity, and the upward bias in CPI inflation measures. Then, is it desirable to target a 2% inflation rate? This is a quantitative exercise. To answer this question, the literature uses dynamic stochastic general equilibrium models to compute an optimal inflation rate that maximizes economic welfare. Here, economic welfare is represented by the average utility of the representative household. The basic framework used is a New Keynesian model that incorporates nominal price stickiness. Diercks (2017) is a very comprehensive and useful survey on the optimal inflation rate literature. He surveys 160 existing studies on optimal monetary policy from the mid-1990s to the time the paper was written. Of 160 studies, 100 provide quantitative values for the optimal inflation rate. He reports that 80 studies suggest that the optimal inflation rate should be zero or negative. Those studies typically focus their analysis on the welfare cost of inflation due to the opportunity cost of holding money and price stickiness. There are about 20 studies that suggest a positive inflation rate. Those studies consider the factors that can justify a positive optimal inflation rate; however, many of them imply that the optimal inflation rate is positive but less than 2%.

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Then does it make sense for central banks to target 2%? Alternatively, how bad is it to deviate from the optimal inflation rate suggested by the theoretical literature? Japanese inflation has been below 2% for a long period of time. How costly is this situation in terms of social welfare? This is again a quantitative question. It turns out that welfare changes little. Coibion et al. (2012) show that the optimal inflation rate for their model is 1.3% and that welfare changes very little when inflation is somewhere between 1 and 2%.2 This may surprise the reader, but it stems from the nature of monetary policy. That is, monetary policy does not change the longrun growth trend and/or the average level of economic activities such as real output. This point is closely related to the literature on the cost of business cycles. In general, it has been shown in the academic literature that the welfare benefit of stabilizing business cycle fluctuation is much smaller than the benefits of other policies. For example, Lucas (2003) surveys the welfare benefits of macroeconomic policy. The welfare benefit of reducing high inflation (reducing the nominal interest rate from 10% to zero) is equivalent to a permanent increase in consumption levels of 1%. The benefit of capital tax reform (in terms of a permanent increase in consumption) is from 2 to 4%, while that of labor income tax reform is 20%. Compared with the benefits of those policies, Lucas (2003) reports that the benefit of removing business cycle fluctuations is much smaller, only 0.05%. The main reason for this small benefit is that removing business cycle fluctuations does not change either the long-run output growth rate or its average level. In contrast, labor income tax reform, for example, changes the long-run average income level by changing the average labor supply. Similarly, the reason welfare changes very little even if the average inflation rate changes, say, from 2 to 1%, is because that change in the average inflation rate barely changes the long-run level or growth rate of output. This reflects the fact that, in the long run, the super-neutrality of money holds in developed economies with low inflation (roughly speaking, inflation rate of less than 10%). There are two kinds of money “neutrality”—neutrality and super-neutrality. The neutrality of money means that a change in the level of the money supply does not affect real activity (in the long run); it only changes the price level. The super-neutrality of money means that a change in the average inflation rate does not change real activity (in the long run).3 There is evidence for the super-neutrality of money, at least in developed economies with low inflation. For example, Atkeson and Kehoe (2004) analyze data on inflation and the growth rate of output from 17 countries between 1920 and 2000. They restricted their analysis to moderate (less than 20%) inflation episodes. They then break the data into five-year episodes and compute the average inflation and growth rate of output for each episode. Their main interest is whether there is an empirical link between deflation and depression. They define deflation as a negative five-year average inflation rate, while depression means that five-year average GDP growth rate is negative. They find that although there is a positive relationship 2

See Fig. 2 of Coibion et al. (2012). In standard textbooks, superneutrality is explained in terms of the growth rate of the money supply. Super-neutrality holds if a change in the growth rate of the money supply changes only inflation and not real activities.

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between deflation and depression during the Great Depression episode of 1929–1934, there is no link between the inflation rate and GDP growth rate in any of the samples. Their analysis is clear evidence of the super-neutrality of money. Of course, it is also both theoretically and empirically clear that very high inflation (say, more than 10%) reduces welfare. However, since the super-neutrality of money holds in low inflation economies, economic welfare changes very little even if the average inflation rate changes, say, from 2 to 1%.

1.4 Conclusion The Bank of Japan’s various unconventional monetary policy measures did increase the bank loan supply by suppressing the long-term interest rates of Japanese government bonds. However, inflation has remained low and below 2%. In 2016, the Bank of Japan published a report on the assessment of QQE and offered some explanations why inflation did not reach its target of 2% (Bank of Japan (2016)). Among several reasons, the Bank emphasized the importance of sluggish inflation expectations. More research is needed to explore the reasons why Japanese inflation has been low. Both from the theoretical and empirical points of view, it is not clear that the welfare cost of not achieving a 2% inflation rate is very large. This is because as long as the inflation rate is not too high, the long run average inflation rate has little effect on the long-run economic growth rate, which is crucial for economic welfare. As Lucas (2003) argues, there should be more emphasis placed on growth-enhancing policies, and his argument also applies to the Japanese economy.

References Atkeson A, Kehoe PJ (2004) Deflation and depression: is there an empirical link? Am Econ Rev 94(2):99–103 Blinder AS (1999) Central banking in theory and practice. MIT Press Brunnermeier MK, Koby Y (2018) The reversal interest rate. National Bureau of Economic Research, Working Paper 25406 Claessens S, Coleman N, Donnelly M (2018) “Low-For-Long” interest rates and banks’ interest margins and profitability: cross-country evidence. J Financial Intermediation 35:1–16 Coibion O, Gorodnichenko Y, Wieland J (2012) The optimal inflation rate in New Keynesian models: should central banks raise their inflation targets in light of the zero lower bound? Rev Econ Stud 79(4):1371–1406 Diercks AM (2017) The reader’s guide to optimal monetary policy. Available at SSRN 2989237 Friedman M (1969) The optimum quantity of money. In: The optimum quantity of money, and other essays. Aldine, Chicago Gürkaynak RS, Levin A, Swanson E (2010) Does inflation targeting anchor long-run inflation expectations? Evidence from the US, UK, and Sweden. J Eur Econ Assoc 8(6):1208–1242

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Heider F, Saidi F, Schepens G (2017) Life below zero: bank lending under negative policy rates. Working paper International Monetary Fund (2017) Global financial stability report Lucas RE Jr (2003) Macroeconomic priorities. Am Econ Rev 93(1):1–14 Ono A, Aoki K, Nishioka S, Shintani K, Yasui Y (2018) Long-term interest rates and bank loan supply: evidence from firm-bank loan-level data. Tokyo Center for Economic Research (TCER) Paper, (e119) Shiratsuka S (1998) Bukka no keizai bunseki. University of Tokyo Press, Tokyo, Japan (in Japanese) Shirai S (2013) Monetary policy and forward guidance in Japan. Speeches at the IMF (September 19). https://www.boj.or.jp/en/announcements/press/koen_2013/data/ko130921a1.pdf Summers L (1991) Panel discussion: price stability: how should long-term monetary policy be determined? J Money Credit Bank 23(3):625–631 Tobin J (1972) Inflation and unemployment. Am Econ Rev 62(2):1–18

Chapter 2

Central Bank Independence in a Changing Environment Wataru Takahashi

2.1 Introduction In the late 1990s, the renewal of central bank laws brought about the independence of central banks in several major economies. The Bank of England, which was nationalized by the Labour government in 1946, recovered its independence under “New Labour” in 1997. The Bank of Japan, which was fully controlled by the military regime in 1942, was granted independence in 1998. Based on the Maastricht treaty of 1993, the European Central Bank was established in 1998 as an ideal independent central bank and an heir to the German Bundesbank in the European Union. In monetary policy, independence means that a central bank determines its policy targets, such as money market interest rates and monetary base without external, and especially political, interference. This is widely practiced by major central banks by adopting an inflation targeting goal. Following the pioneering move by the Reserve Bank of New Zealand, an increasing number of central banks adopted inflation targeting in the 1990s. By doing so, they have succeeded in containing the runaway inflation seen in the previous decades. Although independence is limited to instrument independence in many cases, the idea of a single mandate of price stability for a central bank became widely established. The idea was promoted in the Economics discussions of that time and was put into practice following the renewal of central bank laws. Thus, central bank independence was well-established, theoretically and practically, in the late 1990s.

This work was supported by JSPS KAKENHI Grant Number 15H05729. This was originally presented at “Europe and Japan: Monetary policies in the age of uncertainty,” Bruegel-Graduate School of Economics, Kobe University Conference, October 2nd, 2017. I am grateful to the conference participants, especially Professor Tamotsu Nakamura and Professor Yoich Matsubayashi, for their comments and support. I also thank my longtime friend Mr. Hiroshi Nakaso for his suggestions and comments, especially for Appendix A. I am proud to have worked for the Bank of Japan for over 35 years while helping each other with him. © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2021 Y. Matsubayashi et al., Monetary Policies in the Age of Uncertainty, Kobe University Social Science Research Series, https://doi.org/10.1007/978-981-16-4146-6_2

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However, the situation is dramatically different in the twenty-first century, and central bank independence is being seriously challenged in the changing economic environment. What was previously an inflationary price situation has become a deflationary situation. The 2008 global financial crisis (GFC) changed the central bank’s role, making a central bank with a single mandate no longer relevant. Consequently, central banks now hold multiple mandates. If such environmental changes were temporary, the previously established model would need not be reviewed. However, the current situation is likely to continue in the foreseeable future. Although the passion for independence seems to have faded recently, we must reconsider central bank independence to reconstruct national economic governance and overcome the economic difficulties faced after the GFC. In this paper, I consider central bank independence and propose an updated model suitable for the current environment. The study of central bank independence focuses on the institutional arrangement for central banks. Although most present-day monetary economics argues institutional arrangements as given, it is indispensable to consider the institutional aspect of the model. This paper contributes to such a policy and academic debate.

2.2 Central Bank Independence in the 1990s Before presenting the proposal, let me provide a brief review of the discussion that took place in the 1990s. The promotion of a global market economy was a dominant background for the debate. Supported by new liberalism in politics and economic thought in the 1980s, market liberalization or deregulation in developed economies and the transformation of the former socialist economies into market economies became the driving forces in changing the world economy. This was labeled “globalization.” The autonomy of the market mechanism was respected, and the earlier policy style of regulations and directions by the government was discarded. Policy through central banks utilizing market mechanisms became mainstream. The proper functioning of the market mechanism requires price stability, thus central bank inflation control is recognized as the most important aspect of a market economy. The model of central bank independence around that time was quite simple. In his pioneering work, Rogoff (1988) argues that monetary policy should not be assigned to a government, but to a conservative central bank in a setting of inflationary biased politics and an anti-inflationary central bank. In the argument at that time, an independent central bank was considered ideal for conducting monetary policy. However, unconstrained independence is not allowed in a democracy. Since any public entity should be under the control of the elected government, in deference to the democratic principle, the central bank must also fulfill some requirements. First, independence in monetary policy is divided into goal independence and instrument independence. The former applies to an inflation target. In pursuit of a policy goal, such as a targeted rate of inflation, determined in consultation with the government, instrument variables, such as the short-term interest rate and monetary base, can be determined by autonomously by a central bank. Second, in lieu of its independence, a central

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bank is required to exhibit “transparency” and “accountability.” Public disclosures through policy meeting minutes, press conferences, and speeches are encouraged. In addition, a rules-base policy, which can minimize discretion and maximize transparency, is considered desirable for accountability and avoiding political interference. Accountability is regarded as indispensable for central bank independence.1

2.3 Changing Environment The elements of central bank independence have changed substantially in the twentyfirst century. Certain changes are evident: (1) (2) (3) (4) (5)

The price situation has changed from inflation to deflation. So-called “unconventional policies” have been adopted. Central banks are subject to several mandates, including monetary policy. Management of financial crises has emerged as a top priority. Debt management has also become important in the presence of mounting government bond issuance.

In addition: (6) The economy has become politicized, with greater governmental intervention.

2.3.1 Deflation Advanced economies, such as those of Europe and the United States, have experienced a decline in inflation, with slightly positive rates below the target of 2% in the 2000s. Japan has even experienced a slightly negative rate since the 1990s. Although deflation remains mild, it has become a major concern for policy makers. This could be partly because economies with low interest rates are highly leveraged, which could lead to the burden of “debt deflation” in deflationary situations. These changes have influenced both the theory and practice of monetary policy. In theory, the conservative central bank model, which argues that monetary policy should be assigned to the central bank, appears flawed. This easily invites a counter argument that monetary policy should not be assigned to a central bank because a conservative central bank is likely to bring about deflation. In practice, one needs to reconsider inflation targeting, which was originally designed to contain inflation. Of course, it is easy to redesign by setting a symmetrical target for inflation and deflation. However, fighting deflation becomes difficult 1

In addition, as a general principle of democracies, central bank top officials such as the governor and board members are appointed by the government and parliament. However, in Japan and elsewhere, it has been criticized that the abuse of political appointments threatens the independence of central banks, even though the independence of central banks has finally been established.

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when facing a zero lower bound. Further, it is argued that deflation is brought about by “secular stagnation.” Declining potential growth rates are being observed in many advanced economies, which might reflect “structural” change in the global economy owing to a decline in labor population and productivity. In the prospect of a growing economy, an increase in productivity would be caused by expanding capital expenditure. In contrast, it becomes difficult to increase capital investment, which likely induces innovation in declining growth. As the monetary policy is a demand management policy with little power to boost potential growth, a supply-side policy should be implemented. Japan suffers most from a rapidly aging society and, in addition to deflation, has experienced potential growth close to zero. In a society where a decline in sales is predicted because of a population decline, it is generally difficult to raise prices. Therefore, because deflation is rooted in secular stagnation, it becomes far more difficult to conquer by monetary policy alone. However, at the same time, it becomes evident that so-called structural policy such as tax cuts, deregulation, and so on, takes time to become effective and has a relatively weaker influence on economic growth. Therefore, we must be careful of expecting too much from monetary policy for achieving long-run economic growth.

2.3.2 Relationship with Fiscal Policy Under deflation, a significant change took place in both monetary and fiscal policy. Two elements comprise unconventional monetary policy (UMP).2 First, the current account balance at the central bank is adopted as an operating variable, thereby replacing short term interest rates and quantity measures, such as base money. A policy that increases quantity measures is called “quantitative easing (QE).” Central banks purchase risky assets, such as stock and corporate bonds, in addition to safer government bonds, which are purchased under traditional or conventional monetary policy. The purchase of risky assets is called “credit easing (CE).” In many cases, QE contains some elements of CE. It should be noted that such policies have aspects of both financial system stability and price stability. An ample provision of central bank money (base money) could solve the financial sector’s liquidity problem. The central bank’s purchase of risky assets lessens financial product risk premiums. Second, control of expectations has emerged as monetary policy’s main practical tool. In theory, the role of expectations has attracted attention since the “rational expectations revolution” in the 1970s. It developed the concept of “time-consistency” in the 1990s, which provided the theoretical foundation for a rules-based policy. It also proposed a “constrained discretionary” policy, which is a combination of inflation targeting and a Taylor rule type of policy recommended in traditional monetary policy. In UMP, however, such a policy rule cannot be fully established. Alternatively, the

2

Takahashi (2014) points out UMP is a challenge to a central bank’s independence.

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commitment for future monetary easing is developed as “forward guidance.” Theoretically, it induces recovery by promising future monetary easing through intertemporal choices. In practice, however, it aims to reduce the long-term interest rate. UMP creates problems for central bank independence. First, while UMP has a relatively weak effect on real economic activities, such as production and consumption, it has a rather strong impact on prices in asset markets. The lack of the conventional policy channel of interest rates results in a weak effect on the real economy. In contrast, bullish expectations caused by extraordinary monetary easing and forward guidance boost asset prices, such as real estate, stock prices, and exchange rates. Since politicians tend to pay attention to stock prices and big corporations, who have political power and serious concerns about exchange rates, this could invite political interference into monetary policy. Second, as UMP does not provide reliable feedback about real economic activities, it is difficult to set a policy rule, such as the Taylor rule, using empirical evidence. A policy rule is a means to avoid political interference; however, UMP promotes such interventions. Furthermore, UMP has an impact on fiscal policy. As seen in the UK and Europe, central bank independence has to be coupled with fiscal discipline. However, fiscal outlay has expanded after the GFC and this loosens fiscal discipline. By the largescale purchase of national debt, UMP may help loosen fiscal discipline.

2.3.3 Fiscal Dominance Although central banks are traditionally responsible for public debt management, this is a second-order mandate after monetary and financial stability policies. However, because of mounting national debt, monetary policy is forced to consider fiscal sustainability. The term “fiscal dominance” describes the situation when central banks are deprived of freedom in monetary policy because they need to consider the fiscal situation. Using the consolidated balance sheet of the government and central bank, fiscal dominance claims that fiscal policy has the final power to determine price levels. This argument is known as the theory of the “fiscal theory of the price level,” which first appeared in Sargent and Wallace (1978). In effect, the theory proves that fiscal discipline is a necessary condition for central bank independence. Loosening fiscal discipline could violate the central bank’s independence. It is no coincidence that fiscal rules such as the “Golden Rule” and “Sustainable Rule” were set at the same time as the renewal of the Bank of England Law in 1997. These rules were regarded as safeguards for central bank independence.

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2.3.4 Reassigning Responsibility for Financial Stability As shown by the Bank of England in 1997, the central bank was deprived of its mandate of financial stability in exchange for monetary policy independence. The reasoning given is: (1) a potential conflict of interest exists between the mandates of monetary policy and financial stability. Goodhart and Schoenmaker (1995) argue that a financial stability policy has a bias toward using monetary easing to support banks; (2) a financial stability policy has an aspect of industrial policy, for which the government should be primarily responsible; and (3) a rescue fund for insolvent financial institutions should be provided in the government’s fiscal budget. An additional reason has been advanced for setting up a financial supervision agency in the government that is separate from the central bank; an example is the U.K.’s Financial Service Agency (FSA). Because of financial liberalization and financial innovations, new types of financial instruments have been traded by institutions, including new institutions that are not traditional banks. “Non-bank” financial institutions, such as shadow banks and hedge funds, have emerged as the main players in the financial services industry. The old regulatory system, which focuses mainly on banks and traditional financial institutions, has become obsolete. A new government agency was set up to bring all such new businesses under one umbrella. During the financial crisis, the GFC revived the important role of a central bank. The nature of financial risk has changed from being a matter of simple insolvency to one of liquidity shortage. Financial product securitization and an expanded network of financial institutions has intensified the risk of contagion, highlighting the importance of the market and fund liquidity (Brunnermeier and Pedersen 2008). A central bank has better access to both types of liquidity. Because a prompt provision of liquidity is required to diffuse a crisis, the central bank is the most appropriate provider of liquidity. The role of the lender of last resort (LLR) has become more important in the twenty-first century. Following the recent crisis and its drastic changes, the Bagehot principle, which claims that a central bank should provide liquidity only to solvent banks, is no longer relevant because practical identification of solvency has become difficult. A bank recognized as solvent can easily become insolvent. Thus, the central bank is forced to provide liquidity before exercising judgment about solvency. It is critically described that the previous LLR becomes the “Lender of First Resort.” A rescue operation for an insolvent bank has a political aspect. Considering the potential loss of liquidity provision, the central bank needs to work in close cooperation with the government.

2.3.5 Politicized Economy In the 1990s, “laissez faire” with minimum political interference in the economy became a popular economic policy. The Washington Consensus was widely adopted.

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However, there has been a dramatic reversal after the crisis. Government regulations and interventions are being enforced, and active policies have been implemented as macroeconomic policies. While asset prices have risen, wages have stagnated. Inequality has attracted political concern. The previous market-oriented policy is now being severely criticized. As shown by the “Audit the Fed” campaign in the U.S., central banks are facing political anger. I discuss populism and central banks in the appendix.

2.4 Proposal of Constitutional Model 2.4.1 Constitutional Model3 The economic theory on which the previous central bank model was based is no longer relevant in the changed environment. When an alternative model is needed, at a minimum, the following conditions need to be satisfied: (1) it should be applicable to any economic circumstance, whether it is inflation or deflation; (2) when a central bank conducts public debt management and financial stability policies that require cooperation with government, it should maintain its independence, especially in monetary policy; and (3) as an economy becomes politicized, the model needs to pay attention to politics. Next, I consider central bank independence in the constitutional framework using two viewpoints. First, a central bank can be defined as an independent government agency. Although it remains within the government’s purview, it is independent of members of an executive branch, such as a prime minister and treasury. There are similar independent agencies, such as judicial courts4 and fair-trade associations. Independence works through the separation of powers and the existence of “checks and balances” between the independent agency and the executive branch. Second, as a central bank conducts banking business that is similar to that of private banks, its independence must be compared to semi-private public agencies, such as public broadcasting houses. Public agencies are under the control of the government, but their autonomy is guaranteed. Furthermore, a central bank is central to the financial market. Although many central banks are established by national states, they are naturally needed by markets. Thus, the governance used for private corporations is appropriate for central banks. The central bank’s accountability is analogous to public disclosure by private firms. 3

Persson and Tabellini (1997) present an economic model using a constitutional framework. Using the contract theory approach, they demonstrate that separation of powers improves the accountability of elected officials and utility voters under appropriate checks and balances. 4 Goodhart and Meade (2004) compares the independence of central banks and supreme courts in the U.K. and U.S. They argue that the rules governing central banks and supreme courts are very similar within each country but are very different between countries.

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The previous model tends to take a narrow view of central bank independence. Much consideration is given to the bank’s relationship with the fiscal agency. For an example, although article 5 of the national Fiscal Law (Public Finance Act) in Japan prohibits the direct purchase of public debt by the central bank, some coordination is required under the current circumstances. The proposed model tries to broaden this perspective. By adopting the constitutional framework, we can consider the central bank’s relationships with other agencies.

2.4.2 Central Bank Independence and Democracy5 In the constitutional framework, the authority of central bank independence could be because its character is different from that of the government. Being different from the government, central banks are expected to have a longer and non-political perspective on the economy. In addition, a central bank, which has a group of experts for economic analysis, is expected to play the role of an institution of intelligence within the government. Central bank independence has an aspect that is inconsistent with democracy. Democracy sometimes requires opting for myopic benefit. The famous “taking out punchbowl” speech by the Federal Reserve Board’s chairman, William Martin, reflects this.6 Similarly, Haruo Maekawa, one of the most respected figures in the Bank of Japan, gave the “leader of wild geese” the role of a central bank in the society. This is still the Bank’s philosophy. Conventional political control, of the type exercised by the Prime Minister and Parliament to control the government, cannot be directly applied to it. A central bank is held accountable by maintaining transparency through active disclosure.

2.4.3 Active, Not Passive, Independence Modern constitutions are based on the principles of separation of powers and democracy. These two principles sometimes conflict with each other. For example, human rights cannot be infringed, “even if the majority is in favor of such a course of action.” These are essentially protected by the judiciary, under the principle of separation of powers. The independence of public entities is also guaranteed by the constitutional framework. As mentioned, public broadcasting houses, such as the BBC in the U.K. and the NHK (Japan Broadcasting Corporation) in Japan, remain independent based 5

A detailed discussion on democracy and central banks is given in Appendix 1. The speech, given at the New York Group of Investment Bankers Association of America on October 19, 1955, notes that “The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”.

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on the constitutional value of freedom of speech. These broadcasters are expected to criticize politicians to fulfill their journalistic responsibilities. Similarly, under separation of powers, the central bank is required to exert its independence to check the government. The discussion of central bank independence has so far only considered the passive aspect of independence (“passive independence”). A central bank tends to avoid conflict with the government to defend its independence. However, to ensure that economic policymaking moves in the right direction, a central bank has a responsibility to act as a check on policies by using its longterm and non-political viewpoint. This “active independence” is at the core of the constitutional model to maintain a sound separation of powers. Another background of central bank independence is promoting a market economy. The market economy is based on the idea that individual economic agents make independent decisions; that is, each agent should be guaranteed his or her autonomy. However, they are also disciplined by market forces. This atomism, or self-governance, is similar to the principle of separation of powers.

2.4.4 Constitutional Reform as History Although the constitutional framework I propose here sounds new, the model itself traces its origins to the renewal of central bank laws, whereby central bank independence was established after constitutional reform in several countries. For example, in the U.K., granting independence to the Bank of England was accompanied by enhancing local autonomy in Scotland and Wales. The National Assembly for Wales and the Scottish Parliament were established by the Blair government in 1998 and 1999, respectively. Political powers were de-centralized, and the autonomy of each institution was strengthened. In the case of the Bank of Japan, three major constitutional reforms—reorganization of the central government, enhancement of local autonomy, and judicial reforms—were mooted by the Hashimoto government. On the continent, the European Union moved to establish the government of Europe. The European Central Bank’s established followed that of three major institutions—the European Commission, European Parliament, and European Court of Justice.

2.4.5 Practices of Central Banking in a Constitutional Model So far, I have discussed central bank independence by focusing on the institutional aspect. While this can guarantee its independence as an institution, further consideration is required for its operational independence. A central bank conducts a variety of operations and some of them require cooperation with the government. This has become more important in the present situation. Therefore, let me discuss central bank operations in terms of the bank’s independence over them.

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Practices of Central Banking in a Constitutional Model

In monetary policy, there is a distinction between “goal independence” and “instrument independence.”7 This distinction is widely accepted and supported by academics. As for “instrument independence,” it is desirable to conduct monetary policy based on rules, such as the Taylor rule. In addition to the optimality of economic welfare that these rules ensure, as proven by Woodford (2003) and others, they also enhance the transparency and accountability of monetary policy. The Taylor rule was widely adopted by central banks in the 1990s but has become irrelevant under the zero lower bound interest constraint experienced in the 2000s. As an UMP, such as QE, could not established a Taylor type robust rule, it tends to be discretionary. It is likely to induce political interference. Unless it establishes a robust rule, a central bank requires greater accountability. There is room for debate regarding “goal independence.” A minimum degree of democratic control by the majority entails involving the government in setting the “goal.” In particular, they support the idea that the numerical value under inflation targeting should be determined by involving the government and/or parliament. Thus, a basic contradiction arises when myopic politics determine the long-term goal. Despite the argument of “goal independence,” the targeted number should be objectively examined by the central bank. Many central banks have presented 2% inflation as policy target since the 1990s. However, its relevance should be verified under the reduced natural interest rate. It is natural to assume lower inflation under the lower growth expected in the balanced growth perspective.8

2.4.5.2

Coordination with Fiscal Policy

Under the zero-interest bound constraint, economic theory proves that monetary policy needs fiscal coordination with the government. This is another reason why UMP tends to invite political interference. As shown in the discussion of the 1990s, central bank independence requires fiscal discipline. However, it cannot ensure balanced budgets after the expansion of fiscal spending in the aftermath of the GFC. As “fiscal dominance” suggests, unless the central bank checks the fiscal policy, it loses autonomy over monetary policy. Balls et al. (2018) suggest that the Bank of England should send an open letter about fiscal policy to the exchequer every quarter. This would be a significant proposal, with respect to the separation of powers, that government agencies should check one another.

7

This distinction was made by Debelle and Fischer (1994). Debelle uses his experience of 20 years to discuss its usefulness. 8 Takahashi(2019) has pointed out that the Bank of Japan has fallen into a “2% trap” that cannot be tightened for the foreseeable future because the 2% goal is unachievable.

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Financial Stability Policy

As the bank of banks, a central bank’s most traditional function is a financial stability policy. Central banks are better placed than the government to grasp the market conditions banks face. The recent financial crisis reminds us of the important role they play in a financial crisis. This shows that only the central bank can act promptly to ensure liquidity in the financial market. The policy has two problematic aspects that distinguish it from monetary policy. First, rescue operations sometimes lead to fiscal burdens. Second, it is difficult to create a rule and meet a numerical target under this policy (Balls et al. 2018). Therefore, further accountability is required and coordination with the government is an essential part of this policy.9

2.5 The Central Bank Independence: Japanese Case 2.5.1 Unfortunate Start So far, we have discussed the general case of central bank independence. Although the Bank of Japan enjoys the legal independence that other central banks have, it has struggled to exert its independence from the time it was granted. As I mention later, the independent power of the Bank of Japan seems to have weakened under the strong political pressures that have been exerted on it since its independence. This is in contrast to the trend of an increase in the power of other major central banks, and it is discussed to control of such highly empowered central banks. The Bank of Japan lacked legal independence for more than half a century under the old Bank of Japan law.10 In the rapid economic development led by bureaucrats in post-war Japan, when the bank showed its powerful influence on the banking sector, the Bank of Japan itself was controlled by the Ministry of Finance (MoF). The MoF was regarded as the strongest ministry in the government, but in the politician-led government reform in the late 1990s, the MoF’s role began to weaken. The independence given to the Bank of Japan reflected the debilitation of the MoF. Although the reform was largely conducted at the constitutional level, the Bank of Japan was given its independence as a byproduct of the MoF’s weakening. In contrast to the circumstances surrounding the independence granted to the Bank of England, there was no strong political will to grant independence to the Bank of Japan.

9

Financial stability entails the financial burden of bailing out troubled banks and also creates moral hazard on the bank side, as symbolized by the too big to fail problem. Brunmmeier (2016) calls it financial dominance and argues that coordination between financial authorities, central banks, and banks is difficult. 10 The previous law was enacted in 1942 under the military regime. Despite a minor change, the basic structure remained unchanged. I discuss this in more detail in the Appendix.

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In this political environment, the first phase of the Bank of Japan’s independence began on an unsatisfactory note. The Bank of Japan law of 1997 is similar to other central bank laws with respect to the independence of monetary policy. However, fiscal discipline, a necessary condition for independence, was not maintained in Japan. The code for fiscal stability was passed in 1998 in the U.K., and in Europe, the Maastricht Treaty was enacted in 1993. In Japan, the fiscal structure reform act was enacted in 1997. However, due to a sudden economic downtown in 1997 that was caused by an increase in the consumption tax and the emergence of a banking crisis, the act became invalid in 1998. After fiscal discipline was loosened, the fiscal deficit rose to over 200% of GDP. Thus, fiscal dominance acted as a restraint on monetary policy.

2.5.2 Deflation Another unfortunate episode in Japan is the prolonged deflation that began in the 1990s. The newly independent Bank of Japan had to confront the deflation problem that was largely ignored during the discussions about central bank independence in the 1990s. It was at first thought that deflation was caused by the bursting of the asset bubble and the banking crisis. However, it gradually became clear that a declining natural growth rate was the fundamental reality. In such a situation, the effectiveness of monetary policy is constrained. On the other hand, the fiscal deficit has continued to soar owing to stagnant tax collection and an increase in social security provision. The effectiveness of fiscal policy has also weakened. In such a situation, political pressure on monetary policy has been rising. The Bank of Japan, which adopted the zero-interest policy in 1999, was considered a front-runner in choosing UMP (Nakaso 2017). Since then, it has experienced a hard time and proceeded on the basis of trial and error. For example, the Bank of Japan was, at first, reluctant to adopt an inflation target. It changed the concept of the inflation target (‘understanding’, ‘outlook’, ‘goal’) and finally adopted the 2% target under strong political pressure in 2013. It can be said that the failure to establish a consistent policy invites political interference.

2.5.3 Abenomics Prime minster Abe won the general election after promising large-scale monetary easing in his manifesto in 2012. This was clearly the most direct political intervention in monetary policy and had never been seen before. Governor Kuroda, who was appointed by Mr. Abe, started the extraordinary monetary easing known as quantitative and qualitative easing (QQE) in April 2013. As the planned increase in consumption tax was postponed, fiscal discipline was further loosened. Because the

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Bank of Japan holds about half of the government bonds outstanding in the economy, it contributes to maintaining a low bond yield. This supports further loosening of fiscal discipline. The economic recovery that started in 2009 has been the second-longest in Japan since 1945 and the unemployment rate is at the lowest level ever. However, it has failed to meet the targets of 2% inflation and 2% growth under Abenomics. Although it is doubtful that it will meet these targets, Japan is set to continue the current fiscal and monetary easing in an attempt to reach them. This will bring about a further rise in government debt. An open letter about fiscal policy from the central bank to the treasury is proposed in the U.K., but there is no such discussion in Japan. The Bank of Japan does not act as a check on the government to ensure fiscal sustainability. The presence of political appointees as board members weakens the bank’s ability to check the government. Further, the central bank is forced to maintain silence about government policies. The 20-year experience of the Bank of Japan’s independence is characterized by “passive independence.” Under difficult economic circumstances, the Bank of Japan defends its independence to avoid conflict with the government. However, Japan has not come out from the economic slump that has lasted nearly three decades. The policy-making system must be refined to ensure that stakeholders bounce ideas off one another. Thus, this is the right time to reexamine central bank independence. We should reconsider the significance of an independent agency within the government. The separation of powers is the key to national governance in the future. There is an important difference in the central bank independence across the globe. The independence of the major central banks, such as the Federal Reserve, European Central Bank, Bank of England, and Bank of Japan, is commonly challenged. However, the three central banks in the U.S. and Europe are attacked because they have become very powerful as financial regulators and bank supervisors following the GFC. The discussion focuses on the control of highly empowered central banks (Tucker 2018). This is not the case when it comes to the Bank of Japan. The Bank of Japan has been criticized for the prolonged economic slump and her presence has weakened. Thereby, Japan faces the challenge of strengthening, in practice, the central bank’s independence to improve its national economic governance.

2.5.4 Proposal for Restoration of Independence Under Abenomics In the current political situation, many independent governmental agencies, such as the broadcasting house (NHK) and the central bank (Bank of Japan) maintain their independence by avoiding conflict with the government, especially the Prime Minister’s Office. The current government does not welcome critics from either inside or outside the government. This is not sound from the perspective of separation of

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powers and checks and balances. Independent agencies, including the Bank of Japan, should express their views on government policies more openly. With respect to transparency and accountability, although government representatives attend the monetary policy meeting, there must be extensive and informal daily communication between the central bank and the government. The government usually shows its initiative through such communications. However, such communications would not be made public. For example, the current inflation target of 2% was decided in January 2013 in a joint statement with the government. Journals and books report political pressure from the Prime Minister’s Office, but it is not revealed in public documents. The key element of central bank independence would be its relationship with the government. In the current situation, the most effective way to restore independence is to record its detailed communications with the government and disclose them. This could enhance the bank’s accountability; it would also reduce governmental interference and strengthen its ability to independently express its views to the government.

2.6 Conclusion: Future of the Central Bank After the GFC, many central banks adopted UMP. In addition, they have formally taken up the mandate of a financial stability policy and public debt management. At present, many central bankers and scholars support the use of “unconventional” monetary policy tools, such as forward guidance, even in normal times. Unconventional policies might be transformed into conventional policies. It is also widely admitted that central banks formally hold mandates other than monetary policy. Before the GFC, the ideal central bank model had the following features: (1) It should hold government bonds as its assets rather than those issued by the private sector. (2) In addition to prohibiting direct purchases of government bonds, there is a rule to limit for holding long-term government bonds. (3) It should minimize the size of its assets. (4) It should adopt a rules-based policy, such as the Taylor rule. In other words, in the ideal model, the central bank: (1) (2) (3) (4)

Avoids influencing private credit evaluation; Ensures fiscal discipline; Maintains the central bank’s sound financial condition, and Avoids directionality of policy operations.

These disciplines supported central bank independence, but the GFC makes the ideal model completely irrelevant. For example, the Fed: (1) Actively purchases private debt, such as mortgage-backed securities and government agency bonds;

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(2) Purchases government bonds without any limit; (3) Rapidly expands the size of assets held; and 4) Conducts UMP using its discretion. The disciplines mentioned above have loosened after the GFC.11 This loosening is not supportive for central bank independence. In this paper, by focusing on the political aspect, I have proposed a constitutional model for central banks. The model works as a system of checks and balances within the government. Thus, even the central bank enjoys independence as an institution; separate examinations are required for operations such as financial stability policy. A change in independence that reflects the social and economic circumstances is unavoidable. However, we should retain the basic principles of independence in the constitutional framework. It is the central bank’s mission to use its expertise to act as a general check on the government’s economic policies. This would be significant for central bank independence during the current difficult economic conditions being faced.

Appendix A: Culture, Democracy and Central Banking12 Introduction Since the global financial crisis, central banks have attracted social interest, and discussions about central banks have become active in academic fields other than economics. For example, Riles (2018) offered insight into an “independent central bank” in terms of the central bank’s culture. The central bank’s culture is being sought as a reasons why central bank independence is not easily accepted by society. In this appendix, we discuss the central bank’s independence with reference to the anthropology discussion. In every country around the world, a central bank was a rather isolated presence, with its own peculiar closed-off culture. Until the second half of the 1990s, most central banks were under government control. They did not stand out in society, and consequently, their culture did not attract social attention. However, as central banks grew increasingly independent and free from government interference, they were able to make policy decisions autonomously. While at first this independence concerned only monetary policy, after the experience of the 2008 global financial crisis, central banks have come to hold greater authority, such as by being responsible for financial stability. But who controls these more powerful central banks and how? As seen in 11

Takahashi (2019) argues in more detail that the unconventional policies of the last 20 years are the process of loosening the discipline of monetary policy. 12 This appendix is based on my comment in “Featured Panel - Author Meets Critics: “The Changing Politics of Central Banking” by Annelise Riles (Cornell University Press, 2018)” at the Society for the Advancement of Socio-Economics in June, 2018. I thank Professor Riles for giving me this wonderful opportunity and the chance to comment on her excellent book.

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the movement to “Audit the Fed” in the United States and calls for “People’s QE (Quantitative Easing)” in Britain, there are increasing calls for democratic control of central banks and monetary policy. Will central banks be allowed to remain strongly independent under such conditions? Riles (2018) suggests that the critical eye with which central banks are viewed today reflects a type of culture gap. Independent central banks proactively provide information about policies and other matters to fulfill their accountability obligations. However, the culture gap is a deep-rooted issue concerning far more than accountability. It would be desirable for the general public to understand central banks as strongly independent presences. A more open culture in the banks themselves might also be preferable, but these seem to me to be extremely difficult to achieve. This is because central banks originally involve some sort of undemocratic characteristics. This paper discusses deepening the public understanding of central banks by describing their undemocratic qualities.

What is a Central Bank? We start by addressing the question of just what a central bank is. Central bankers think of themselves as presences that provide underlying support for markets, rather than controlling them from above. Central banks employ monetary policy to control markets by tuning interest rates and the money supply. The source of this control is the fact that the central bank is the final provider of market liquidity as central bank credit. At times such as a financial crisis, when no one else is able to supply liquidity to the markets, the central bank is the only one that can provide it. This is why a central bank is referred to as the “lender of last resort.” As described in monopoly theory, the central bank, as the exclusive supplier of liquidity, can freely decide on both its price (interest rates) and the volume (monetary base) supplied. However, there are limits to such control. As market guardians, central banks have a duty to respond to liquidity demands from the banking sector. While explaining complex processes will be avoided here, monetary policy is implemented through financial tuning that has both an active nature of controlling the markets by supplying liquidity and the passive nature of this requirement to respond to market demand. Monetary policy also has its limits as macroeconomic policy. But since central banks have played major roles in resolving financial crises, expectations for central banks have increased excessively. Current macroeconomic challenges include decreased growth capacity, referred to as secular stagnation. The monetary policy central banks implement is a policy of controlling aggregate demand, and theoretically, it does not have the power to increase the potential for economic growth. While a recent debate has focused on monetary policy’s contribution to enhancing growth potential by increasing capital investment, theoretically, monetary policy has little effect on the supply side. The mismatch between excessive expectations for monetary

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policy and the power that central banks possess is one factor behind dissatisfaction in central banks. Also, central banks are essentially a presence that provides underpinning support for the markets. Central banks are “bankers’ banks.” In a market economy, privatesector banks process settlement of payments between businesses and households, while central banks process settlement of payments between banks. Ultimately, settling payments throughout the economy as a whole is concentrated in settlement performed by the central bank. The central bank’s most important responsibility is that of smoothly managing settlement throughout the economy as a whole. This relationship between the economy and the central bank can be depicted as an inverted triangle (Fig. 2.1). The inverted triangle depicts how, like water flowing downhill, settlement in the economy is concentrated in central banks through private-sector banks; it also shows how the central bank is a presence that provides underpinning support for settlement throughout the economy as a whole. A settlement system or payment system, as it is formally called, is an important societal infrastructure, providing support for markets. Its maintenance is another important central bank responsibility. In addition to maintaining and improving payment systems, the Bank of Japan also has long established and maintained money markets such as short term bills and securities, and recently has done the same for asset-backed securities. Traditionally, the central bank’s nature has been a passive one of serving as the unsung hero behind the scenes. The way central banks have been in the spotlight since the financial crisis is a historical aberration.

The Market Economy and Democracy One problem of central banks can be a lack of affinity with society. Probably one of the factors behind this is the poor relationship between the market system and democracy. The relationship between the economy and democracy is one of the most fundamental issues in the field of political economy. The conflict between democracy and central banks is expressed in monetary policy. William Martin, the sixth Chairman of the Federal Reserve, described the role of a central bank as to “order the punch bowl removed just when the party was really warming up.” His words express the “undemocratic” nature of a central bank as reflected in its responsibility to look toward the future and respond from a mediumto long-term perspective, as opposed to democracy, which tends to be short-sighted.

Central Bank Culture For economists, one of the innovative perspectives proposed by Riles (2018) is that of focusing on culture, something normally not given much importance in economics. A central bank, which is not necessarily compatible with democracy, has its own

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unique culture. As in any profession, central bankers are conscious of their mission in society and consider their work to have some kind of public significance. An organization is a group whose members share a social mission; thus, the norms that develop from this relationship govern their own behavior. The nature of a strongly independent central bank is an aristocratic one, and its norms may be likened to the concept of noblesse oblige. While at first glance such norms may seem outdated, they are important in that they have preserved the autonomy of central bank organizations until now. While private-sector business have also recently begun to stress social responsibility, the norms of central bank organizations have come to serve as important factors behind central bankers’ awareness of their social responsibilities. Yukichi Fukuzawa is one of the representative intellectuals in the Meiji period and had a great influence on the modernization of Japan. His expression “the leader of wild geese” is cited to describe the norms of the Bank of Japan staff as central bankers. This concept was introduced at the time of the BoJ’s centennial in 1982 by Governor Haruo Maekawa, one of the most respected figures in the BoJ. It can be considered an apt description of the Bank of Japan’s role within Japanese society: “When a flock of wild geese peck for food in wilderness, there is always one goose that stays vigilant and raises its head to watch around for signs of danger. This is the leader goose that looks after the flock” (Yukichi Fukuzawa, 1874). This description likening the role of a central bank to a leader of wild geese is an apt expression of the strong independence of a central bank with its eye on the medium and long term.

Constitutions and Central Banks If central banks are not necessarily compatible with democracy, does that mean that they also are incompatible with the constitutions that describe the overall framework of national governance? The constitutions of contemporary democratic states are based on the principles of not only democracy but also constitutionalism, as symbolized by separation of powers. In fact, the independence of central banks has a natural affinity with this concept of constitutionalism. An understanding of the central bank as a constitutional presence would strengthen understanding of the institution in society. However, this would depend on central banks proactively performing their constitutional roles. Respect for basic human rights is at the root of constitutionalism, whose main objective is to ensure that even majority rule through democracy does not infringe upon basic human rights. The courts are a typical example of constitutionalism’s separation of powers. Goodhart et al. (2017) likens the independence of central banks in individual countries to the independence of their supreme courts and notes that just as international comparison shows that the degree of Supreme Court independence varies by country, so does that of central bank independence.

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Constitutions and Central Banks As Riles (2018) points out, today’s criticism of the central bank is due to its nondemocratic culture. A harsh attack by populism could come from this point.13 As discussed before, the central bank is undemocratic in nature, and what is important is to make this point understood by society. Accountability is the most important means of communication. At present, it appears as if accountability is misunderstood by many. For example, currently it is being argued that one desirable means of accountability is that of setting clear policy objectives in advance and then achieving them. This is important for improving policy transparency. However, it goes no further than achieving objectives, resulting in a negative effect due to a loss of flexibility in monetary policy. While it is preferable for monetary policy to be managed as much as possible in accordance with rules specified autonomously, at the same time there is also a need for flexibility to quickly adapt to changing circumstances. In its original legal meaning, accountability refers to ex-post-facto accountability. The significance of accountability is in explaining the excuses for any failure to achieve objectives. Accountability should not place too much severe limits on policy beforehand. If accountability is understood properly as ex-post-facto responsibility, then central banks would recover their freedom of action, having been freed from the spell of accountability. After being freed from this spell, central banks should act proactively. As a constitutional presence, the central bank is responsible for serving as a constructive check on government through proactively advising on macroeconomic policies as a whole, in addition to its traditional duties of monetary policy and financial stabilization. The results should strengthen society’s understanding of a central bank as a constitutional presence beyond conventional accountability.

Conclusion The democratic upsurge of populism is strengthening the tension between central banks and society. This can be seen as society’s refusal to understand the central bank’s culture as a strongly independent presence even as the authority of central banks has strengthened since the financial crisis. However, central banks have an “undemocratic” nature and are not highly compatible with democracy. A central bank is a constitutional presence and should be understood in the context of constitutionalism rather than that of democracy. To advance such an understanding, it is essential that the meaning of the central bank as a constitutional presence be understood fully. Central banks themselves need to take advantage of this status to generate stronger track records by demonstrating their own independence. To do so, they must act as proactive checks on government as a constitutional presence, rather 13

See Goodhart et al. (2017).

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than merely independently managing monetary policy. This is the way the central bank really gains social understanding.

Appendix B: The Historical Development of the Bank of Japan Law: A Political Economics Analysis Introduction This appendix argues the developments of the central bank legislation in Japan from its foundation using a political economics viewpoint.14 Major changes in the legislation took place twice prior to the present Bank of Japan law. These changes reflect not only economic situations but also the political developments in each era. Although the previous two laws in Japan, particularly the previous one, are known as heavily regulated by the government, it could be argued that they contributed a lot to Japan’s economic development after the World War II. By contrast, despite an increase in freedom for central bank policy making, the current law does not necessarily succeed at playing an expected role. Comparing three cases, this appendix explores the problems of the present law in the context of Japan’s political and economic reform. The three changes in central bank law in Japan correspond to (1) the emergence of capitalism (1882), (2) the implementation of the wartime economic system (1947), and (3) the transition to low growth and globalization (1998). In other words, each reflects a major shift in the Japanese economy in modern Japanese economic history. In each case, the government reformed the economic and political system to reflect changes in the economy, and reforming the central banking system was part of this. In each period, the government’s approach to economic intervention has been different. The Bank of Japan Law of the Meiji and Showa periods was pursued in tandem with the clear political economics strategy of “developmental dictatorship.” The government was led to economic development through industrial promotion and the wartime economy. The strategy became widely rooted across the economy and allowed the economic system to change. However, in the case of the current law, although amendments were conducted in conjunction with major political governmental reform, decentralized powers were promoted in politics, and more market oriented measures ware proceeded, it cannot be said that these reforms have successfully changed Japan’s politics and economy as the reform of the central bank law has not necessarily been successful. In the remainder of this appendix, I provide a brief description of the central bank legislation since the Meiji period, which will illustrate the problem of the amendment in the current law. 14

This appendix focuses the political economics aspect of its history. A comprehensive analysis is given by Shizume (2018). Takahashi (2012) discusses the transition between a national governance system and the Japanese economy.

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Period of the Former Bank of Japan Laws The Bank of Japan was founded in 1882 (the 15th year of Meiji; hereafter, e.g., “M15”). The modern currency legislation, the Currency Act, was set in 1871 (M4) but it waited more than 10 years to establish the central bank. This is because Japan first adopted an American type of national banks system, a decentralized system of banks without a central bank. Banknotes were issued by national banks (1872, M5), but this finally ended in financial turmoil. The Bank of Japan was established to bring the currency system turmoil to an end. Central banks are typically established to procure funds for fiscal spending, as well as to act as central clearing houses for payments between banks. This was the case with the Swedish Riksbank and the Bank of England. However, there had been a previous example of a central bank being established to end currency system turmoil, as the Banque de France was founded after a long period of currency system turmoil following the French Revolution. The Bank of Japan, which was a similar case, issued its banknotes in 1885 (M18); it took three years after the bank’s foundation to settle the turmoil. In addition to issuing banknotes, the Bank of Japan operated at the heart of the Japanese banking system and contributed to the development of the Meiji-period Japanese economy by supplying credit to banks, facilitating interbank settlements, and so on. The Meiji government’s basic strategy for economic development was to promote an industrial revolution to catch up with Western powers. In the early Meiji period, the banking system had been established to supply funds to nascent important industries such as textiles, steel, and electricity. The Bank of Japan was modeled after the National Bank of Belgium. At that time, Belgium had become independent from France and was in a phase of development similar to that of Japan. Specialized banks, Nippon Kangyo Bank (1896, M29) and the Nippon Kogyo Bank (1897, M30) were established to supply investment funds to such industries. A doctrine of specialization was established, which came to characterize the Japanese banking system. Its basic structure lasted until the 1990s. Long-term credit banks that were built to provide funds for heavy industries, disappeared in the wake of the Japanese banking crisis in 1997–1998. In developing countries, the central bank often supplies long-term credit for investment, but the Bank of Japan was designed to provide short-term credit, similar to commercial banking. With regard to credit provision, working capital was supplied through the discounting of commercial bills.15 15

However, the system of commercial bills had not been widely adopted in the Meiji period, so it was difficult to provide central bank credit only through rediscounting bills. Even though the Bank of Japan was prohibited from making loans with real estate or shares as collateral (Article 12), in fact, what was frequently used in addition to loans (fixed-term loans) was “discounting of guaranteed bills,” such as public bonds and gold bullion. Their scope of collateral was expanded to include “discounting of bills secured by shares,” and then further expanded to include “discounting of bills secured by collateral goods.” Furthermore, while the Bank of Japan in the Meiji period was charged with adjusting liquidity through discounting commercial bills, there has been criticism that, in practice, the government was in charge, with a large proportion of funds being supplied for long-term industrial funding and public bonds. However, taking a broader view of the formation of

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At the time of the first Bank of Japan Act (Meiji law, hereafter), the relationship between the Bank of Japan and the government could be described as one in which government intervention was more limited than it would later be under the second Bank of Japan Law (Showa law, hereafter). The government appointed a supervisor and maintained the right for general oversight over the Bank of Japan’s operations. In addition, the governor was appointed by the emperor, while the directors and auditors, after their election at shareholders meetings, had to be formally appointed by the government. Therefore, while there was government involvement, the central bank was basically organized similar to a joint-stock company under the Commercial Code in the Meiji period. The directors and auditors were elected at shareholder meetings, and bill discount rates/amounts, which constituted monetary policy, were determined after a resolution by a board that comprised the governor, deputy governor, and directors. This system was modeled after that of the National Bank of Belgium and was fairly standard for central banks in the world at the time, with the exception of countries such as Germany where the government had a high level of involvement. Although the Meiji government exercised leadership, it aimed to develop capitalism by establishing joint-stock companies like those in the advanced capitalist countries. Moreover, the central bank was probably also established not to achieve state control of the economy, but rather as a necessary tool for developinomg capitalism. As a result, it was natural that the central bank would be launched in the form of a joint-stock company.

Period of the Former Bank of Japan Act The establishment of the former Bank of Japan Law in 1942 (the 17th year of Showa; hereafter, “S17”) is generally understood as having been vital for establishing a wartime financial system suited to the wartime economy. Beside the central bank law, the series of measures taken under the wartime financial system established a mechanism for prioritizing allocation of funds to industries supplying the military. The measures included enactment of temporary monetary coordination legislation in 1938 (S13), establishment of a system for ordering banks to make loans in 1940 (S15), legislation for companies supplying the military in 1943 (S18), and legislation for special measures for munitions financing in 1945 (S20). The establishment of the former Bank of Japan Law (Showa law) coincided with the end of its business under the Meiji Act of 1882.16 This can be seen as marking the transition to a wartime system and a shift to total state control over the economy. the Meiji-period banking system, there was a separation of functions. For example, besides Kangyo Bank, Noko Bank, and Kogyo Bank, there was also the Yokohama Specie Bank. It can therefore be said that the role of the Bank of Japan in industrial finance was expected to be limited. 16 Until the wartime economic system was established, amendments to the Bank of Japan Act were considered on several occasions, and some amendments were actually made. The Genoa Conference (1922, the 5th year of Taisho; hereafter, “T11”) was symbolic of a worldwide trend in the interwar period toward strengthening the independence of central banks. During this period, the

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However, it also met the needs of that time’s economic realities, supplying funds to increase the appetite for government bonds and expand production capacity.17 Actually, although Japan had a full-scale war-time economy in the 1940s, rapid development and fiscal expansion were seen much earlier. Even under Meiji law, while the range of bills eligible for discounting was gradually expanded, as long as “involvement with industry either directly or indirectly” (Article 12) was prohibited, it was clear that the principles of Meiji law were at odds with the changing economic system. Under Meiji law, there was no regulatory basis for the central bank to take administrative measures as a branch of the government. It became an organ of state control over the economy and, with the launch of the Financial Control Council (1942), was responsible for controlling finance, including arranging financing from private-sector banks and providing guidance.18 The Showa law of 1942 went beyond the principles of commercial banking to provide more means for supplying funds to industry. For example, it expanded the range of bills that could be discounted (Article 20). Furthermore, it included provisions for the Bank of Japan to play an active role in controlling the financial sector (Article 3), which was intended with the supply of funds to munitions industries. Later, it allowed the Bank of Japan to play an active role in Japan’s post-war economic development through interventionist policies. In addition, by expanding the scope of commercial bills and the range of securities that it could deal, the Bank of Japan became more active in achieving the national economic goal. In the currency system, the gold standard was formally abolished in favor of a managed system (Articles 29– 31). The adoption of the managed currency system and a stipulation concerning providing credit to the government (Article 22) allowed wartime expenses to be covered through the indefinite monetization of fiscal funds. In addition, a dictatorial system was adopted whereby the governor alone determined policy. In other words, the joint-stock company system was overhauled, with shareholders becoming equity investors without rights of common interest. Shareholders meetings were also scrapped. As for personnel, the governor and deputy world experienced a shift toward a market economy and globalization. As markets developed independently, the significance of central banks as the heart of market economies became emphasized, and debates about making them more independent began to occur. Moves to strengthen the Bank of Japan’s independence were also seen in the active utilization of the advisor system (established in 1932, S7) (advisory director system, 1937, S12). 17 Among these, there had been calls from in the past from inside the Bank of Japan to expand the Bank’s authority and allow it to supply funds to industry. As mentioned earlier, Japan’s financial system from the Meiji period onwards involved separately establishing banks to provide funds to industry. However, as the heavy and chemicals industries became established in conjunction with development of the Japanese economy, the role of finance in supplying funds to industry became increasingly important. Thus, it was probably natural for the idea to emerge that if the Bank of Japan was to be responsible for the economy as a whole, it should also have influence on the industrial finance side. This was also the personal opinion of Seihin Ikeda, who was appointed governor of the Bank of Japan in 1937 (S12), and amendments to the wording of the Law were prepared (a similar amendment had also been proposed previously in 1930 (S5)). 18 The Bank of Japan governor was also the chairman of the Control Council, which was administered from inside the Bank of Japan.

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governor were appointed by the Cabinet, while the directors were appointed by the Minister of Finance. There was also a provision that allowed the government to dismiss officers. In addition, the name of the board was changed, and it was put under the control of the governor, with the deputy governor and directors losing their voting rights. Showa law of 1942 was strongly influenced by the Reichsbank Law established by the Nazis, and it was an extreme piece of legislation for the wartime economy. During wartime, however, central banks in every country were forced to act on a wartime economic basis to a greater or lesser extent. Immediately after the war, the Bank of England was nationalized, and an accord was established in the U.S. between the Federal Reserve and the Treasury. In this way, greater control was being exerted over central banks. During this period, the war resulted in economic crises both during and after the conflict, and regulation of the economy as a whole was tightened in response. However, it needs to be borne in mind that the fact that this strengthening of regulation and government intervention that extended as far as the central-banking system could not be applied as is to economic crises in peacetime. On the other hand, attention can be paid to the fact that even as Japan moved to a wartime system and government control was strengthened, the Bank of Japan was awarded status as a private corporation, as it was deemed to be an authorized corporation.19 This means that even under the wartime system, the central bank was not regarded as being part of the government like a ministry or agency. Whatever the case, the principles of Showa law were clearly based on a statist economy. It is important to note that the wartime control-oriented system essentially continued to function for 50 years after being absorbed into the post-war development-dictatorial system. Under the wartime financial system, a system of designated banks charged with lending to individual munitions companies was established, and this formed the prototype for the famous Japanese post-war system of main banks. Consequently the wartime system continued for many years after the war. This also showed that the changes in the wartime economic system were rational in the context of changes in the economy’s structure, namely the establishment of heavy and chemicals industries and a system of mass production. The post-war Japanese economy followed a path of rapid growth that allowed it to catch up with the advanced countries as the government pursued an industrialization strategy based on allocation funds in a controlled fashion. Furthermore, the prohibitions related to government credit were included in the post-war Public Finance Act and fixed exchange rates meant that the balance of payments ceiling effectively served as an anchor. As a result, 19

Regarding the Bank of Japan under Meiji law, constitutional law scholar Tatsukichi Minobe expressed the following view: “Even though the operations that it is charged with performing constitute state business, if the establishment of a company for the purpose of conducting said business is based on the will of individuals (shareholders), it is a private corporation.” Furthermore, during the debate in the Diet when the former law was amended, which strengthened state control, Finance Minister Kaya stated that the Bank of Japan’s legal status was as a private corporation. Thus, the Bank of Japan, which had been established by the state in the Meiji period and increasingly took on the character of an organ of the state under the wartime system, was given the status of a “private corporation.” This reflected the basic character of a central bank as an organization that is required by a market economy and reflected the fact that in addition to the state requiring a central bank, the economy also required a central bank.

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discipline was restored as the fiscal authorities adopted a policy of balanced budgets. Meanwhile, the Bank of Japan, under what was initially a fairly regulation-oriented financial system, would be responsible for interventionist financial administration, such as arranging loans. Later, while also implementing regulatory measures such as “window guidance,” it would loosen its controlling style with regard to matters such the Bank of Japan’s supply of credit to the banking sector as the economy developed.

The Current Bank of Japan Law The current Bank of Japan Law (Heisei law, hereafter) was passed in 1997 and came into force in 1998. Heisei law entrusts monetary policy to a committee called the Policy Board,20 and strips the government of the right to dismiss Board members, whose status is guaranteed. Through provisions such as these, independence concerning the decision of monetary policy is enhanced. It also strips the government of general supervisory power (the right to give orders concerning any operation), which follows global standards concerning central-bank independence, particularly with regard to monetary-policy decision. The committee system was introduced much earlier under the influence of the U.S. as part of the post-war administrative reforms. Committees such as the Statistics Commission (1946) and the Education Commission (1948) were organized, and within the Bank of Japan, the Policy Board was established in 1949 (S24). However, because the Ministry of Finance retained wide-ranging supervisory authority, the Board did not possess significant authority. It can be argued that this situation had much in common with the fact that the various administrative committees that had been established as part of the post-war reform of the Government in Japan had subsequently either been abolished or turned into rubber-stamping organizations with no real power. In other words, with the principle of decentralization of authority failing to gain traction, systems like these did not take root. So, the current Bank of Japan Policy Board system renews the mission of committee system. It fulfills the role of pooling the wisdom of the expert Board members concerning monetary-policy decisions. At the same time, it led the introduction of external members of Director in the board of private corporations in Japan. Under Heisei law, it is clearly stipulated that monetary-policy decisions by made by a majority vote at monetary policy meetings. Just as has always been the case at meetings of the Policy Board, government members are permitted to attend monetary policy meetings and state their opinions, yet the two government members no longer have voting rights. In addition, while the government members have the right to delay the adoption of a resolution until the next meeting, if exercised, this right is 20

The committee system for the determination of monetary policy was adopted not only by the Bank of Japan but also the European Central Bank, which was established at around the same time, the reformed Bank of England, and others. It has been pointed out that in the background to this was the fact that central banks where decisions were already taken by committee, such as the German Bundesbank and the U.S. Federal Reserve, monetary policy had been comparatively superior.

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deemed to have been exercised by a Board member other than one of the government members. The current Bank of Japan Law champions “open independence”. The Bank of Japan is subject to the Freedom of Information Act as a public body.21 Furthermore, actions such as semiannual reports to the Diet and the publication of meeting summaries and minutes are typical examples of accountability that provide evidence of policies that have actually been implemented. These sorts of accountability are the price the Bank of Japan has to pay for its independence in its policies and operations, and are particularly important as checks and balances for the Bank of Japan, over which supervision by the government and the Diet has been weakened. On the other hand, the Bank of Japan has strengthened publicity. For example, with respect to the monetary policy, it has always published summaries and minutes of the Board meeting, and also given press conferences. The U.S. Federal Reserve also began holding press conferences in 2011 after meetings to determine policy (meetings of the Federal Open Market Committee (FOMC)), but the Bank of Japan has been doing so since Heisei law came into force. Regarding summaries, the Bank of Japan has speeded up publication of its financial and economic reviews, which express the Policy Board’s view of the economy, and since 2000 has published a report called the “Outlook for Economic Activity and Prices” (normally referred to as the “Outlook Report”), which gives the Policy Board’s outlook for the future of the economy. Later, it brought forward the timing of publication, and also extended the period covered by the outlook from the current fiscal year to the following fiscal year. This expansion in publicity partially fulfills accountability obligations as it allows policy decisions to be tracked. For example, as a means of integrating information provision with policy, an approach called “forward guidance” has been adopted for the purpose of disclosing future policy and influencing market expectations, and thereby, for example, controlling long-term interest rates.22 With regard to its budget, authorization from the Minister of Finance continued to be required, but the budget for monetary policy no longer needed to be approved. Also abolished was a provision that the government would cover the Bank of Japan’s losses if it ever ran short on capital. This set of measures served to prevent the government from ex-ante intervention in monetary policy, but they also mean that the Bank of Japan undertakes full responsibility for monetary policy.

21

Strictly speaking, it is not a public body, and is subject to the Act on Access to Information Held by Independent Administrative Agencies (which came into force in 2002). 22 Typical examples are commitments and time-related effects such as pledges to continue the current policy until this or that point in the future or continue the current policy until the economy satisfies certain specific conditions.

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Problems with the Current Bank of Japan Law In the case of Japan, the period during which the amendment of the Bank of Japan Law occurred was, as described earlier, one in which the previous political system had reached a turning point marked by reforms. As for the economy, it was in an adjustment phase as the economy entered a low-growth era. In addition, liberalization of the financial system had been completed, so it was also a period of transition to new forms of financial sector. During this transition phase, the corporate sector went from being short of funds to having a surplus, which had a major impact on money flows by eradicating the excess demand for funds that had characterized the post-war financial system. At the same time, the accumulation of financial assets continued and assets began to play a greater role in the economy. Regarding the world economy, as the so-called globalization of finance progressed, a major change also occurred in the shape of the rise of the economies of neighboring Asian countries. The period of the amendment of the Bank of Japan Law was therefore a huge turning point in both politics and economics from both a domestic and international perspective. During this period, Japan chose the large scale reform of the political and economic system. And in the area of the economy, the preceding trend was reflected in the promotion of a market economy in which government intervention and regulation was reduced and market mechanisms were respected. The principle behind major reforms such as deregulation, the decentralization of authority to regions, the demarcation of roles of the public sector and the private sector, and judicial reform was the promotion of decentralization and the strengthening of the independence of the Bank of Japan formed one part of that. The decentralization of authority is highly congruent with the promotion of market economy, in that individual entities are they themselves responsible for making decisions autonomously. It was hoped that this would open the door to new possibilities in the twenty-first century. However, looking at what the subsequent reforms achieved, and at progress with regional decentralization of authority, various problems, including with judicial reform, have become apparent, and it cannot be said that adequate results have been made. These reforms have been “the reform of national governance system in Japan,’ which was accustomed to being ruled and tended to depend on the government,23 ” yet politically, reforms such as local-government reform and judicial reform have only gone halfway, and in the area of economics and finance, a backdrop of prolonged economic stagnation and financial crises has actually led to the central government becoming more protective. Looking back over the history of amendments to the Bank of Japan Law, considering that the amendments of the Bank of Japan Act of the Meiji period and the Bank of Japan Law of the wartime years during the Showa period contributed to the development of the economy during the Meiji period and the Second World War, even though there is room to discuss the soundness of their objectives, they represent a trend toward reforming systems to reflect major structural changes, and in that sense they can be said to have been successful. The current Law, on the other hand, was a 23

Final Report from the Administrative Reform Council, December 3, 1997.

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Fig. 2.1 Central Bank, Banking Sector, Economy

response to new economic changes, success or failure in the future will depend on going back to the original principles with reform with those principles in mind. In that sense, the amendment of the new Bank of Japan Law are not yet finished.

References Balls E, Howat J, Stansbury A (2018) Central Bank Independence Revisited: after the financial crisis, what should a model Central Bank look like? M-RCBG Associate Working Paper No. 87. Available at https://www.hks.harvard.edu/sites/default/files/centers/mrcbg/working.papers/ 87_final.pdf Brunnermeier MK, Pedersen LH (2008) Market liquidity and founding liquidity. Rev Financial Stud 22(6):2201–2238 Brunnermeier MK (2016) Financial dominance. Banca d’Italia Lezioni Paolo Baffi di Moneta & Finanza Debelle G, Fisher S (1994) How Independence should a Central Bank be? Working Papers in Applied Economic Theory Goodhart CAE, Lastra R, María A (2017) Populism and Central Bank Independence (Centre for Economic Policy Research Discussion Paper; No. 12122 Goodhart C, Meade E (2004) Central Banks and Supreme Courts. Monede Y Credito, No. 218:11–42 Goodhart C, Schoenmaker D (1995) Should the functions of monetary policy and bank supervision be separated? Oxford Economic Papers, New Series 47(4):529–560 Nakaso H (2017) Evolving monetary policy: The Bank of Japan’s Experience. Available via https:// www.boj.or.jp/en/announcements/press/koen_2017/data/ko171019a1.pdf Persson T, Roland G, Tabellini G (1997) Separation of powers and political accountability. Quart J Econ 1120(November):1163–1202 Riles A (2018) Financial citizenship: experts, publics, and the politics of Central Banking. Cornell University Press Sargent TJ, Wallace N (1981) Some unpleasant monetarist arithmetic. Federal Reserve Bank of Minneapolis Quarterly Review (Fall), pp 1–17

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Shizume M (2018) A history of the Bank of Japan, 1882–2016. In: Edvinsson R, Jacobson T, Waldenstorm D (eds) Sveridge Riksbank and the History of Central Banking. Cambridge University Press Takahashi W (2012) The Japanese financial sector: from high growth to lost decades: economic transitions from the perspective of market economy orientation. In: Walter A, Zhang X (eds) East Asian Capitalism: diversity, change and continuity. Oxford University Press Chapter 10 pages, pp 201–222 Takahashi W (2014) When central bank independence is challenged by unconventional monetary policies. Bruegel Blueprint Series 22:67–77 Takahashi W (2019) Monetary policy in Japan: a review of the Heisei period, mimeo Tucker P (2018) Unelected power: the quest for legitimacy in Central Banking and the regulatory state. Princeton University Press, Princeton Woodford M (2003) Interest and prices: foundations of a theory of monetary policy. Princeton University Press, Princeton

Additional non-cited References Allen WA (2017) Quantitative Easing and the Independence of the Bank of England. NIESR Policy Paper. 001 (2017) Available at https://www.niesr.ac.uk/sites/default/files/publications/NIESRP P001.pdf Bank of England (2017) Independence—20 years on. Available at https://www.bankofengland.co. uk/events/2017/september/20-years-on Buiter W (2014) Central Banks: powerful, political and unaccountable? Discussion Paper No. 10223, Centre For Economic Policy Research Chrystal A (1998) Summary of discussions. In Government debt structure and monetary conditions. Bank of England, London Cukierman A (1992) Central Bank strategy, credibility, and independence: theory and evidence. MIT Press, Cambridge Cukierman A (2008) Central bank independence and monetary policy making institutions—past, present, future. Eur J Political Econ 722–736 Cukierman A (2013) Regulatory reform and the Independence of Central Banks and financial supervisors. In: Morten Balling EG (ed) States, bans and the financing of the economy: monetary policy and regulatory regimes. SUERF, Vienna, pp 121–134 Debelle G (2017) Central Bank Independence in retrospect. In: Address at the Bank of England Independence: 20 years on conference. Available at https://www.rba.gov.au/speeches/2017/spdg-2017-09-28.html Drazen A (2000) Political economy. In: Macroeconomics. Princeton University Press, Princeton Eggertsson G, Woodford M (2004) Optimal monetary policy and fiscal policy in a liquidity trap. NBER International Seminar on Macroeconomics. Reykjavik, Iceland Eijffinger SC, De Haan J (1996) The political economy of Central Bank Independence. Special Papers in International Economics, Princeton Eijffinger S, Geraats P (2006) How transparent are central banks? Eur J Political Econ 22(1): 1–21 Feldstein M (2002) The role for discretionary fiscal policy in low interest rate environment. NBER Working Paper 9203 Fischer S (2017) The independent Bank of England, Board of Governors of Federal Reserve System. Available at https://www.federalreserve.gov/newsevents/speech/fischer20170928a.htm Geithner T (2014) Stress test: reflection on financial crises. Broadway Books Goodfriend M, King R (1988) Financial deregulation, monetary policy, and central banking. In: Haraf W, Kushmeider R (eds) Restructuring banking and financial services in America. AEI

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Goodhart C (2010) The changing role of Central Banks. Bank for International Settlement working Papers No. 326 King M (1997) Changes in UK monetary policy: rules and discretion in practice. J Monet Econ 39:81–97 Krugman PR, Dominquez KM, Rogoff K (1998) It’s baaack: Japan’s slump and the return of the liquidity trap. Brooking Papers Econ Activity 2:137–205 Kydland F, Prescott E (1997) Rules rather than discretion: the inconsistency of optimal plans. J Political Econ 85: 473–491 Persson T, Tabellini G (2002) Political economics: explaining economic policy. The MIT Press, Cambridge Rogoff K (1985) The optimal degree of commitment to an intermediate. Quart J Econ 100:1169– 1189 Svensson LO (2000) The zero bound in an open economy: a foolproof way of escaping from a liquidity trap. NBER Working Papers 7957 Walsh CE (1995) Optimal contracts for central bankers. Am Econ Rev 150–167

Chapter 3

Japanese Experiences and an International Comparison Yoichi Matsubayashi and Tamotsu Nakamura

3.1 Introduction In Chap. 1, a leading macro and monetary economist provides a clear theoretical background and highlights the importance of inflation targeting in unconventional monetary policy. In Chap. 2, a monetary economist with extensive work experience and a proven track record of analysis explores the role of central banks and the meaning and desirability of their independence. Although we believe that most readers will be quite familiar with monetary policy theories and discussions, some might not be familiar with them. Hence, this chapter offers some basic concepts related to recent monetary policies, which are sometimes referred to as unconventional monetary policies. Traditionally or conventionally, central banks have targeted nominal interest rates, such as the official discount rate in Japan and the federal funds rate in the United States, as a primary measure for conducting monetary policy. However, they are unable to set interest rates. Nominal interest rates have a clear lower bound, which is, of course, zero. As Keynes (1973[1936]) points out, the lower bound is not necessarily zero. In fact, he states as follows in Chap. 15. There is the possibility,…, that, after the rate of interest has fallen to a certain level, liquiditypreference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. (Page 207, Keynes 1973[1936])

As Fig. 3.1 shows, for the Group of 7, or G-7, countries, the rates of return on the safest financial assets, that is, government bonds or treasury bills, declined after the Lehman shock in 2008 and were at their lowest in 2016. In other words, the G-7 countries made every effort to push down nominal interest rates. Nevertheless, they © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2021 Y. Matsubayashi et al., Monetary Policies in the Age of Uncertainty, Kobe University Social Science Research Series, https://doi.org/10.1007/978-981-16-4146-6_3

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14.0 12.0 10.0 8.0

10-year Bond Yields for G7 Countries (%) US

Japan

France

Germany

UK

Italy

Canada

6.0 4.0 2.0 0.0 -2.0

Fig. 3.1 Nominal interest rates for G-7 Countries. Source Bloomberg (2020/11/4 access)

could not ensure continued economic recovery through traditional monetary policy, which forced them to plunge into unconventional monetary policy. In retrospect, 2017 was an epoch-making year for economic policy authorities, especially for the central banks in most advanced economies. Since the global economy was observed to be steadily recovering, central banks, including the Federal Reserve Bank of the United States, the European Central Bank, and the Bank of Japan, were beginning to try to identify the best time to begin a retreat from these unconventional monetary policies, as well as how to retreat, that is, their “way-out” strategies. As Fig. 3.2 shows, the Japanese and world economies attained their highest growth rates after the 2008 Lehman crisis in 2010. Of course, this is a phenomenon that is often seen after a serious economic downturn. What is important in Fig. 3.2 is that although the world economy showed steady recovery in the 2010s, the sluggish Japanese economy did not. This may suggest that although 2017 was a little early for the Japanese economy, 2017 was a good time for many advanced economies to discuss or even begin their retreat from unconventional monetary policies. Another important indicator for determining an accurate time to retreat is the inflation rate. Figure 3.3 shows the inflation rates for the G-7 economies, including Japan, which are also presented in Chap. 1. The graphs show that the G-7 economies experienced near-zero inflation in 2015 and/or 2016 and escaped from the situation in 2017. In addition to nominal interest rates, growth and inflation rates were at least somewhat influenced by the central banks’ policies. An understanding of unconventional monetary policy is essential for examining their behaviors. It is well known that the unconventionality of recent monetary policy consists of three pillars: quantitative and qualitative monetary easing, negative interest rates (or inflation targeting), and

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Growth Rates: World and Japanese Economies 10 5 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 -5 -10 World

Japan

Fig. 3.2 Growth rates of Japanese and World Economies. Source IMF World Economic Outlook Database April 2020

Inflaon Rates for G7 Economies 8 6 4 2 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

-2 Japan

Italy

UK

Canada

Germany

France

US

Fig. 3.3 Inflation rates for G-7 Countries. Source IMF World Economic Outlook Database April 2020

yield curve control. In the following three sections, we discuss each of those three pillars in turn to review the policies and consequences.

3.2 Quantitative and Qualitative Monetary Easing (QQE) 3.2.1 Quantitative Versus Qualitative This section discusses quantitative and qualitative monetary easing, which is usually abbreviated as QQE. QQE includes two similar but different words: “quantitative”

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and “qualitative.” In the context of monetary policy, “quantitative” means the volume of money supply (or monetary base), while “qualitative” means the composition of the open market buying operations. To reduce nominal interest rates, the central bank purchases financial assets, the main portion of which is government bonds. As discussed above, interest rates have lower bounds. Put differently, an economy can potentially fall into a “liquidity trap.” During a liquidity trap, further money supply, that is, future buying operations, seems to have no impact on economic activities. However, this idea stems from considering only the interest channel of monetary policy. When the private sector has insufficient liquidity for economic activities, the sector benefits from an increase in the money supply, which helps the economy as a whole recover. Even if the central bank purchases only very safe assets, such as government bonds, its operations can have a positive impact on the economy by reducing interest rates and injecting money into the private sector, that is, quantitative easing. In response to a decrease in the safe asset’s rate of return, the risky asset’s rate of return also decreases, even if the gap between the two rates widens. This gives the public an incentive to purchase risky assets and hence, helps private firms raise money to invest in human and physical capital. Quantitative easing facilitates investment activities through this channel; however, these are evidently rather indirect effects. The central bank’s purchase of risky assets instead of very safe assets will help the private sector more directly. Since this qualitatively changes open market operations, it is referred as to qualitative monetary easing.

3.2.2 Central Bank Balance Sheet Size or Quantitative Easing First, we examine quantitative monetary easing. Figure 3.4 shows central bank balance sheet sizes relative to nominal GDP in the advanced economies. Even before the Lehman crisis, the Bank of Japan’s balance sheet was as close as 30% of nominal GDP, while those of the Federal Reserve Bank, European Central Bank, and Bank of England were at about 10%. Central banks other than the Bank of Japan started quantitative monetary easing in 2008, which clearly shows that they learned from Japanese monetary policy in the 1990s and realized the effectiveness of quantitative easing. Surprisingly, however, the Bank of Japan did not promptly accelerate easing in response to the 2008 Lehman shock, as it started rapidly increasing the monetary base again in 2013. Of course, we should note that the graph shows the bank balance sheet sizes relative to nominal GDP. If GDP grows rapidly, the relative size decreases even if the central bank does not reduce the monetary base.

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Central Bank Balance Sheet Size Relative to Nominal GDP 120

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40

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0 2004

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2012 2014 term (quarterly)

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Fig. 3.4 Central Bank balance sheet size relative to nominal GDP. Source Federal Reserve Economic Data, Bank of Japan, European Central Bank, Bank of England, Office for National statistics (UK) (2020/10/17 access)

3.2.3 Composition of Central Bank Balance Sheets (Qualitative Easing) Second, we look at qualitative monetary easing. Traditionally, central banks purchase safe financial assets, such as government bonds. Figure 3.5 shows the share of outstanding government bonds held by the central banks in four advanced economies. It is interesting to compare Fig. 3.4 and the green lines in Fig. 3.5. The yellow line in Fig. 3.4 and the green line in Panel (A) in Fig. 3.5 move in much the same way. That is to say, in the case of Japan, quantitative easing has been largely accomplished by purchasing government bonds and has not necessarily been accompanied by qualitative easing. In contrast, the light blue line in Fig. 3.4 moves very differently than the green line in in Panel (B) in Fig. 3.5, especially during 2008 and 2012. The Federal Reserve Bank’s quantitative easing was surely accompanied by qualitative easing. The actions taken by the European Central Bank and the Bank of England in response to the Lehman crisis were somewhere between those of the Bank of Japan and the Federal Reserve Bank. As we can see by comparing the gray and yellow lines in Fig. 3.4 to the green lines in Panels (C) and (D) in Fig. 3.5, the European Central Bank policy

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Fig. 3.5 Central Bank Shares of Government Bonds. Source Bank of Japan, Ministry of Finance (Japan), Federal Reserve Economic Data, European Central Bank, UK Debt Management Office (2020/10/20 access)

was rather close to the Bank of Japan’s policy, while the Bank of England’s actions were close to those of the Federal Reserve Bank. We collectively refer to monetary policy as quantitative and qualitative easing, that is, QQE. However, it should be noted that the composition of QQE varies greatly among central banks.

3.3 Negative Nominal Interest Rates 3.3.1 Forward-Looking Monetary Policy One of the important distinctions between traditional or conventional monetary policy and untraditional or unconventional policy is the role of expectations. Unconventional monetary policy includes policy measures that mainly aim to influence people’s future expectations to facilitate economic recovery. This idea is not new but has often been pointed out by economists in the past. One of the most influential economists who

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emphasized the importance of people’s expectations is John Maynard Keynes, who states the following in his General Theory1 : Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits - of a spontaneous urge action rather than in action, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. (Page 161, Keynes 1973[1936])

Before Keynes (1973 [1936]), Hawtrey (1922) also stressed the importance of conducting monetary policy in a forward-looking manner, that is, by influencing people’s expectations, as follows: The explanation is that it is not the past rise in prices but the future rise that has to be counteracted. The problem is a psychological one. As soon as the rate is high enough to offset the traders’ hopes of future profits it becomes deterrent. And a very relevant factor in the psychological problem is the traders’ expectations as to the intentions of the authority which fixes rates. If that authority means business and can be relied on to push up rates relentlessly till, they become deterrent, the mere expectation that this will happen may make quite a moderate rate adequate. For the prospect of rising prices is dispelled and normal standards of profit and interest are re-established in the traders’ minds. (Page 236, Hawtrey (1922))

As noted in the first section of this chapter, nominal interest rates have a clear lower bound of zero, and Keynes (1973[1936]) points out that the liquidity trap may emerge even when nominal interest rates are positive. Although a central bank is not able to push the nominal interest rate below zero, it may be able to lead the real interest rate into a negative range by influencing people’s expectations about inflation. Here, we should be aware of the Fisher equation which states that the real interest rate is the nominal interest rate net of the expected inflation rate. In the past, however, we have long believed certain boundaries existed in terms of zero real interest rates; thus, a negative interest policy may be considered one of the innovations in the monetary policy arena. Monetary authorities are now believed to engage in deliberate and long-lasting efforts to influence people’s expectations about the future.2

3.3.2 Nominal and Real Interest Rates Figure 3.6 shows the call rates in the advanced economies. We clearly see from the figure that all the central banks immediately reduced rates in response to the Lehman crisis. Moreover, the Federal Reserve Bank, the Bank of England, and the Bank of Canada began increasing call rates in 2017. In other words, they seemed to begin to retreat from their unconventional monetary policies. Two types of real interest rates exist: the ex-ante real interest rate and the ex-post real interest rate. The ex-ante rate, which corresponds to Fisher’s definition, is of 1

The importance of the psychological factors, such as animal spirits, are also emphasized and well explained in many books, such as Akerlof and Shiller (2009). 2 Kuroda (2016) provides a perspective on the role of expectations in monetary policy in the history of academic theory.

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(%)

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16 14 12

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Japan

EU

UK

10 Canada

8 6 4 2 0 -2

Fig. 3.6 Call rates in major economies. Source Bloomberg (2020/11/4 access)

course more important than the ex-post rate in shaping people’s decisions. However, it is impossible to precisely detect expected inflation rates or, consequently, ex-ante real interest rates. Figure 3.7 shows the ex-post real interest rate, which is equal to the nominal interest rate net of the actual rate of inflation.

(%)

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Fig. 3.7 Real interest rates in major economies Source Ministry of Internal Affairs and Communications (Japan, 2020/11/17 access), Bloomberg (others, 2020/11/6 access)

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3.3.3 Japanese Problem (1): Low Labor Productivity Central banks can control nominal interest rates, especially in the downward direction, because they can buy financial assets to reduce those rates. However, they cannot directly control the inflation rate because the market determines general price levels and hence, inflation rates. Basic economic theory tells us that prices are determined by demand and supply. While demand plays an important role in the short run, supply plays a key role in the long run. Accordingly, inflation is determined mainly by productivity growth in the long run. It is often pointed out that Japanese productivity is low compared to that in other advanced economies; Fig. 3.8 presents an example of this evidence. Although generally speaking, this fact is considered a negative factor in the economy, this is not always the case. It can be considered a positive factor in the sense that it shows possible and/or potential economic growth if we recognize that one of key drivers for economic growth is productivity growth. In fact, as Fig. 3.9 shows, the labor productivity growth in Japan in the 2010s did not compare unfavorably to those of the other G-7 economies. If, however, productivity growth dominated the increase in demand, it could have been a cause of deflation.

Internaonal Comparison of Labor Producvity (USA=100, 2010) 120 100 80 60 40 20 0 Japan

Italy

UK

Canada Germany

France

US

Fig. 3.8 Labor productivities for G7 Economies. Source OECD National accounts database, employment and labor market statistics

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Annual Labor Producvity Growth Rates (2011-2018) 4 3 2 1 0 Japan

Italy

UK

Canada

Germany

France

US

Fig. 3.9 Annual labor productivity growth for G7 economies in 2010s. Source OECD National accounts database, employment and labor market statistics

3.3.4 Japanese Problem (2): An Increasing Number of Non-regular Workers It is also often pointed out that there is a large wage gap in Japan between regular and non-regular workers. As Fig. 3.10 shows, the gap not only exists, but has not shrunk at all for more than ten years. It is rational for firms to reduce production costs by replacing regular employees— high-cost labor—with non-regular workers—low-cost labor. Other things being equal, this of course improves firm profitability. As a matter of fact, as Fig. 3.11 shows, the number of non-regular workers has gradually increased since the 1990s. In boom periods, the labor shift benefits not only individual firms but also the economy as a whole because it prevents the economy from entering an inflationary spiral. In contrast, the labor shift is harmful for the economy in deflation periods because it forces the economy into a deflationary spiral. This might be considered an example of the fallacy of composition in the sense that individual firms might not attain their initial objective of increasing profits.

3.4 Yield Curve Control 3.4.1 The Yield Curve A central bank’s target interest rate is usually the rate for a short maturity bond. However, one of the crucial determinants of an interest rate is the maturity or term of

3 Japanese Experiences and an International Comparison

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Annual Wages for Regular and Non-Regular Workers (thou. yen)

5,000 4,000 3,000 2,000 Regular Non-Regular

1,000 0

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 year Fig. 3.10 Wage gap between regular and non-regular workers in Japan. Source Basic survey on wage structure (2020/12/2 access)

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Regular Non-Regular

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Fig. 3.11 Numbers of regular and non-regular workers in Japan. Source Basic survey on wage structure, The Japan Institute for Labour Policy and Training (2020/12/2 access)

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Yield Curve (Japan)

1M 3M 6M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y15Y20Y30Y40Y Fig. 3.12 Recent yield curve in Japan. Source Bloomberg (2020/11/7 access)

the bond. The relationship between interest rates or yields and the maturity or term is known as the term structure of interest rates. The graphical representation of the term structure, measuring maturities on the horizontal axis and interest rates on the vertical axis, is called the yield curve. The recent yield curve in Japan is shown in Fig. 3.12. As the graph shows, the yield curve is normally upward-sloping. The yield curve is believed to reflect the market’s perceptions of the future. If the curve is upward sloping, that is, normally shaped, then the economy is believed to be normal or in an expansionary phase. If it is downward sloping, that is, short-term interest rates are higher than long-term interest rates, then the economy is believed to be in, or about to enter, a recession. If flat, that is, there is little variation between shortand long-term interest rates, the market is unsure about the future of the economy.

3.4.2 Yield Curve Control (YCC) Central bank movements in the target interest rate, which is typically the overnight interest rate, are thought to influence mid- and long-term rates, and hence the yield curve. Since firms base a large portion of their human and physical capital investment on their mid- and/or long-term perspectives, these interest rates, rather than short-run interest rates, are important for investment decisions. Hence, in addition to quantitative and qualitative monetary easing, control of the price of liquidity over a long period is important. Monetary policy that encompasses this idea is often referred as to quantitative and qualitative monetary easing with yield curve control (YCC).

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The Bank of Japan implemented YCC in 2016 along with a predetermined 2% inflation target. The short-term target rate on government bonds was set at −0.1%, while the 10-year target rate was set at zero percent. Of course, as Amamiya (2017) correctly explains, this was not the first implementation of YCC in history, but was truly the first time it was used by an advanced economy in the last half century. As stated above, YCC is not an independent policy measure but rather a complement to Japan’s QQE. As Fig. 3.4 and Panel (A) in Fig. 3.5 show, the size of the Bank of Japan’s balance sheet increased sharply from 2012 through 2016 due to QQE. After the introduction of YCC, the pace of the increase was clearly slowed. Although this is some evidence that YCC is a complement to QQE, for YCC to be an effective complement, the BOJ’s pursuit of YCC must be well done. Figure 3.13 shows the Bank of Japan’s ability to control the yield curve. Both in 2016 and 2020, Japan’s yield curves go up only in the very long end, that is, only for bonds with maturities longer than 10 years. In particular, it succeeded in pushing interest rates for one-year to five-year maturity bonds down to a negative range. Put differently, when the Bank of Japan initiated YCC, it almost achieved its target rates of −0.1% for short-term bonds and zero percent for bonds with maturities longer than 10 years and has continued to achieve its objective up to the present. It commonly understood that interest rates from one to five years are the most important indicators used by commercial banks to set lending rates. Although this can be considered evidence that shows the Bank of Japan’s ability to shape the yield curve, we cannot reach this conclusion without comparing it to those of the other central banks. Fig. 3.13 Yield curve control in Japan. Source Bloomberg (2020/11/7 access)

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Fig. 3.14 Yield curve control in the United States and Germany. Source Bloomberg (2020/11/7 access)

3.4.3 An International Comparison of Yield Curve Control Figure 3.14 illustrates the yield curves in the United States and Germany. In 2016, as Panel (A) shows, 2016 interest rates over all maturities were positive in the United States, while Panel (B) shows that even the 10-year maturity interest rate was negative in Germany. While negative interest rates are beneficial for firms, they are harmful for commercial banks, especially for long maturities, because the banks are unable to earn profits from lending. Compared to the United States and Germany, the Japanese yield curves under YCC were better. The Japanese curves were very flat for the 1to 7-year range, and then sloped upward for long maturities. Overall, YCC has been a good complement to QEE in Japan since it was introduced. As mentioned before, YCC is considered to have contributed to slowing the expansion of the Bank of Japan’s balance sheet since 2016.

3.5 Concluding Remarks The monetary policies implemented by central banks in advanced economies after the Lehman shock have often been categorized together as unconventional monetary policies. They are the same in that all of them consist of three important pillars: quantitative and qualitative monetary easing, negative interest rates, and yield curve control. However, it is also true that each central bank may place different weights on the pillars.

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We have observed some significant differences in monetary policies and their consequences by comparing Japanese experiences with those of other advanced economies. Of course, people will have different perceptions of which differences are most important. This chapter’s purpose is not to determine which difference is the most important, but to provide basic data and materials for thinking about it. This objective has been achieved if the chapter’s discussions are useful for evaluating monetary policies in the advanced economies, especially Japan, after the Lehman crisis.

References Akerlof GA, Shiller RJ (2009) Animal spirits: how human psychology drives the economy, and why it matters for global capitalism. Princeton University Press, Princeton, New Jersey Amamiya M (2017) History and theories of yield curve control. In: Kenote speech at the financial markets panel conference to commemorate the 40th meeting Hawtrey RG (1922) The federal reserve system of the United States. J Roy Stat Soc 85(2):224–269 Keynes JM (1973 [1936]) The general theory of employment, interest, and money. Maruzen Co., Ltd. Tokyo, Japan Kuroda H (2016) The role of expectations in monetary policy: evolution of theories and the Bank of Japan’s Experience. Speech at the University of Oxford

Afterword

The Bank of Japan implemented unconventional monetary policies and was the first among the advanced economies to recover from the severe recession in the 1990s, a time referred as to the lost decade. After the Lehman shock, most advanced economies also conducted similar monetary policies to boost their economies. At the same time, the G-7 and the G-20 countries closely cooperated to recover the world economy. The Japanese experiences in the 1990s and 2000s undoubtedly played a key role during this period. Although these experiences have been examined from various aspects, we believe there is still more to learn from them. Moreover, collaboration between scholars and practitioners is needed. This book has provided an interesting review of Japanese monetary policies after the bubble economy. Although many books have been published on the same topic, only a few are based on discussions between theorists and practitioners. This book is unique in the sense that while a leading macroeconomist in Japanese academia explains the theory behind the policies in Chap. 1, a monetary economist with extensive work experience and a proven track record of analysis offers an assessment of monetary policy and the institution’s role in Chap. 2. In addition to these insightful discussions, we provide a basic explanation of recent monetary policies and examine the consequences in Chap. 3. In Chap. 3, we review the Japanese monetary policies and consequences compared to those in other advanced economies. Although we learned a lot from the presentations and discussions at the 2017 Bruegel conference, especially from the presentation by Ms. Tokiko Shimizu, who is currently an Executive Director of the Bank of Japan, we do not know precisely what kind of data and materials are required to learn from these experiences. The title of Ms. Shimizu’s talk at the conference, Uncertainty and Unconventionality in Uncharted Waters-Getting on board a ship named expectation-, may clarify our situation. In an age of uncertainty, we lack clear charts for both monetary policy and a research agenda. Nevertheless, we must continue this research’s voyage.

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2021 Y. Matsubayashi et al., Monetary Policies in the Age of Uncertainty, Kobe University Social Science Research Series, https://doi.org/10.1007/978-981-16-4146-6

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Afterword

Although we do not discuss it extensively, forward guidance must be a key tool in unconventional monetary policy. Monetary authorities use it to communicate with the public about the future course of monetary policy. When they provide forward guidance, firms and households will use it to make decisions about real economic activities such as production, investment, and consumption, as well as decisions about financial activities such as borrowing and lending. Forward guidance about future policy can influence current economic and financial conditions only if there is confidence in the authority. This applies not only to monetary policy, but to government policy in general. Figure A shows the actual and predicted rates of economic growth for the G-7 countries based on the World Economic Outlook Database of the International Monetary Fund (IMF), which is believed to be one of the most reliable forecasts. The top, middle, and bottom graphs show them as of 2010, 2015, and 2020, respectively. The lines in the gray part of each graph show the predicted rates. As most people believe, it was impossible in 2015 for even the IMF to predict the COVID-19 pandemic. We understand that no one could make accurate predictions at that time. However, it is also true that the five-year forecast as of 2010 was not very accurate. Although the IMF predicted that all G-7 economies would achieve stable growth between 1 and 4 percent, some countries experienced low and even negative growth. Most of us come to realize uncertainty only when the economy falls into a severe recession due to crises such as the Lehman shock and COVID-19 pandemic. However, in reality, we are always exposed to considerable uncertainty. In addition, COVID-19 may be considered the beginning of a new type of uncertainty. Only twelve years ago, many people believed that the Lehman shock was a once-in-a-century peace time disaster. However, the world economy has recently faced an unprecedented and massive challenge. Considering SARS in 2002–2004 and MARS in 2012–2014, we are almost certain that the spread of infectious diseases will occur repeatedly in the future, while we are quite uncertain about when they will occur, what policies should be made, what measures are effective, and so on. However, we have learned from the experiences with unconventional monetary policy that the conversation between authorities and the public is crucial for reducing the effect of uncertainties and restoring stability. We are aboard a ship named expectation. Hence, even without charts, we must continue the voyage with trust and confidence.

Afterword

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