Future of Central Banksand Central Banking
Opening Speechby Masaaki Shirakawa,
Governor of the Bank of Japan

I. Introduction
Good morning. I am very pleased to address the Bank of Japan international conference.
On behalf of my colleagues at the Bank of Japan, I welcome all the participants from
central banks, international organizations, and academia.
The global financial crisis which started in the summer of 2007 poses a renewed but
fundamental question on the role of a central bank. This year’s conference focuses on
this timely theme of “Future of Central Banking under Globalization.”
In exploring the future of central banks, I set my benchmark at the monetary andfinancial system and the environment surrounding central banks at the time when I
started my career at the Bank of Japan in 1972. In those days, on the monetary policy
front, central banks did not obtain sufficient understanding and support about theirprimary objective of achieving price stability from politicians and the public at large.
In the mid-1970s, shortly thereafter, double-digit inflation became a crucial challenge
for central banks in major countries. And many central banks were yet to establish their
independence. The foreign exchange rate system for the advanced countries was in atransition period from the adjustable peg under the Bretton Woods system to the floating
rates. As for the financial system, the banks’ activities were still highly regulated, andthe memory of a financial crisis became faded just as a remote past event.
The situation changed significantly after that.1 Macroeconomic performance improved considerably. Many central banks established their independence, and succeeded in improving the understanding on their role from politicians and the public.
“Quiet Revolution” called by Alan Blinder can be understood along such a trend.2 The
theory of monetary policy also advanced considerably.3
Just when we feel comfortable with the positive developments, which just I mentioned, the situation has already been changing gradually, thereby posing a new challenge for central banks. That is, asset-price and credit bubbles and subsequent economic
1. Cagliarini, Kent, and Stevens (2010), Caruana (2010), and Crockett (2010) provide excellent reviews on
development in the macroeconomy, the financial system, and the international currency system, respectively.
2. See Blinder (2004).
3. Clarida, Galí, and Gertler (1999) say that research on monetary policy reaches a stage of a “science ofmonetary policy” by establishing a number of useful principles for optimal monetary policy with fairly
general applicability.
MONETARY AND ECONOMIC STUDIES/NOVEMBER 2010
DO NOT REPRINT OR REPRODUCE WITHOUT PERMISSION

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stagnation and financial crises after the burst of bubbles. Japan faced that challenge
first, and then countries in various parts of the world experienced similar challenges
one after another.
In view of the current global financial crisis, we clearly know that we are facing the
new challenge. But, to what extent did central bank policymakers predict the current
situation a couple of decades ago? Instead of venturing into a long-term future, I willrather narrow my focus on a near-term future.

II. Performance of Central Banks
Central banks in the world do not play the exactly same roles, reflecting their historicalbackgrounds. But to consider the nature of modern central banking, we need to focus
on three aspects. First, a central bank provides central bank money with ultimate safety
and liquidity and operates payment and settlement systems. Second, a central bankconducts monetary policy to guide the level of interest rates for achieving price stability.
Third, a central bank plays a key role in maintaining financial system stability. About
the third role, a central bank has a unique role as a lender of last resort, and, moreor less, it shares the important role of financial regulation and supervision. I begin byreviewing the performance of central banks in the three areas.
A. Central Bank Money and Payment and Settlement Systems
First, speaking of central bank money and payment and settlement systems, large-value
payments settled through central bank accounts have increased significantly, reflecting
the growing financial market transactions. At the same time, the settlement methods
have also changed drastically. In the early 1970s, only the Fedwire, run by the U.S. Federal Reserve System, employed the real-time gross settlement (RTGS) system, which
immediately settles funds transfer instructions between central bank accounts on an
instruction-by-instruction basis. Most of the remaining systems employed the deferred
net settlement (DNS) system, which settles funds transfer instructions between central
bank accounts on a netted amount basis at fixed points in time. The Bank of Japan
carried out most of settlements either at nine o’clock in the morning, one or threeo’clock in the afternoon.4 However, most of the central banks in the world, including
the Bank of Japan, have moved to RTGS systems.5
As for foreign exchange transactions, Continuous Linked Settlement (CLS) started
its operation in 2002. The system settles foreign exchange transactions in 17 currencies
on a payment-versus-payment (PVP) basis between seven o’clock in the morning tonoon, central European time. Those fixed hours, which were enabled by the extensionof operating hours of central bank systems, are often called the “five-hour window”
linking settlements on the globe.
The observations just I mentioned, are very limited, but they clearly show a dramatic
improvement in the safety and efficiency of payment and settlement systems. That was
4. The settlement time at five o’clock was introduced in 1993 when the Zengin system moved from next-day
settlement to same-day settlement.
5. See Shirakawa (2009).

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Future of Central Banks and Central Banking

proven resilient under the current financial crisis, as a result of steady and tremendous
efforts to reduce settlement risk by all the parties concerned in the past.
B. Monetary Policy
Next, let me move on to reviewing the performance of monetary policy. Although inflation accelerated from the 1970s to the early 1980s, it then started declining noticeably
around the mid-1980s. In the 1990s, inflation came down to a low and stable level where
central banks in major countries could declare a victory in the battle against inflation. In
parallel, public understanding about monetary policy was enhanced in two points: pricestability as the primary objective, and the importance of central bank independence
to that end.
However, bubbles have often emerged since central banks just won the battle against
inflation. As I mentioned earlier, Japan first experienced that problem in the second halfof the 1980s. Around that time, Japan delivered a remarkably good macroeconomic performance, compared with other advanced countries. Real GDP growth reached 5.1 percent in Japan, while the average of other G-7 countries stayed at 3.4 percent. Consumer
price index (CPI) inflation came down to 1.1 percent in Japan, while the average ofother G-7 countries remained at 3.9 percent. Japan received high marks in performance
criteria for inflation targeting, which would prevail later on.
At that time, there was debate about the necessity of exiting extremely accommodative monetary policy in Japan. In fact, all the macroeconomic indicators except for one
showed the necessity of withdrawing monetary easing: high economic growth, tightlabor market conditions, rapidly growing bank lending, and bloated asset prices. The
outlier indicator, however, was exactly CPI inflation. As a result, low inflation stoodagainst the Bank of Japan, and delayed the policy reversal toward tightening. What
happened later on was the expansion and burst of an asset-price and credit bubble andthe subsequent financial crisis. Since then, many countries had the same experience thatprice stability would not automatically ensure macroeconomic stability.
To digress a little bit, before the current crisis, a safety margin against the zero lower
bound of nominal interest rates was often pointed out as one of the justifications for targeting a small but positive rate of inflation. In the end, major countries found themselves
virtually constrained by the zero lower bound under the current crisis. Looking back at
the serious economic downturn after the failure of Lehman Brothers, very few think that
reducing interest rates by a few percentage points, enabled by having a higher target
rate of inflation, would have materially changed a recovery path of the economy.6 Thatsuggests how devastating damage financial system instability inflicts on the economy.
We have learnt two things from our experiences in the last few decades. First,
price stability and financial system stability are both prerequisites for macroeconomic
stability. Second, price stability itself is desirable, but it entails a complex mechanism
for destabilizing the financial system, if combined with over-confidence in economic
agents and unfounded expectations about the prolonged low interest rates.7

6. Blanchard, Dell’Ariccia, and Mauro (2010) point out that it is necessary to examine costs and benefits of raising
an inflation target in light of the current financial crisis.
7. See White (2006).

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C. Financial System
So, I will move on to reviewing the performance of central banks in the third role, theachievement of financial system stability. In the early 1970s, a major financial crisis
seemed remote to many countries, including Japan. Of course, some financial crises
occurred after that, such as the Secondary Banking Crisis in the United Kingdom andthe S&L Crisis in the United States, while they were far from a full-fledged crisis affecting the entire economy and the financial system. Such a situation, however, changed
significantly in the 1990s.
First, financial crises have occurred more frequently than before. That is apparent
from the recent episodes: Japan’s crisis, the Nordic crisis, the East Asian crisis, the
LTCM crisis, the Russian crisis, and the current global financial crisis. In addition,
financial crises have increased their magnitude.
Second, financial crises have occurred on a more global scale than before. Japan’s
financial crisis was an isolated event for the global financial system, albeit a serious
event for Japan. However, the subsequent crises strengthened their global nature. The
crisis after the failure of Lehman Brothers was truly a global financial crisis.
Third, financial crises have a bit different nature, compared with the past. Financial
crises always surface in the form of a liquidity shortage. Under the current crisis, theshortage of market liquidity, in addition to funding liquidity, did matter. In addition,such liquidity shortage became extremely acute in the shadow banking system, which
is outside the traditional banking sector.

III. New and Difficult Challenges from SuccessAs the last couple of decades show, central banks have achieved a great success instabilizing prices as well as economic activity. As a result of such success, central
banks seem to ironically face new and difficult challenges.8 I will next explain suchdifficult challenges.
A. Changes in the Manifestation of Economic ImbalancesFirst, the imbalances in the economy are unlikely to appear immediately in the form ofimbalances in general prices. A benign macroeconomic condition tends to make economic agents irrationally bullish, and change their risk perception in a laxer direction.
Low inflation, however, tends to delay the reversal of easy monetary policy. Under
such a situation, overconfidence, if created by some reasons, ignites an increase in asset
prices, expansion of credit and leverage, and extension of maturity mismatches. If theimbalances in the economy had appeared in the form of a rise in general prices, acentral bank would have relatively easily been able to respond by orthodox monetary
tightening. The imbalances in the economy, however, appeared in the form of financial
imbalances. Then, why have general prices become less responsive to the imbalancesin the economy?

8. Shirakawa (2010) points out a mechanism of so-called the “cycle of confidence” behind the bubble andfinancial crisis.

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Future of Central Banks and Central Banking

One reason, often pointed out, lies in the enhanced credibility for a central bankin conducting monetary policy. In that case, firms do not change their product prices
immediately, when they perceive general price fluctuations as just temporary. Anotherreason is related to the tendency toward non-price competition. Firms are concernedthat a simple raise in the prices results in losing their customer bases in a low inflation
environment, and that a simple reduction in the prices just invites subsequent pricereductions by competitors.
Although I basically agree with the analyses, just I mentioned, I conjecture thata more fundamental reason lies in the fact that price measurement itself has become
hard in recent years. Of course, in theory, the price index is supposed to trace qualityadjusted prices over time. In practice, however, value added and attendant risk are hard
to be identified, as the economy becomes more information-driven, service-oriented,
and network-intensive.9 A case in point is financial services consumers purchase fromfinancial institutions. Financial services are about risk assessment. As our experience ofthe financial crisis shows, however, such risk assessment turned out to be inadequate. If
an ideal quality adjustment method had been available to us, quality-adjusted pricesof financial services would have increased reflecting their declined quality. Such astatistical treatment has hardly been implemented in practice, and the situation seems
to remain the same in the future.
B. Policy Responses after the Burst of a Bubble
The second difficult challenge is that a policy response, if successful in the short term,
does not necessarily imply a success in the long term. Central banks moved swiftly
and aggressively, countering a serious economic downturn stemming from the burst of
the bubble. We have to be aware that such policy responses could cause other risks,
including the emergence of an asset-price and credit bubble. Given the increase in thefrequency and magnitude of bubbles since the 1990s, I mentioned earlier, we need tohave a longer time horizon to tell whether a policy response will succeed or not.
C. Central Bank in Democratic Society
The third difficult challenge is related to the fact that a success in policy responses poses a new problem as to what responsibility a central bank should bear indemocratic society.
Confronted with the financial and economic crises, central banks in major countries have all introduced unconventional policy measures. In that regard, the Bank ofJapan was the first to experience a financial crisis, and, thus, was the first to employ
unprecedented measures. Since the late 1990s, the Bank of Japan has been moving aggressively as a lender of last resort, including the funds provision to the securities firm.
The Bank of Japan also launched various unprecedented measures, such as a stock
purchase program from financial institutions and the outright purchase of asset-backed
commercial papers and asset-backed securities. Thus, it is my regret that innovationsin the Bank of Japan’s policy responses have not been well recognized. In fact, under
the current financial crisis, major central banks have also taken unprecedented policy
measures, just like the Bank of Japan did.
9. See Varian (2001).

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Unconventional policy measures taken by a central bank involve quasi-fiscal policy
elements, such as potential taxpayers’ burden incurred by a loss from such operations,and intervention in resource allocation at a micro level. In the midst of a crisis, a central
bank faces growing demand for introducing unconventional policy measures, which
involve more or less quasi-fiscal policy elements. Since a central bank generally thinksthat such measures need to be decided and implemented by government in democraticsociety, a central bank falls into a difficult position, when decisions by government are
just postponed.
The border between pure monetary policy and quasi-fiscal policy sometimes becomes ambiguous. Looking back at the experiences of various countries since the1990s, when their central bank law had clauses for making some quasi-fiscal policy
measures possible, they decided to carry out such measures after careful consideration.
Once a crisis was overcome, with the help of such unconventional policy measures,
central banks were criticized for violating the fundamental rule in democratic society.
As a result, such a situation is likely to undermine credibility for central banks, and thus
affect their policy performance.

IV. Tasks for Central BanksAs I discussed so far, central banks face new and difficult challenges at the moment.
With considering such difficult challenge, I will point out some tasks in addressing
such difficult challenges.
A. Understanding of a Primary Mandate for a Central Bank
The first is the understanding of a primary mandate for a central bank. Without social
understanding on that point, central bank independence and, eventually, central bankcredibility itself are likely to be undermined.
I think that a primary mandate for a central bank should be to achieve a stable financial environment, that is, a financial environment that is consistent with, and contributes
to, sustainable economic growth. Price stability is certainly one important element inachieving a stable financial environment. That is, however, not the sole factor. When acentral bank feels constrained by short-term developments too much, that is more likely
to amplify macroeconomic fluctuations.
After all, deposit money, which has a major share in broad money, is created as a
product of maturity mismatches and leverage of private financial institutions. A central
bank needs to adequately monitor the financial environment, including such behavior of
financial institutions. Macroprudential perspectives, recently reemphasized in light ofthe current global financial crisis, should be understood as examining the interactions
between the real and financial sides of the economy, considering the behavior of private
financial institutions. Such an analysis is an essential task for a central bank, although
it is a typical example of “easier said than done.” In addition, macroprudential analyses and perspectives are crucially important in conducting monetary policy as well as
designing financial regulations and supervising financial institutions.

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B. Financial Infrastructure
The second is the efforts to improve the financial infrastructure. In achieving a stablefinancial environment, while monetary policy certainly plays an important role, weneed to avoid overstating the effectiveness of the fine-tuning policy, given our incomplete knowledge. As is well known, we have difficulty in measuring the output
gap and inflation in an accurate manner. It is even more so in projecting such indicators. We also need to pay attention to the risk of destabilizing the economy, due to arecognition lag.
By contrast, we can count more on assured benefits from enhancing the financial
infrastructure, as evident from the observation that such efforts are very effective instaving off the aggravation of the current global financial crisis. In that respect, one of
the most important tasks is to improve cross-border funding markets.
C. International Monetary System
In discussing the future of central banking, I cannot conclude my speech without
touching upon the international monetary system.10 In that regard, we sometimes hear
the arguments for macroeconomic policy coordination to facilitate the adjustmentsof global imbalances. The current-account imbalances themselves are an adjustment
mechanism for the differences in savings and investment patterns due to the variationsin the level of economic growth and demographics between countries. So the imbalances themselves are not necessarily evil. What should be adjusted is unsustainableimbalances, but, as the current global financial crisis shows, those imbalances arecaused primarily by internal imbalances, reflecting inappropriate management ofmacroeconomic policy and financial regulations and supervisions. I well understandthe necessity of reforming the international monetary system as a long-term task, but
I should emphasize the bottom line that each country should make every effort to put
its own house in order.
Having said that, we need to recognize new challenges we are facing in an international context. As the role of globally operating financial institutions and investors
expands, easy monetary policy in one country comes to influence other countries. We
thus observe a phenomenon that the insulating effect of the floating exchange systemdoes not always work perfectly, as it is described in textbooks. One example is thegrowing effects of carry trade. Considering such changes in the transmission channel ofmonetary policy, I am wondering whether and to what extent we need to alter our way of
thinking on monetary policy management for the advanced countries or an international
key currency country. That seems to remain an open question.

V. Institutional Culture for a Central Bank
As discussed so far, central banks are facing wide-ranging challenges. In any event, thefiat money system is a system to control money with wisdom. To that end, the institutional culture and human capital accumulation in such culture are crucially important
10. We see some renewed interests in the international monetary system. See, for example, Padoa-Schioppa (2010)
for that line of arguments.

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for a central bank.11 In closing my remarks today, let me touch upon some aspects of
the institutional culture for a central bank I deem important.
The first aspect in the central bank culture is banking operations. A central bankis not just an ivory tower to discuss the macroeconomy and the financial system in an
abstract manner. Rather, a central bank itself is a bank, which implements policy actions
through banking operations, as in the case of monetary policy as well as a lender of lastresort. Those operations require wide-ranging operational knowledge, such as collateralhaircut setting, counterparty selection, payment and settlement of funds and securities,
and debt-collection from failed financial institutions.
In addition, such knowledge is also useful in assessing the subtle working of thefinancial system and its interaction with the macroeconomy. In introductory textbooks,
money is described as a mechanical concept just as a product of the monetary baseand the money multiplier. Such a way of understanding of money misses the importantrole played by money. As I noted earlier, money is created as a product of maturity
mismatches and leverage in financial transactions. That implies that a central bankis unable to understand developments in the financial system and the macroeconomy
without hands-on knowledge on how banks operate. The current global financial crisis
clearly shows that point.
The second aspect is to keep learning. The economy, including the financial systemand financial markets, is changing all the time. When we have confidence in acquiringknowledge on something, the situation has already started changing before we know it.
One such example is financial system instability after achieving price stability.
We are unable to write fully state-contingent rules and contracts. Actual markets
are inevitably incomplete markets in economists’ terminology. A central bank canbe regarded as a device for dealing with such incompleteness. If that is the case, acentral bank needs to make use of all the available knowledge in understanding thedevelopments in the economy and their implications, and mapping out necessary policy actions. Thus, a central bank needs to put emphasis on the institutional culture ofconstant learning.12
The third aspect is the integration of wide-ranging areas of knowledge. Taking an
example of monetary policy, a central bank generally relies heavily on the macroeconomic theory in conducting monetary policy. The economic theory plays an important role in providing a framework for understanding a complex world. At the sametime, we should be careful that sticking to one specific theory potentially distorts ourviews. Historical knowledge is also useful. Looking back at the history of financial
crises, we are stunned by the common mentality of “this time is different.”13 In addition,knowledge on banking operations, just I mentioned, is also indispensable. A central
bank needs to make constant efforts to produce synergy effects between monetary policy and prudential policy wings by overcoming some differences in the cultures of thetwo policy wings.

11. Williamson (1999) discusses the governance of public institutions. Oritani (2010) analyzes the governance andorganization of a central bank using the institutional economics.
12. See King (2005) for the importance of learning for central banks.
13. See Reinhart and Rogoff (2009).

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Future of Central Banks and Central Banking

The fourth aspect is cooperation among central banks. We expect that economic
activity and financial market transactions will continue to grow across borders, but
we do not imagine that sovereign nations will disappear in the foreseeable future. Inthat case, cooperation between central banks will become increasingly important inachieving financial system stability. Under the current global financial crisis, central
banks have communicated with each other intensively at various levels, from top central
bankers to mid-class staffers, which surely becomes considerable wealth for the futureof the central bank community.

VI. Closing Remarks
Central bank conferences reflect the institutional culture of central banks, and this conference entails such aspects more clearly with its title of “Future of Central Banking.”
I am convinced that the one-and-a-half-day conference will give us profound insights
into the future of central banks and central banking.
Thank you very much.

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References

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IMF Staff Position Note, International Monetary Fund, 2010.
Blinder, Alan S., The Quiet Revolution: Central Banking Goes Modern, Yale University Press, 2004.
Cagliarini, Adam, Christopher Kent, and Glenn Stevens, “Fifty Years of Monetary Policy: What Have
We Learned?” paper presented at the 50th Anniversary Symposium of the Reserve Bank ofAustralia, February, 2010.
Caruana, Jaime, “Financial Stability: 10 Questions and About Seven Answers,” paper presented at the50th Anniversary Symposium of the Reserve Bank of Australia, February, 2010.
Clarida, Richard, Jordi Galí, and Mark Gertler, “The Science of Monetary Policy: A New Keynesian
Perspective,” Journal of Economic Literature, 37 (4), 1999, pp. 1661–1707.
Crockett, Andrew, “What Have We Learned in the Past Fifty Years about the International Financial
Architecture?” paper presented at the 50th Anniversary Symposium of the Reserve Bank ofAustralia, February, 2010.
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Economics,” BIS Working Paper No. 299, Bank for International Settlements, 2010.
Padoa-Schioppa, Tommaso, “The Ghost of Bancor,” speech at Louvain-la-Neuve, February 25, 2010.
Reinhart, Carmen M., and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial
Folly, Princeton: Princeton University Press, 2009.
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Varian, Hal R., “Markets for Information Goods,” in Kunio Okina and Tetsuya Inoue, eds. Monetary
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White, William R., “Is Price Stability Enough?” BIS Working Paper No. 205, Bank for International
Settlements, 2006.
Williamson, Oliver, “Public and Private Bureaucracies: A Transaction Cost Economics Perspective,”
Journal of Law, Economics and Organization, 15 (1), 1999, pp. 306–342.

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