Discussion Paper Series No.208
A Reassessment of Japan’s Monetary Policy
during the Great Depression: The Constraints and Remedies

SHIZUME Masato

November

Kobe University

2007

The Discussion Papers are a series of research papers in their draft
form, circulated to encourage discussion and comment. Citation anduse of such a paper should take account of its provisional character.
In some cases, a written consent of the author may be required.

A Reassessment of Japan’s Monetary Policy during the Great Depression:
The Constraints and Remedies

Masato Shizume*
Research Institute for Economics and Business Administration
Kobe University
Rokkodai 2-1, Nada-ku, Kobe 657-8501, Japan
E-mail:shizume@rieb.kobe-u.ac.jp
October 2007
[Abstract]

Temin [1989] and Eichengreen [1992] argue that monetary policy played a key role ineach country’s economic performance during the Great Depression, and that some
European policymakers hesitated to pursue an expansionary monetary policy even after
departing from gold. Why did these policymakers not pursue the opportunities they
were able to pursue to the fullest extent? This study explores this issue by looking at thecase of Japan, focusing on the constraints it faced and the remedies available to it as asmall, open economy. This study explores the relationship between interest rates inJapan and in the major international financial centers, using a new series ofrepresentative long-term interest rates and narratives. This study reveals that Japan
imposed a restrictive monetary policy on itself even after departing from the gold
standard. Japan did so because it needed to maintain its ties both with its trading
partners and with the international financial markets.

JEL Classification: E42, N15* I would like to thank Mariko Hatase, Hideki Izawa, John James, Yoichi Matsubayashi,
Kris Michener, Ryuzo Miyao, Chiaki Moriguchi, Takashi Nanjo, Kunio Okina, Mari
Onuki, Hugh Rockoff and Richard Smethurst for their helpful comments. This research
project was supported by Grant-in-Aid for Scientific Research No.19530274 from theJapan Society for the Promotion of Science. Any remaining errors are my own.

1. Introduction
Departing from the gold standard was the necessary precondition for an earlyrecovery from the Great Depression in the 1930s (Eichengreen and Sachs [1985]).
Temin [1989] and Eichengreen [1992] both argue that monetary policy played a key rolein the economic performance of each country.
Temin [1989] and Eichengreen [1992] also suggest that some European
policymakers hesitated to pursue expansionary monetary policies even after departingfrom gold. On British monetary policy after Great Britain had departed from gold,
Temin claims “The policy was of only limited success… because the British authorities
did not take advantage of this opportunity as they should have.”1 On Swedish policy
after Sweden had departed from gold, Eichengreen claims “Policymakers’ newfoundfreedom from its constraints, which would have allowed them to implement more
expansionary policies, was very incompletely exploited.”2
Why did these policymakers not pursue the opportunities they were able topursue to the fullest extent? We will explore this issue by looking at the case of Japan.
We use Japan as a case study to explore how a peripheral country looked at andresponded to the collapse of the international gold standard system. In a sense, thisstudy complements those of Temin [1989] and Eichengreen [1992], given that theirstudies focused primarily on the core countries, although Eichengreen mentions certain
peripheral countries, including Japan.
Japan departed from the gold standard in December 1931 under the leadershipof its veteran Finance Minister, Korekiyo Takahashi. 3 Many observers argue that
Temin [1989], p.74.
Eichengreen [1992], p.302.
3 Korekiyo Takahashi (1854-1936) was a distinguished financial and political leader inJapan. He joined the Bank of Japan (BOJ) in 1892 and served as Governor of the Bank
from 1911 to 1913. He then served as Finance Minister 7 times between 1913-36 and as
Prime Minister once from 1921-22. He was assassinated by a group of militarists on
February 26, 1936. During his career in public service, he played a central role inraising funds in Western countries during the Russo-Japanese War (1904-05). He solveda major financial crisis in Japan in 1927 and implemented a drastic economic stimulus
112Takahashi’s three-pronged economic stimulus package, combining depreciation of theyen, expansionary fiscal policy, and the lowering of interest rates, contributed to theearly recovery of the Japanese economy during the Great Depression (Nakamura [1971],
Patrick [1971]).
A few previous quantitative studies have analyzed Takahashi’s economic
policies. Among these studies, Nanto and Takagi [1985] stress the effects of the increasein exports accompanying the depreciation of the yen. Cha [2003] emphasizes the effectsof the debt-financed fiscal expansion. However, very few studies have focused on the
conduct of monetary policy. Most previous studies on monetary policy in interwar Japan
have been constrained by the lack of data enabling empirical research to be conducted.4
This study explores monetary policy during the interwar period in Japan,
making use of a new dataset and narratives. It derives a new series of representative
long-term interest rates from the market price of one kind of government bond. It thenuses this interest rate series to explore the relationship between long-term interest
rates in Japan and in the two main financial centers, Great Britain and the UnitedStates. This study also explores the contemporary view of Japanese policymakers atthat time using narratives. In doing so, it delivers a new interpretation of monetary
policy in Japan, a small open economy, during the interwar period.
This study reveals that Japan imposed a restrictive monetary policy on itself
even after departing from the gold standard. Japan did so because as a small, open
economy, it needed to maintain its ties both with its trading partners and withinternational financial markets. Quantitative analysis shows that Japanese long-term
interest rates had a long-run relationship with British rates throughout the interwar

package during the Great Depression. According to Smethurst [2007], Takahashi had
learned the essence of economic policy before becoming Finance Minister for the 5th timein December 1931.
4 Shizume [2002] employs “Taylor rule” analysis, and shows that Japanese monetary
policy was pro-cyclical in the period 1885-1940, including the period after Japan’s
departure from the gold standard.
2period. Narrative analysis shows that Japan sacrificed monetary policy autonomy inorder to stabilize the exchange rate. The primary reasons for the adoption of restrictive
monetary policy in Japan, as a small open economy, were to maintain its relationships
with its trading partners and to service its external debts. A comparison of the Japanese
economy with other countries suggests that monetary policy did not contribute to theearly recovery of the Japanese economy, but that the depreciation of the currency anddebt-financed fiscal stimulus did.
The rest of this paper is organized as follows. Section 2 derives a new data
series of long-term interest rates. Section 3 employs quantitative analysis, using the
new data derived in Section 2. Section 4 interprets the results of quantitative analysis
using narrative analysis. Section 5 concludes the paper.

2. A New Series of Long-Term Interest Rate DataFirst, we need to resolve the problem of data constraints in order to formulate aquantitative analysis of Japanese monetary policy during the interwar period. To thisend, we need to create a new dataset comprising a series of Japanese interest rates
because previously available interest rate data are problematic. Existing short-term
interest rate data for the interwar period in Japan are those for private sector debts
such as bills discounted by banks or bank certificates of lending5. These private sector
interest rates were subject to high and volatile credit risk premiums because theJapanese economy suffered from periodic financial panics, including the financial crisisof 1927, and financial instability throughout the interwar period.
No representative data is available on short-term interest rates in interwar

The interest rates for “discounted bills” and “certificates of lending” were reported by
the Tokyo Bankers Association. Their maturities varied, and they were often refinancedon maturity. According to Aoki [1932], the average maturities in 1927 were about 2
months for discounted bills and 8 months for certificates of lending (Aoki [1932], p.45).
It is often claimed that certificates of lending included various kinds of lending withhigher levels of risk and less liquidity than discounted bills. See Sano [1936], p.8.
35

Japan for public debt (such as Treasury bill rates) that can be used as a substitute forthe existing private sector data. While Treasury bills were issued from time to time
during the interwar period, they were circulated for short periods only and theavailability of interest rate data was limited.
During the interwar period, investors traded various types of bonds, including
government bonds, municipal bonds, and corporate bonds, both in the official markets
and over the counter via securities companies. The Tokyo Stock Exchange (TSE) served
as the central market of Japan. In November 1932, the TSE listed 37 issues of Japanese
government bonds, one issue of foreign (Chinese) government bonds, 95 issues ofmunicipal bonds and 463 issues of corporate bonds for its spot transaction facility.
Interest rates on government bonds are important for an analysis of Japanesemonetary policy during the interwar period for two reasons. First, they represented
policy target rates for Japanese policymakers during the 1930s. As Fukai Eigo, adistinguished economist and then Vice Governor of Bank of Japan, observed, “loweringinterest rates on government bonds was essential to lower interest rates in general.” 6
In the 1930s, the BOJ regarded its open market operations in government bonds as oneof its primary policy instruments. Second, unlike interest rates for the private sector,
interest rates on government bonds are risk-free rates, which are used as a basis forcomparing rates in different countries.
Nevertheless, one series of long-term interest rate data for government bonds
does exist. Nippon Kangyo Ginko (Japan Hypothec Bank, or JHB) collected price datafor bonds, and calculated compound yields to maturity for the bonds it covered. However,the series begins only in July 1921, and the data is calculated only for the first working
day of each month.
We create a new series of long-term interest rate data from the market prices of

6

Fukai [1941], p.365.
4

a government bond called the “Ko-go” 5 percent government bond.7 We use the TSE
price data for spot transactions in the Ko-go. The Ko-go was the most actively tradedbond in Japan during the interwar period. Trading in the Ko-go accounted for 18
percent of the total number of transactions in government bonds on the TSE in 1932.
Investors regarded the Ko-go as the benchmark.
We calculate compound yields to maturity on monthly average prices fromJanuary 1919 to December 1938. The monthly average price means total traded value
divided by the total number of bonds traded in a month. The compound yield tomaturity is derived using the formula below:nj −t

Pt = ∑ CF j ⋅ (1 + rt ) 12 ,

(1)

j =t

where rt is the compound yield to maturity in period t, Pt is the bond price in period t,

CF j is the cash flow in period j, and n ( n ≥ t ) is the maturity date. Here, t, j, and n are
expressed on a monthly basis.
We confirm that our method of calculation is consistent with that used forpreviously available JHB data. While JHB did not publish its method of calculation, weare able to compare the results of our calculation with those for JHB data. For the yieldon the same day for the same bond, the discrepancies between our estimates and thefigures in JHB data are less than 1 basis point (one hundredth of one percent).
Our data has certain advantages over the JHB data. First, our data covers theperiod from 1919 to 1938, while the JHB data is available only from 1921. Second, we
have calculated monthly averages using data for all trading days, while the JHB data
covers only one particular day in each month. Our data is convenient because the dataon Great Britain and the United States, which we are going to analyze in relation to theJapanese data, are also monthly averages.
The “Ko-go” 5 percent bond was issued in the years 1908 and 1909 after 17 large
private railway companies were nationalized in 1906 and 1907. The bonds weredelivered to the stockholders of the predecessor railway companies. The bonds reachedtheir maturity date in 1962 and 1963.
57

3. Econometric Analyses
Using the long-term interest rate data derived in Section 2, we will now explore
the relationship between the long-term interest rates of Japan and two international
financial centers, Great Britain and the United States.8 We employ the approach taken
by Obstfeld and Taylor [2004] and Obstfeld, Shambaugh and Taylor [2004], using thedegree of co-movements in domestic and international interest rates as the indicator of
sacrificing independent monetary policy.

a. The Time-series Properties of Long-term Interest Rates
We examine the basic time-series properties of long-term interest rates in thethree countries selected. Figure 1 shows developments in long-term interest rates fromJanuary 1919 to December 1938.

Long-term interest rate data for Britain and the United States, as well as for Japan,
are monthly averages. The data for Britain are the yields for 2.5 percent consols, asreported by the Board of Trade in the Statistical Abstract for the United Kingdom. The
data for the United States are unweighted averages for partially tax-exempt
government bonds, which were callable after eight years during the period 1919-25 andafter twelve years during the period 1926-38. The data for the U.S. are from the Boardof Governors of the Federal Reserve System’s Banking and Monetary Statistics, 1943,
p.429 and pp.468-471.
68

Figure 1. Long-term Interest Rates
percent
7

departure from gold,
Japan(Dec. 1931)

return to gold, Japan(Jan. 1930)
6

5

4

3

2
1919

1925

1930
Japan

Britain

1935

1938

US

Sources: Tokyo Stock Exchange, Monthly Report; Nomura Securities, Annual Report on
PublicandCorporate
Securities;
NBER,
Macrohistory
Database,
http://nber.org/databases/macrohistory/contents/; Board of Governors of theFederal Reserve System, Banking and Monetary Statistics.

Table 1. Unit Root Tests for Long-term Interest Rates(Sample period: Jan.1919-Dec.1938; Number of observations: 240)
Japan
Britain
United States(level)ADF-2.865-2.931-3.007
(11)
(12)
(9)
PP
-3.200 *-2.738-2.832(firstdifference)
ADF-5.836 ***-4.099 ***-4.589 ***
(10)
(11)
(8)
PP
-11.225 ***-14.516 ***-11.588 ***Notes: 1.Tests are employed to examine the formula with a constant and a trend term for level
data, and without them for first difference data.
2."***", "**" and "*" indicate rejection of a unit root at the 1, 5, and 10 percent levels ofsignificance, respectively.
3.Numbers in parentheses indicate lag orders for ADF tests. The lag orders are
determined by being iteratively reduced from 12 to the order at which the longest lag
term is statistically significant.
4.The critical values are from Table 10.A.2 of Fuller [1996] for ADF tests, and from
Mackinnon [1996] for PP tests.

Table 1 reports the results of unit root tests for long-term interest rates in thethree countries. The results indicate that the order of integration for long-term interest

7

rates in all three countries is one.9
We employ Granger causality tests to examine interest rates in the three
countries, using formula (2). This tests whether movements in lagged foreign interest
rates are statistically significant in explaining movements in contemporary domestic
interest rates.
p

p

p

i =1

i =1

i =1

∆Rt = a 0 + ∑ ai ∆Rt −i + ∑ a F 1,i ∆R F 1,t −i + ∑ a F 2,i ∆R F 2,t −i + u t ,(2)

Rt denotes the domestic interest rate at time t, and RFj ,t denotes the foreign country’s
interest rate at time t (j=1,2).

Table 2.

Granger Causality Tests (F-Statistics)

Dependent
Japan
Britain
United States
Variable
Independent
Britain
United States
Japan
United States
Japan
Britain
Variables
Max lags
1
4.94 **
6.17 **
0.96
16.82 ***
0.99
17.89
2
13.87 ***
11.58 ***
4.70 **
19.10 ***
8.71 ***
28.03
3
12.89 ***
10.89 ***
9.93 ***
20.78 ***
8.61 ***
29.32
4
12.69 ***
11.92 ***
11.57 ***
21.47 ***
8.14 ***
35.34
5
13.16 ***
18.53 ***
12.62 ***
23.33 ***
8.50 ***
36.73
6
17.06 ***
18.78 ***
17.63 ***
32.43 ***
13.49 ***
44.07
Notes: 1.Tests are employed with the formula including self-lags, which are not reported in the table.
2."***"and "**" indicate statistical significance at the 1 and 5 percent levels, respectively.

Table 2 reports the results of Granger causality tests. The results are
consistent with the notion of interwar Japan as a small, open economy.
The results indicate that movements in lagged foreign interest rates are
statistically significant in explaining movements in contemporary Japanese interest
rates. Japanese long-term interest rates are Granger-caused by both British andAmerican rates with a lag of one month. Neither British nor American long-term
interest rates are Granger-caused by Japanese rates with a lag of one month. This is
To be precise, the ADF test fails to reject the existence of a unit root for Japan, while
the PP test rejects it at the 10 percent level of significance.
8

9

***
***
***
***
***
***

consistent with the notion that Japan was a peripheral country.
All three countries’ interest rates are Granger-caused by each other with lagsof more than two months. This is consistent with the conventional understanding thatthe international financial market was integrated.

b. Preparatory Tests for Examining the Long-run RelationshipWe examine the long-run relationship, defined as cointegration, between
interest rates in Japan and in the two major international financial centers fromJanuary 1919 to December 1938. Table 3 reports the results of cointegration tests
presented by Engle and Granger [1987]. These results indicate that Japanese long-term
interest rates were cointegrated with those of Great Britain throughout the interwar
period. This implies that Japanese rates had a stable, long-run level relationship with
British rates. The table also indicates no such relationship between Japanese rates andAmerican rates.

Table 3. Cointegration Tests (Engle-Granger)
Dependent variable: Japan ("Ko-go" 5 percent bond)
Independent variables: Constant term and Great Britain (Consols) / Constant term and United States(Treasury)
Sample period: January 1919-December 1938, Number of observations: 240
Long-term interest rate
Britain (Consols)

United States (Treasury)

ADF statistics-2.902 ( 1 ) **-1.949 ( 11 )Notes: 1. This table shows the results of ADF tests on the residuals of ordinary least square regressions(the Engle-Granger test). The ordinary least square regressions are calculated using the formula
below:

Rt + µ + λRb ,t + et ,2. The critical values are from Table IIa of Phillips and Ouliaris [1990]. "**" indicates statisticalsignificance at the 5 percent level.
3. Figures in parentheses show the lag order. The lag orders are determined by being iteratively
reduced from 12 to the order at which the longest lag term is statistically significant.

9Gregory and Hansen [1996] argue that a simple cointegration test fails to
detect cointegration in the event of a structural change in the long-run level
relationship between variables. We conduct cointegration tests with a structural changepresented by Gregory and Hansen [1996] for the relationship between Japanese andAmerican long-term interest rates. Table 4 reports the results. In contrast with theresults derived using the Engle-Granger tests, the results derived using theGregory-Hansen tests indicate that Japanese

long-terminterest rates

werecointegrated with American rates during the interwar period, and that there was astructural change in the relationship in December 1932 or January 1933. The timing of
the structural change indicated by the Gregory-Hansen tests is close to the timing of theAmerican departure from the gold standard (March-April 1933).

Table 4. Cointegration Tests with A Structural Change (Gregory-Hansen)
Dependent variable: Japan ("Ko-go" 5 percent bond)
Independent variables: Constant term and United States (Treasury)
Sample period: January 1919-December 1938, Number of observations: 240
United States (Treasury)ADF*-4.817 +[ Dec. 1932]

Zt*

-4.701 +[ Jan. 1933]

Za*

-38.642--

Notes: 1. The table shows residual-based cointegration test statistics for "regime change" (C/S) presented
by Gregory and Hansen (1996).
The "regime change" (C/S) is described by the expression below;

Rt = µ1 + µ 2 Dt + λ1 Rb ,t + λ2 Rb ,t Dt + et ,Dt has a value of zero before and at the time of the structural change; Dt has a value of one after
the structural change.
2. Dates in brackets show the time points when the structural change occurs.
3. The critical values are from Table I of Gregory and Hansen [1996]. "+" indicates statisticalsignificance at the 10 percent level.

10

c. Error Correction Models
An error correction model is applicable when there is a cointegrating
relationship among a set of variables (Engle and Granger [1987]). The model allows thevariables to converge to the cointegrating relationship, a long-run equilibrium. In themodel, the cointegration term is called the error correction term.
We formulate error correction models which explain the difference in Japanese
long-term interest rates using lag-difference terms10 and an error correction term.11
The formula is expressed by equation (3).

∆Rt = α + ∑ β j ∆Rt − j + ∑ γ j ∆Rb ,t − j + ω (σ + Rt −1 − θRb ,t −1 ) + u t ,
p

p

j =1

j =0

(3)

Rt denotes the domestic interest rate at time t, and Rb ,t denotes theinternational base rate at time t. Table 5 reports the regression results.

Lag orders are chosen using Schwarz information criteria.
Cointegrating vectors are calculated using the dynamic OLS method proposed by
Stock and Watson [1993]. Lag orders are chosen using Schwarz information criteria.
11
10
11

Table 5.

Estimation Results of Japanese Interest Rate on International Base Rate (Error
Correction Model)

Dependent variable: Japan ("Ko-go" 5 percent bond)
Estimation formula: ∆Rt = α +∑ β j ∆Rt − j + ∑ γ j ∆Rb,t − j + ω (σ + Rt −1 − θRb,t −1 ) + ut ,
p

p

j =1

j =0

Sample period: January 1919-December 1938, Number of observations: 240

Rb: Britain (Consols)
a)

b)

α

-0.001(-0.30 )

-0.002(-0.38 )

β1

0.287

(

4.72 ) *** 0.299(

4.89 )

γ0

0.115

(

2.44 ) **

γ1

0.053

(

1.08 )

0.057(

1.14 )

ω-0.070(-3.59 ) *** -0.074(-3.79 )***

half-life

9.61

--

***

--

9.01

(cointegrating vector)
σ-3.161( -39.63 ) *** -3.161( -39.63 )

***

θ

0.549

( 28.54 ) *** 0.549( 28.54 )***adj. R2

0.171

0.153

Notes: 1. Figures in parentheses are t-statistics. "***", "**" and "*" indicate statistical significance at the 1
percent, 5 percent and 10 percent levels, respectively.
2. In all cases of error correction model estimation, lag orders are chosen to be 1 using Schwarz information
criteria.
3."Half-life" means the half-life of the shock based on the adjustment speed, ω.
4. Cointegrating vectors are calculated using the dynamic OLS method. Lag orders are chosen using
Schwarz information criteria.

Obstfeld and Taylor [2004] and Obstfeld, Shambaugh and Taylor [2004] argue
that the cointegrating slope coefficient, θ , represents the long-term level relationshipbetween the domestic interest rate and the international base rate. The expected sign ofθ is positive. If the domestic interest rate moves parallel with the international baserate, then θ = 1 . They also argue that the absolute value of the coefficient of the error
correction term, or the adjustment speed, ω , represents the degree of dependency ofthe domestic interest rate on the international base rate.12

They employ the method developed by Pesaran, Shin and Smith [2001] (PSS test) for
testing the significance of the level relationship among a large set of country data. Since
the orders of integration in the data for Japan, Britain and the United States are all 1,
we do not employ the PSS test and instead directly estimate the error correction model.
1212

We first use the British interest rate as the international base rate. We conduct
two patterns of regressions regarding the lag structure. In the formula reported in thefirst column, (a), we use the same lag pattern as that used by Obstfeld and Taylor [2004]
and Obstfeld, Shambaugh and Taylor [2004]. Their formula includes the difference inthe base rate at time t ( ∆Rb ,t ) in explanatory variables.13 In the formula reported in thesecond column, (b), we use the lag pattern used in a standard error correction formula,which does not include the difference in the base rate at time t ( ∆Rb ,t ) in explanatory
variables.
Different lag patterns give qualitatively the same results. The coefficient γ 1 is
not statistically significant. Other coefficients are statistically significant and have theexpected signs. The statistical significance of γ 0 indicates the immediate impact ofBritish rates on Japanese interest rates. The cointegrating slope coefficient, θ , isstatistically significant, confirming the long-term level relationship between Japaneseand British interest rates. The coefficient of the error correction term or the adjustment
speed, ω , has the absolute value of .07, indicating that the half-life of the initial
disturbing shock to the long-run relationship is 9 to 10 months.
The Gregory-Hansen tests indicate that Japanese long-term interest rates
were cointegrated with American rates during the interwar period, and that there was astructural change in the relationship in December 1932 or January 1933.
We now use the American interest rate as the international base rate and run a
regression with dummy variables in the error correction term. The formula is expressedby equation (4). We also run a regression without dummy variables, which is expressedby equation (3).14

We assume that Japanese interest rates did not influence British rates because
Japan was a small economy, and that there are no simultaneous biases. Theseassumptions were also applied in Obstfeld and Taylor [2004] and Obstfeld, Shambaugh
and Taylor [2004].
14 The result of the formula without the difference in the base rate at time t ( ∆Rb, t ) in13
13∆Rt = α + ∑ β j ∆Rt − j + ∑ γ j ∆Rb ,t − j + ω (σ + σ Π Dt + Rt −1 − [θRb ,t −1 + θ Π Rb ,t −1 Dt ]) + u t , (4)
p

p

j =1

j =0

Dt has a value of zero before and during December 1932, and a value of one
subsequently. Table 6 shows the results.

Table 6.

Estimation Results of Japanese Interest Rate on International Base Rate (Error
Correction Model)

Dependent variable: Japan ("Ko-go" 5 percentp bond)
Estimation formula in column a): ∆Rt = α +in column b): ∆Rt = α +p∑ β ∆R
j =1

j =1

j =0

+ ∑ γ j ∆Rb ,t − j + ω (σ + σ Π Dt + Rt −1 − [θRb ,t −1 + θ Π Rb ,t −1 Dt ]) + ut ,
p

t− j

j

t− j

j

+ ∑ γ j ∆Rb ,t − j + ω (σ + Rt −1 − θRb ,t −1 ) + ut ,p

∑ β ∆R
j =0

Sample period: January 1919-December 1938, Number of observations: 240

Rb: United States (Treasury)
a)

b)

α

-0.002(-0.41 )

β1

0.322

(

5.25 )

γ0

0.060

(

γ1

-0.055ω

-0.056-0.002

(

-0.42

)

0.358

(

5.90

)

1.24 )

0.052

(

1.09

)

(

-1.12 )

-0.062

(

-1.31

)

(

-3.39 )

-0.123

(

-4.96

)

***

-4.681(-56.20

)

***

0.068

(

0.33

)

0.253

(

12.36

)

***

-0.176

(

-2.52

)

**

***

***

half-life 12.00

***

5.27

(cointegrating vector)
σ-3.693( -46.36 )

σΠ

--

--

θ

0.476

( 22.40 )

θΠ

--

--

adj. R2

0.127

***
***

0.171

Notes: 1. Figures in parentheses are t-statistics. "***", "**" and "*" indicate statistical significance at the 1
percent, 5 percent and 10 percent levels, respectively.
2. Dt has a value of zero before and during December 1932; otherwise, Dt has a value of one.
3. In all cases of the error correction model estimation, lag orders are chosen to be 1 using Schwarz
information criteria.
4."Half-life" means the half-life of the shock based on the adjustment speed, ω.
5. Cointegrating vectors are calculated using the dynamic OLS method. Lag orders are chosen using
Schwarz information criteria.

The result with the dummy variables is reported in column b). Neither γ 0 nor

explanatory variables is similar to that reported in column a).
14

γ 1 is statistically significant. Other coefficients are statistically significant and havethe expected signs. The coefficient of error correction term or the adjustment speed, ω ,has the absolute value of .12, indicating that the half-life of the initial disturbing shockto the long-run relationship is 5 months.
The dummy variable for the cointegrating slope coefficient, θ Π , is statisticallysignificant, indicating a change in the long-term relationship between Japanese andAmerican interest rates in December 1932. According to the regression results, thevalue of the cointegrating slope coefficient before and during December 1932, θ , is .253,
and that after January 1933, θ + θ Π , is .077. This indicates that the level relationshipbetween Japanese and American interest rates weakened substantially in December
1932.
The cointegrating slope coefficients for American interest rates before, during
and after December 1932 are smaller than that for British rates, indicating a weaker
relationship between American and Japanese rates than that between British andJapanese rates.

4. Interpretation and Discussion
a. Japanese Monetary Policy During the Early 1930s: An Interpretation
The quantitative analyses indicate that Japanese long-term interest rates had
a long-run relationship with British rates throughout the interwar period. In addition,
Japanese long-term interest rates had a long-run relationship with American rates
until the end of 1932, but lost such a relationship after 1933 following the departure of
the United States from the gold standard. We will now interpret the results of ourquantitative analyses using narrative analysis.
Obstfeld and Taylor [1997, 2004] utilize the concept of the macroeconomic
policy trilemma in historical studies of a number of countries’ monetary policies. They
claim that any chosen macroeconomic policy regime can succeed in achieving only two15

out of the following three policy objectives:
1) independent monetary policy oriented toward domestic objectives;
2) a fixed exchange rate; and3) full freedom of cross-border capital movements.
They argue that the gold standard is a typical case of a policy regime designed
to maintain free capital movements and a fixed exchange rate, while sacrificing
independent monetary policy. They also argue that national policymakers became more
inclined to control international capital flows after the financial upheavals of the Great
Depression.15
BOJ Archive materials show that contemporary policymakers were aware of
the macroeconomic policy trilemma. Tetsuzo Horikoshi, an executive director of theBOJ, spoke at the fall meeting of directors and branch managers in 1932.16 He said “Ifmoney supply is increased by domestic policy, the exchange rate may fall. If we intend
to maintain the exchange rate, we should curb our domestic policy. If we dare to pursue
domestic policy, we should sacrifice the exchange rate.”
In theory, Japan had several options in the wake of the collapse of theinternational gold standard system. Japan could have moved toward a flexible
exchange rate system to pursue monetary policy independent from international
constraints, as some Latin American countries did. Alternatively, Japan could haveintroduced strict exchange control measures if it needed to prevent capital flight, assome central European countries did.
Japan did not choose either of these options; it sacrificed independent
monetary policy to maintain a fixed exchange rate system. Japan chose a kind of
hybrid option: a combination of a one-shot devaluation, a fixed exchange rate system at

Komiya and Suda [1983] look at postwar Japan’s choices in terms of monetary policy
regime and exchange rate system in the same context.
16 “Documents on the Biannual Meetings of Directors and Branch Managers,
Spring-Fall, 1932,” BOJ Archive No.3943.
1615

a new and sustainable level, and mild exchange rate control measures. Japan did not
move to implement a flexible exchange rate system or strict capital controls to pursue
independent monetary policy.
1) Monetary Policy
Our quantitative analyses suggest that Japanese monetary policy in the 1930s
was not independent from policy in the core country (Great Britain). The existence of along-run relationship between Japanese interest rates and the core country’s rates,
namely British rates, suggests that Japanese policymakers did not pursue monetary
policy independence after departing from the gold standard. In a sense, Japanesepolicymakers imposed a kind of self-constraint even after departing from the gold
standard, as Temin [1989] and Eichengreen [1992] claim in relation to some Westerncountries.
2) Exchange Rate Policy
Figure 2 shows developments in the yen rate vis-à-vis the pound sterling andthe U.S. dollar before and after the departure from gold. It shows that, for Japan,
departing from the gold standard did not necessarily mean moving to a flexible
exchange rate system. Rather, it was a one-shot devaluation under a fixed exchange
rate system. The yen declined sharply immediately after Japan’s departure from thegold standard. The yen depreciated by 40 percent vis-à-vis the pound sterling from theold parity rate. The yen/pound sterling rate stabilized at a new level at the beginning of1933. In this regard, Japan can be classified as a de facto sterling area country similar
to British Commonwealth and Scandinavian countries.
Within the sterling area, the yen was not the only depreciating currency
vis-à-vis the pound sterling. However, while the Scandinavian currencies also
depreciated against the pound sterling in 1932-33, the yen depreciated to a greater
extent.

17

Figure 2. Exchange Rates(Oct. 1897=100)
160

return to
gold(Jan. 1930)

140(yen appreciation)

120
100
80
60
40
departure from
gold
(Dec. 1931)

20
0
28/01

30/01

32/01
yen/dollar(yen depreciation)

34/01

36/01

yen/pound sterling

Source: Ministry of Finance, Reference Book of Financial Matters.

3) Cross-Border Capital Movements
The Foreign Exchange Control Law was issued on March 29, 1933 and cameinto effect on May 1 of that year. Under this law, the regulations on foreign exchangetransactions were extended and tightened. Almost all transactions related tointernational capital flows were subject to some form of regulation. At the same time,
foreign exchange speculation was forbidden by finance ministry ordinance.
Japanese exchange controls were mild in comparison with those imposed inGermany and Austria. In Japan, importers and exporters were able to buy and sellforeign exchange freely via private banks until the end of 1937. Investors were able tobuy and sell foreign securities, although they were required to declare that thetransaction was “not speculative.”17 In Germany, owners of gold and foreign assets
were required to sell them to the Reichsbank. The central bank limited the amount offoreign exchange made available to importers and required exporters to surrender to

17

Ministry of Finance [1963], pp.135-153.
18

the bank all foreign currency earnings. In Austria, the authorities rationed foreignexchange and required exporters to surrender foreign currency to the central bank.
Gold parity was officially maintained, and the publication of foreign exchange
quotations was prohibited (Eichengreen [1992], p.270 and p.310).18

b. Why Did Japan Not Pursue an Independent Monetary Policy?
Why did Japan not pursue independent monetary policy to the extent it wasable to, but instead sacrificed independent monetary policy to maintain a fixedexchange rate system?
The primary reasons were economic: to maintain relationships with its trading
partners and to service its external debts. To this end, Japan had to stabilize its
currency at some level. Furthermore, Japan had a political reason for maintaining its
position in the international community.
First, Japan needed to stabilize its exchange rates with its trading partners tosettle its external transactions.
The Japanese economy depended heavily on trade with regions outside the yen
bloc. Table 7 shows the regional breakdown of Japan’s trading partners in 1926-36.
Japan depended on regions outside the yen bloc for more than 60 percent of its imports
and exports. Japan depended on imports of strategic materials such as oil, metals andmachinery from outside the yen bloc. Japan also depended on imports of raw materials
such as raw cotton and wool for the production of export goods, which had to be exported
to earn foreign currency.

18

Eichengreen [1992], p.270 and p.310.
19

Table 7. Japan's Foreign Trade, 1926-36(mil. yen)
Exports

1926

1931

1936

changechangebetweenbetween

1931-36

1926-36

The yen bloc

469.2

410.0

1389.8

979.8

920.6

China

421.9

143.9

159.7

15.8

-262.2Other Asia

381.9

283.7

713.2

429.5

331.3

Europe

129.4

104.1

307.7

203.6

178.3

Africa and Oceania

105.0

85.5

295.4

209.9

190.4

North America

890.1

438.9

608.9

170.0

-281.2Latin America

16.8

13.5

110.0

96.5

93.2

(80.6)(72.3)(61.2)----

2414.31479.63584.72105.11170.4The yen bloc

697.3

582.5

1116.3

533.8

419.0

China

239.4

103.7

154.8

51.1

-84.6

Other Asia

621.2

258.2

666.0

407.8

44.8

Europe

416.3

199.7

330.1

130.4

-86.2

Africa and Oceania

173.5

135.7

318.6

182.9

145.1

North America

755.5

378.0

920.7

542.7

165.2

Latin America

11.9

7.3

134.0

126.7

122.1

(76.1)(65.0)(69.3)----

2915.1

1665.13640.51975.4725.4(exports outside theyen bloc as apercentage of totalexports)
Total exports
Imports(imports from outside
the yen bloc as apercentage of total
imports)
Total imports

Source: Yamazawa and Yamamoto[1979], Table.13, pp.206-213.
Note: The yen bloc consisted of Korea, Taiwan, Kwangtung Province and Manchuria.

Japan had a good reason to peg its currency to the pound sterling rather than
to the U.S. dollar. Japan had lost export markets in China and the United States during
the late 1920s and early 1930s because of the Great Depression and also because of the20

deterioration in its trading relationships with these two countries. While the volume ofworld trade shrank during this period, the United States introduced protectionist
measures through the Smoot-Harley Tariff Act of 1930. Japan was one of the main
targets of the Act. In addition, the Japanese invasion of Manchuria and other parts ofMainland China led to boycott movements against Japanese products in China and theUnited States. Japan was not able to regain these markets during the 1930s. Japansought new markets in parts of Asia other than China, and in Europe, Africa, andOceania, a large part of which belonged to the pound sterling area. Japan had an
incentive to stabilize the yen/pound sterling rate to settle its external transactions withthe pound sterling bloc countries and territories.
Second, Japan needed to stabilize its currency value to service its debts andgive relief to international investors because of its indebtedness to foreign investors
under foreign-denominated debts. Outstanding Japanese bonds issued externally in
1905, during the Russo-Japanese War, and denominated in pounds sterling, were due tomature in January 1931. Before Japan’s return to gold in 1930, the Western investors inthese bonds insisted that a stable Japanese currency was a prerequisite to conversion of
the debt.19 Japan returned to gold in January 1930 and successfully issued refinancing
bonds in May 1930.20
In light of the devaluation of the yen in 1932, Japan needed to stabilize the yen
at a certain level to keep servicing its debts. The depreciation of the yen added to theburden of debt servicing. According to official statistics, 20 percent of the total national
debt was denominated in foreign currency at a conversion rate of the old parity (1 yen =1 shilling 0.582 pence). When the foreign debt was converted at the new exchange rate,
which became effective in April 1933 (1 yen = 2 shillings 2 pence), foreign-denominateddebt accounted for 30 percent of total debt. If the yen had depreciated further, the19
20

Tsushima[1965], p.65.
Tsushima [1965], pp.64-65.
21

burden of debt servicing would have increased, and Japan might have lost its ability toservice its debts. As the Japanese economy depended on international trade and finance,
Japan avoided defaulting on its international debts.
Japan had another good reason to peg its currency to the pound sterling, rather
than to the U.S. dollar. Japan depended more on the London market than on the New
York market as a financial center. From 1870 to 1930, Japan issued government bonds
with a total value of 2,843 million yen abroad. Of this amount, 2,148 million yen (220million pounds), or 75.6 percent, was issued in London. At the end of 1931, 60.7 percent
of Japan’s total outstanding foreign debt was denominated in pounds sterling.
Third, Japan had a political reason to maintain its pegged exchange rate
system. Japanese policymakers made efforts to maintain Japan’s position in theinternational community.21 One of the criteria for participating in the establishment of
the Bank for International Settlements (BIS) in 1929 was to have a “stable currency.”
Japanese policymakers took seriously the need to meet the criteria for participating in
the BIS.22
For the above reasons, Japan decided to sacrifice independent monetary policy
to peg the yen to the pound sterling.
The Japanese experience provides a good case study of a peripheral country
during the Great Depression. After departing from the gold standard, Japanesepolicymakers did not pursue their potential policy objectives to the fullest extent. They
cautiously followed the monetary policy of a core country, Great Britain.
Eichengreen [1992] comments on the policies of countries that had alreadyApparently, for this reason, Finance Minister Takahashi resisted cutting a formal
linkage between the yen and gold when departing from the gold standard in 1931.
Fukai [1941], pp.260-262.
22 In the negotiations that took place in the Young Committee, the term “stablecurrency” referred to maintaining gold parity. Japan succeeded in including an
exception clause allowing a victorious country to participate without reference to thestable currency clause. Still, Japanese negotiators regarded joining and staying on thegold standard as a source of power within the BIS. Cho [2001], p.100.
22
21

suspended gold convertibility in the transitional year of 1932 as follows: “Hence theinitial response of governments to their policy freedom was extremely cautious...
Abandoning the gold standard statutes was necessary but not sufficient to spark theresumption of rapid growth. It was also necessary to abandon the ethos of the gold
standard that encouraged the continued pursuit of restrictive policies.”23This study reveals that the hesitation of monetary authorities during the 1930s,
at least in peripheral countries, does not simply reflect the enduring ethos of the gold
standard, but may also reflect the reasonable concerns of policymakers in a small open
economy.24

c. What Policy Made Japan Exceptional in the Early 1930s? A Comparison between
Japan and Other Peripheral Countries
The quantitative and narrative analyses undertaken in this study reveal thatJapanese monetary policy followed British policy in the early 1930s. This suggests thatJapan was unexceptional in terms of monetary policy during that period. If so, whatmade Japan exceptional in terms of its early recovery from the Great Depression? While
it is beyond the scope of this study to explore all Japanese economic policy during thisperiod, this sub-section provides some insight by comparing Japanese economic
indicators and policy measures with those of other peripheral countries.
Based on Eichengreen [1992], we divide peripheral countries and regions other

Eichengreen [1992], pp.287-289. Countries that had not yet abandoned the gold
standard had to decide whether to do so. Like Japan, export-oriented countries such as
Denmark and New Zealand followed Britain by devaluing their currencies. Less
export-oriented countries such as the United States and France retained the gold
standard. Countries that were home to international financial centers, such as The
Netherlands and Switzerland, had strong incentives to maintain the stability of theircurrencies and retain international investors’ funds, and were the last to go off gold.
24 In this regard, the Japanese experience during the 1930s resembles that of theemerging economies during the currency crisis of the late 1990s. Once they were forced
to depart from a peg system in the wake of the contagious effects of international capital
flows, policymakers devalued their currencies in one shot, and then tried to stabilize
their currencies at their new levels, which were more favorable for their exports. While
doing so, they did not pursue independent monetary policies.
23
23

than Japan into four categories: gold standard countries, exchange control countries,
sterling area countries, and other depreciating countries (Table 8).25 Countries such as
Albania, Belgium, France, The Netherlands, Latvia, Lithuania and Switzerland
remained on gold. Countries with strict exchange controls were Bulgaria, Germany,
Hungary and Yugoslavia. The sterling area consisted of the British Commonwealth,
Scandinavian countries, Portugal and Thailand. Other depreciators include Latin
American countries, Spain, Greece and China.

Table 8. Categories of Countries
Category

Country and region (numbers of countries/regions)a. gold standard

Albania, Belgium, Danzig, France*, Latvia, Lithuania, The
Netherlands*, Poland*, Switzerland* (9)b. exchange controls

Bulgaria*, Germany*, Hungary*, Yugoslavia* (4)c. sterling area

Australia*, Canada, Denmark*, Egypt, Finland*, India,
Malaya,New

Zealand*,

Norway*,Portugal,

Sweden*,China,

Columbia*,

Thailand (12)d. other depreciators

Argentina,

Bolivia,

Brazil*,Chile*,

Ecuador, Greece, Mexico*, Peru, Salvador*, Spain, Uruguay,
Venezuela (14)Note: “*” indicates countries which appear in Table 10-1 in Eichengreen [1992].

We will now compare Japanese economic indicators with those for the four
categories of countries.26 Figure 3 shows annual price changes in Japan and the four
categories of countries. Figure 4 shows annual changes in industrial production. The
two figures confirm the earlier recovery of Japan from the Great Depression incomparison with other peripheral countries. Japan experienced higher rates of inflationand growth in 1932-33 than other countries.
25 Eichengreen [1992], p.293, Table 10.1, and League of Nations[1940], pp.194-204. We
add some peripheral countries and regions to Eichengreen’s table, with reference to the
League of Nations’ description of exchange rate arrangements.
26 Through this section, we calculate the data for the four categories of countries basedon unweighted averages.
24

Figure 3. Prices (percentage change from previous year)
25.0
20.0
15.0
10.0
5.0
0.0
-5.0
-10.0
-15.0
-20.0
1930

1931

1932

Exchange controls
Sterling Area

1933

1934

1935

1936

1937

Gold standard
Japan

1938

1939

Other Depreciators

League of Nations [1940].

Figure 4. Industrial Production(Percentage change from previous year)
25.0
20.0
15.0
10.0
5.0
0.0
-5.0
-10.0
-15.0
-20.0
1930

1931

1932

Exchange controls
Sterling Area

1933

1934

1935

Gold standard
Japan

1936

1937

1938

1939

Other Depreciators

League of Nations [1940].

What kinds of factors, and especially macroeconomic policy factors, contributed
to the early Japanese recovery? Figures 5 through 7 indicate that Japan stimulated the25macroeconomy to a remarkable extent through its exchange rate and fiscal policies, but
not through its monetary policy.
Figure 5 indicates that the quantity of money in Japan moved largely in linewith money supply in sterling area countries until 1936. Japanese money supply
increased by 5.9 percent annually from 1931 to 1936, a period during which money
supply in sterling area countries increased by 5.5 percent annually. At the same time,money supply in gold standard countries decreased by 1.1 percent annually, and money
supply in exchange control countries increased by only 1.6 percent annually. The
quantities of money in other depreciating countries increased by 14.8 percent per
annum over the same period. This indicates that Japanese monetary policy, at least interms of money supply, was comparable to the policies adopted in sterling area
countries. In a sense, Japanese money supply was restrained in line with sterling area
countries. This is consistent with the results of our quantitative analysis of interest
rates.

Figure 5. Currency in Circulation
50.0
40.0
30.0
20.0
10.0
0.0
-10.0
-20.0
1930

1931

1932

Exchange controls
Sterling Area

1933

1934

1935

Gold standard
Japan

League of Nations [1940].

26

1936

1937

1938

1939

Other Depreciators

We plot exchange rates in terms of gold parity (Figure 6) and fiscal balances(Figure 7).

Figure 6. Exchange Rates to Their Respective Gold Parities(percentage change from previous year)
10.0
appreciation

0.0
-10.0
-20.0
-30.0
-40.0
depreciation

-50.0
1930

1931

1932

1933

Exchange controls
Sterling Area

1934

1935

1936

Gold standard
Japan

1937

1938

1939

Other Depreciators

League of Nations [1940].

Figure 6 indicates that the Japanese yen depreciated further than any of thecurrency categories in 1932-33, and that the yen moved in line with sterling area
currencies during and after 1934.
It is conceivable that the depreciation of the yen gave a big boost to theJapanese economy. This view is consistent with Nanto and Takagi [1985], whoemphasize “the importance of price factors -- primarily brought about by Takahashi’s
exchange rate policies -- in the subsequent economic recovery.”27

27

Nanto and Takagi [1985], p.374.
27

Figure 7. Fiscal Balance (as a percentage of fiscal revenue)
10.0
0.0
-10.0
-20.0
-30.0
-40.0
-50.0
1928

1929

1930

1931

1932

Exchange controls
Other Depreciators
Japan

1933

1934

1935

1936

1937

Gold standard
Sterling Area

Economic Intelligence Service, League of Nations [1937-38], Public Finance.

Figure 7 indicates that Japan ran large fiscal deficits during and after 1932,
and never returned to a balanced budget in the period until 1937. Japan’s fiscal deficits
were larger than those of other peripheral countries. This result is consistent with Cha[2003] in terms of the effect of debt-financed fiscal policy. Cha [2003] claims that
“Takahashi’s deficit spending was indeed crucial in ending the depression quickly.”28This comparison of the Japanese economy with the economies of othercountries suggests that the depreciation of the currency and debt-financed fiscal
stimulus contributed to the early recovery of the Japanese economy from the Great
Depression. The comparison suggests that Japanese monetary policy stayed in line with
monetary policies adopted in the sterling area, and that monetary policy did notcontribute significantly to the early recovery of the Japanese economy.

28

Cha [2003], p.136.
28

5. Conclusion
We have found evidence supporting the view that Japanese policymakers
followed the decline in foreign interest rates rather than pursuing an autonomousmonetary policy after Japan’s departure from the gold standard. In other words,
Japanese policymakers sacrificed autonomy in monetary policy in order to stabilize theexchange rate.
In theory, a national policymaker is able to conduct autonomous monetary
policy under a flexible exchange rate system. In reality, Japan imposed a restrictive
monetary policy on itself even after departing from the gold standard. Japan did so
because as a small, open economy, it needed to maintain its ties both with its trading
partners and with the international financial markets.

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32