The Mayekawa Lecture:
The Way Back to Stability and Growthin the Global Economy
by John B. Taylor

I. Introduction
It is an honor to be invited to give the Inaugural Mayekawa Lecture, and it is a special
pleasure to return to Tokyo and the Bank of Japan (BOJ) to do so. I would like to
begin the lecture by taking note of Governor Mayekawa’s comprehensive approach toeconomic research and public policy problems during the 1970s and 1980s. Then, using
a similar approach, I will consider some of the difficulties that researchers and policy
makers face today.

II. A Comprehensive Approach to Research and Policy
The best way for me to describe the influential approach to research and policy that I
have found to be characteristic of Governor Mayekawa’s contributions is through several examples or stories about his work at the BOJ and afterward. I start with monetary
policy in the 1970s.
A. Lessons Learned about Monetary Policy in PracticeHaruo Mayekawa served as Deputy Governor of the BOJ from 1974 to 1979 and as
Governor from 1979 to 1984. The late 1970s and early 1980s were, of course, very
challenging times for economic policymakers throughout the world. In many countries,
the Great Inflation was still raging and the Great Moderation was at best a glitter ofhope in the minds, or the computers, of monetary scholars.
But important lessons for the future were being learned by observing the excellent
performance by the BOJ and Governor Mayekawa during this period. By credibly committing to a non-inflationary monetary policy from the mid-1970s on—quickly learning from the experience of the first oil shock of the early 1970s—the BOJ was able toweather the oil shock of the late 1970s and keep it from passing through to the overall
inflation rate, unlike in the United States and most European economies.
Professor of Economics, Senior Fellow, Hoover Institution, Stanford University(E-mail: John.Taylor@Stanford.edu)
This paper was presented at the 2008 International Conference, “Frontiers in Monetary Theory and Policy,” heldby the Institute for Monetary and Economic Studies, Bank of Japan, in Tokyo on May 28–29, 2008.
MONETARY AND ECONOMIC STUDIES/DECEMBER 2008
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37

I focused on this difference at the BOJ’s Third International Conference in 1987—
the first one I attended (see Taylor [1988]). Several years later, in the 1991 Economic
Report of the President, the U.S. Council of Economic Advisers, of which I was amember at the time, used the success of Japan in contrast with the United States during
this period to show how credibly sticking to a low-inflation policy would mitigate theimpact of the oil shock following the Iraqi invasion of Kuwait, much more effectively
than an accommodative policy would. The comparison was made with the help of two
figures, which I reproduce here (Figure 1). The main difference between the upper chart,
which shows the United States, and the lower chart, which shows Japan, is that during
the period of the late 1970s and early 1980s (1977/Q1 to 1980/Q1) there was little orno increase in inflation in Japan, whereas there was a large increase in inflation in the
United States. The lesson learned was very clear, and by the late 1990s it was being
applied elsewhere, including in the United States.
B. Research and the Creation of the Institute of Monetaryand Economic Studies
We also have to thank Governor Mayekawa for his support of research and the Institutefor Monetary and Economic Studies (IMES), which was created more than a quartercentury ago in 1982 at his suggestion. It is worth recalling his words at the inaugurationof the institute, for I believe the principles he established for a basic research department
at a central bank have influenced researchers and visitors to the Institute ever since:“Basic researches can be compared to the roots of a tree. They may not enjoy a highprofile but are very important. A clear theoretical understanding of the financial andeconomic mechanism is the fundamental basis for understanding the essential forces
behind each phenomenon. This will help us recognize what type of side-effects myopic
policy actions may entail in the long run” (Okina [1998]).
Again the lesson is clear: Good policy requires good theoretical research. I knowthat I have benefited from the institute, as a Visiting Scholar in the spring and summerof 1987 when Yoshio Suzuki was director, and at many of the international conferences
since then. So have many other monetary economists.
C. The Mayekawa Commission
Governor Mayekawa also had an important influence beyond monetary policy and central banking. In 1986, at a time when protectionist pressures were building abroad,
Prime Minister Yasuhiro Nakasone established an Advisory Group on Economic Structural Adjustment for International Harmony. Its main charge was to recommend ways
to reduce the Japanese current account surplus, which was a source of the tension. He
chose Mayekawa, who by then had retired as Governor of the BOJ, as the chairman of
the advisory group, and from that time forward the group was called the “Mayekawa
Commission” and the initial report and its follow-up were called the “Mayekawa
Report.”While the Mayekawa Report was aimed at reducing the current account surplus,
it recommended sensible market oriented economic policies rather than new restrictions. It emphasized “Freedom in principle, restrictions only as exceptions.” It suggested that imports to Japan could be increased through deregulation of the retail and

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The Mayekawa Lecture: The Way Back to Stability and Growth in the Global Economy

Figure 1 Inflation

Note: The impact on inflation of the oil shock of the late 1970s and early 1980s in Japan(lower chart) was much lower than in the United States (upper chart).
Source: The two charts originally appeared in the 1991 Economic Report of the
President.

39other sectors. It was internationalist rather than isolationist or protectionist, stating as acentral purpose to “orient the [Japanese] economy toward international harmony.”
Several years after the Mayekawa report was released, the United States joined withJapan in looking for ways to help implement the recommendations. And in order to reduce protectionist sentiments in the United States, a series of talks, called the structural
impediments initiative talks, was established jointly by Japan and the United States
government. Based on the economic idea that the current account deficit is due to a gap
between investment and saving, the initiative stressed increasing saving in the UnitedStates as well as investment in Japan. Both Japan and the United States would thereby
try to contribute to the effort. As a member of the U.S. side in these talks, I can say that
the Mayekawa Report was consulted and referenced often. Like the Mayekawa Report,
the suggested policies were ones that made economic sense whether or not the current
account was a problem. In my view, the report and such structurally oriented initiatives
did help to reduce protectionist pressures.
D. Recommending a Way Back to Growth in the World Economy
For my fourth example of Governor Mayekawa’s influence, I want to refer to a remarkable speech he gave 25 years ago in 1983, the year of the First International
Conference at the BOJ where Milton Friedman (1983) and James Tobin (1983) both
gave keynote speeches. Governor Mayekawa’s speech was published along with the
speeches by Friedman and Tobin in the first issue of the journal of IMES, Monetaryand Economic Studies.
The speech was given at a watershed time for much of the global economy. Indeed,
the kinds of policy ideas in his speech are, in my view, the reason it was a watershed.
We know now that 1983 (it is hard to pinpoint it exactly, maybe it was 1982 or 1984)
was the beginning of what monetary scholars call the Great Moderation or the Long
Boom. For at least a decade and a half before the Great Moderation started, the world
economy was beset with difficulties: high and variable inflation, frequent recessions,financial instability, high and rising energy prices. These were the problems Mayekawa
addressed in his speech. He recognized the inter-relationship between these problems
and boldly took them all on at the same time. The title of the speech, “The Way Backto the Growth of the World Economy,” conveyed his diagnosis: economic policy had
gotten off track in the 1960s in many countries; this had led to deteriorating economic
performance; the Great Inflation years were the result. In essence, his recommendation
was to get back on track, by going back to basics (Mayekawa [1983]).
Mayekawa began his speech by emphasizing the importance of understanding thecauses of the economic difficulties before recommending policies to solve them—thesame theme he stressed in his inaugural address to the IMES, which I referred to earlier. “Whether or not we can succeed in overcoming difficulties largely depends on ourcapacity to properly assess fundamental causes for the emergence of the difficulties andon our resolve to pursue appropriate policy options to eliminate them” he said. He emphasized that we had to take an international approach: “In working out the strategy toovercome the present economic difficulties. . . [there] is the pressing need for individual
countries to design their policies in an international perspective. . . No country. . . should

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The Mayekawa Lecture: The Way Back to Stability and Growth in the Global Economy

and can maintain policies benefiting only its own people at the sacrifice of people inother countries in this interdependent world.”
One of his main specific recommendations was to focus monetary policy on achieving price stability: “It is my considered opinion that the best way to master the present
difficulties is for all countries around the world to take a global viewpoint, aiming
at the objective of sustained non-inflationary growth.” Regarding exchange rates, hethought that achieving price stability would help reduce commodity price volatility
and exchange rate volatility, but that from time to time exchange rates would drift
away from purchasing power parity and that intervention might then be appropriate.
He deemphasized countercyclical monetary policy and discretionary fiscal policy, saying, “The present difficult situation in the world economy cannot be overcome withthe expansionary demand management policy.” Regarding fiscal policy specifically,
he argued, “There is now little room for the use of fiscal policy to support demand.”And “The reduction of the size of the public sector and of budget deficits constitutes
one of the most pressing tasks in many developed and developing countries.” On the
microeconomic side, he emphasized deregulation and market flexibility, saying that weneed to “promote smooth adjustment on the basis of the market mechanism” especiallyto deal with rising energy costs. He argued for free international trade.

III. Today’s Economic Difficulties and the Need for aComprehensive Approach
The world economy is again faced with numerous economic difficulties. While as researchers we frequently approach these problems separately, I believe they are closely
related and policymakers must recognize this interaction as they create, negotiate, andimplement solutions. The problems are also inherently global, cutting across sovereign
boundaries. For all these reasons, I believe that a bold broad “Mayekawan approach” isneeded today.
Although one must be careful when making generalizations, recognizing importantdifferences among countries, there is no doubt about the following:• Global inflation is high and rising.
• Financial instability and risks are elevated.
• Energy, food, and many other commodity prices are at record highs in real terms.
• Current account imbalances remain high even though they are off their highs.
• Exchange rates policies are globally inconsistent, which, along with high energy
prices, has led to accumulations of financial wealth by sovereign governments.
• Protectionist and isolationist sentiments are on the rise.
To be sure, there is a very important difference between the economic situation
today and that of the late 1970s/early 1980s. From the vantage point of 2008, we canlook back and see remarkably strong global growth and stability for at least a decadein most parts of the world and for even longer in the United States and most developed economies. In contrast, from the vantage point of the early 1980s, economic performance had been dismal for over a decade and a half with high inflation and frequent deep recessions. Today’s economic problems—at least the manifestations of them41

which I just listed—have been with us for a comparatively short time, but that does notmean they will be any easier to analyze and solve. Moreover, only one of the six I
mention here—inflation—is currently less severe than in the 1970s.
Let me now discuss several of these problems, illustrating some of the importantconnections with the others.
A. Global Inflation
There is mounting evidence that inflation is accelerating in many countries. According a
recent compilation by analysts at JPMorgan Chase (Global Data Watch, May 23, 2008),
the consumer price index (CPI) in emerging market countries averaged nearly 8 percent
over the 12 months ending this April, and has risen by 3 percentage points in the past
year. In developed countries, inflation averaged 4 percent over the same time period.
This implies a global average of about 6 percent. As the first deputy managing directorof the International Monetary Fund, John Lipsky, recently warned: “To put the issue
starkly, inflation risks have reemerged as a global challenge following a long absence”(Lipsky [2008]).
What is the cause of this reemergence? Since inflation is ultimately a monetaryphenomenon, the place to look for an answer is monetary policy. A key principle ofgood monetary policy is that interest rates should increase by more than the increase ininflation, after appropriate smoothing out of clearly temporary price changes. This willkeep inflation close to target by letting the real interest rate rise when inflation rises andletting the real interest rate fall when inflation falls. See Woodford (2001).
However, during the past year, as global inflation has risen, global short-term interest rate targets set by central banks have not increased on average by as much as inflation; indeed the global average of these interest rate targets has actually fallen sincelast summer. Again using the compilations of JPMorgan Chase, the GDP-weighted average central bank interest rate fell by 1 percentage point during the past year. Muchof this decline is due to the United States, where the federal funds rate has declined
by 3.25 percentage points. Excluding the cuts in the federal funds rate, the global average was effectively unchanged (declining by 3 basis points), but in the face of rising
inflation, this is counter to key monetary principles. In emerging market countries as awhole, interest rates increased by 137 basis points, but this is far less than the roughly
3 percentage point increase in global inflation in these countries.
Why, by this global measure, do central banks seem to be so far behind the curve?
One reason might be that they are reacting to reductions in real GDP, or an openingof the GDP gap. However, as I discuss later, such GDP declines, even when one uses
forecasts, do not appear to be enough to explain the deviation of interest rates from more
appropriate levels based on inflation and GDP. Another more promising explanation isthat central banks are taking exchange rates into account when setting interest rates.
See Edwards (2006). Indeed, central banks sometimes admit that the prevailing interest
rate around the world affects their decisions. Letting their interest rate rise above a
prevailing but declining global interest rate would cause their currency to appreciate,
something that the central bank might want to avoid because of the effect on exports
and GDP growth. In the case where a central bank follows a dollar exchange rate peg,
the central bank’s interest rate must, of course, be cut along with a decline in the federal

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The Mayekawa Lecture: The Way Back to Stability and Growth in the Global Economy

funds rate, which causes easier monetary policy in the United States to be exported
abroad automatically. See Carlozzi and Taylor (1985) for model simulations of thisphenomenon. But even central bankers with flexible exchange rate policies watch thefederal funds rate and its futures carefully when making policy decisions.
In a presentation I recently gave at the Banque de France (Taylor [2008b]), I noted
the empirical relationship between Eurozone interest rates and U.S. interest rates. I
examined the deviation of the overnight interest rate target for the European Central
Bank from a simple guideline for that interest rate—the Taylor rule—which depends
on the inflation rate and the gap between real GDP and its potential level. An estimatedlinear relationship with that deviation on the left-hand side has a significant coefficienton the federal funds rate for the period from 2000–06. I have found similar strong
foreign interest rate effects for other central banks.
Hence, when faced with declining interest rates abroad, say because of a cut in thefederal funds rate, there is a danger that central banks will move off course due to concerns about the exchange rate. In doing so, central banks will be reducing interest rates
below levels needed for price stability, which could be a factor in the recent resurgenceof global inflation.
How do these results square with the result (for example, Taylor [1985]) that there
is little need for direct interest rate coordination between central banks when exchange
rates are flexible? The reason is that in practice central banks take exchange rates into
account in their interest rate responses. Clearly this would be inflationary in the current
environment, and thereby is part of the explanation for the increased global inflation
today.
In his recent assessment, Lipsky (2008) reaches the same conclusion: “The easing
in US monetary policy also has tended to generate an easing in monetary conditions incountries with currencies closely linked to the dollar. In some economies in Asia andthe Middle East, rising commodity prices have exacerbated general inflation pressures,
while an easing of conditions has made monetary policy overly-accommodative.”
B. Financial Instability and Risks
Much has already been written about the recent crisis in the global financial markets
since last summer (see Cecchetti [2008]), so there is little need here to review thecauses, which trace to low interest rates in the period from 2003 to 2005, the boom
in housing prices, and the excessive lending and underestimation of risks by many financial institutions and investors. There is no doubt that the resulting instability andrisks are highly unusual as has been documented by an examination of money market
spreads by Taylor and Williams (2008). Fortunately, the crisis has not spread thus far
to financial institutions in countries that had no connection to the questionable financial instruments. For example, the sharp rise in spreads in the money markets in North
America and Europe has not been seen in Japan as it was during the “Japan premium”
days in the 1990s.
The crisis has brought forth many policy responses in the United States. A large
discretionary fiscal package was enacted, and checks are now being sent out to millionsof Americans. The Federal Reserve cut interest rates sharply, introduced several new
lending facilities, intervened to prevent creditors from pulling out of investment bank43

Bear Stearns and the credit markets more generally, and numerous programs to support
the housing market and prevent foreclosures have been put in place or are about toget underway. There are also many proposals for increased regulation of the financial
markets, especially in light of the Fed’s facilities that provide loans to investment banks.
Thus far, however, the crisis has not had large depressing effects on the overall
U.S. economy. Real GDP slowed in the fourth quarter of 2007 and the first quarterof 2008, but strength in other sectors has prevented employment declines in housing
and financial services from leading to comparable declines in the rest of the economy.
Moreover, the increase in housing prices during the housing boom has left prices toohigh in many parts of the United States, and it makes sense for these prices to fall toa new equilibrium. Public policy should not get in the way of allowing the appropriate
price adjustments.
According to standard interest rate guidelines, such as the Taylor rule, the cut inthe federal funds rate has been larger than theory or experience over the past 25 years
would suggest is appropriate, even after making corrections for the increased spreads
in the money market as suggested in Taylor (2008a). The connection with the increase
in inflation is, of course, that the lower interest rates will create inflationary pressures,
which will be especially problematic if the impact of the financial crisis turns out toremain mild for the rest of the economy. Moreover, the low interest rates in the UnitedStates may have increased inflationary pressures outside the United States.
C. Energy and Other Commodity Prices
The impetus for the increases in energy and commodity prices is, of course, found in
relative shifts in demand and supply for specific goods. At least in the case of energy,
the high prices are beginning to send signals to firms and consumers that they will
have to make adjustments and public policy should not interfere with price controls or
subsidies. Indeed, there is evidence that part of the high price of certain agriculturalcommodities is caused by subsidies which increase the demand for their production,
corn-based ethanol being a prime example.
However, there is strong evidence that at least part of the increase in energy andcommodity prices is related to the global inflationary pressures and thereby, in part,to the policy response to the financial crisis in the United States. As was clear in the
1970s, oil price shocks tend to be larger, at least in nominal terms, when monetaryinduced inflationary pressures are high. Indeed, that was an important lesson learned
from Governor Mayekawa’s experience in the 1970s as I reviewed in the opening of
this lecture.
More specific evidence comes from recent research at the International Monetary
Fund (IMF). For example, Lipsky (2008) reports: “Preliminary evidence suggests that
low interest rates have a statistically significant impact on commodity prices, aboveand beyond the typical effect of increased demand. Exchange rate shifts also appear toinfluence commodity prices. For example, IMF estimates suggest that if the US dollar
had remained at its 2002 peak through end-2007, oil prices would have been $25 abarrel lower and non-fuel commodity prices 12 percent lower.”

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The Mayekawa Lecture: The Way Back to Stability and Growth in the Global Economy

D. Exchange Rates
I mentioned the inconsistency between certain exchange rate management policies andthe goal of keeping global inflation low. A closely related issue is that in the effort tokeep the exchange rate from rising in the face of declining global interest rates, central
banks have had to increase their foreign reserves. Some of these funds are spilling over
into sovereign wealth funds along with government revenues from higher energy prices.
Indeed, some of these funds have invested in distressed financial institutions increasing
their capital and achieving some needed de-leveraging without reducing loans.
Hence, the interaction between the global inflation, the financial crisis, interest
rates, energy prices, and exchange rates is complex and multidirectional. There aremany other connections, including the impact on asset and liability accumulation fromthe current account imbalances and protectionist reactions, but I think I have saidenough to make my point.

IV. Conclusion and Recommendations
Monetary economists stress the need for dynamic stochastic general equilibrium(DSGE) models of the whole economy, indeed of the whole global economy, in order to properly evaluate monetary policy options. As the list of issues addressed in thislecture illustrates, there is a need to consider an even more comprehensive set of generalequilibrium issues when considering policy options in the current environment. Theseissues go well beyond monetary policy, but are connected to it. Assessing these broader
interconnected issues on a rigorous and comprehensive basis is an important challenge
for researchers in my view.
The challenge for policymakers is to find a way to take account of the interactions
and move forward on a more comprehensive approach. It is clear that the policies musthave an international focus. This was stressed by Mayekawa many years ago and iseven more important today.
Where might policymakers begin? In my view, a good place to start is with discussions about some kind of global inflation target. It does not need to be a numericaltarget. It could be a concept along the lines of Paul Volcker and Alan Greenspan thatthe global inflation rate should not be so large or volatile that it interferes with private
sector decision making.
Such discussions will naturally lead to questions of how such a goal would impact
on the decisions of individual central banks. We are certainly a long way off fromthe science fictional account recently told by Stephen King of HSBC (May 19, 2008).
“Imagine this. Tomorrow morning, Ben Bernanke is woken by a phone call from George
Bush who informs the Fed chairman that, overnight, a new monetary union has beencreated involving the US and all the emerging economies. The Federal Reserve will
no longer look after monetary policy for the US alone, but instead set interest rates forthe good of the new monetary union. The new ‘one size fits all’ approach would surely
force Mr Bernanke to raise interest rates from where they are today because inflation inthis imaginary monetary union is currently averaging about 6 per cent (and rising).”45

More realistically, such discussions will focus attention on exchange rate regimes,
monetary policy strategies, energy prices, foreign reserve holdings, and the proper roleof regulation of financial and other markets. If we can extrapolate from the sensible
recommendations of Mayekawa in the 1980s, we can hope for a push back from theincreased use of demand management and calls for regulation along as well as a pushforward toward market-based adjustments and price stability.

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Cambridge, Massachusetts: The MIT Press, 1985, pp. 186–211.
Cecchetti, Stephen G., “Monetary Policy and the Financial Crisis of 2007–2008,” mimeo, Brandeis
International Business School, 2008.
Edwards, Sebastian, “The Relationship between Exchange Rates and Inflation Targeting Revisited,”
NBER Working Paper No. 12163, National Bureau of Economic Research, 2006.
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, and John C. Williams, “A Black Swan in the Money Market,” NBER Working Paper
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