MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Policy, Def lation,
and Economic History:
Lessons for the
Bank of Japan
Thomas F. Cargill

The paper discusses Bank of Japan policy during the 1990s, especially the late 1990s,
in the context of the historical experiences of the United States, Sweden, and Japan in
the 1930s. Sharp differences exist between Japan in the 1990s and the 1930s environment; however, this paper takes the position that there are qualitative similarities whichcannot be ignored in terms of financial distress, downward price trends, debate overappropriate central bank policy, and how legal independence may constrain appropriate
central bank policy.
The paper reviews the evolution of views about policy targets from the 1930s to thepresent to show how price stability reemerged as the primary policy target. Evidence on the
success central banks have attained in achieving price stability is reviewed. The evidenceshows that claims central banks have overemphasized controlling inflation at the expenseof deflation are incorrect with the exception of Japan. The paper reviews the role of theFederal Reserve in the 1930s to show that failure to prevent deflation during the critical
1929–33 period had adverse impacts on the economy and resulted in rendering
the Federal Reserve de facto dependent on the government despite its legal independence.
The paper then considers the experiences of Japan and Sweden in the 1930s to provide
counter-examples of how the U.S. economy might have responded to central bank policy
designed to prevent deflation. In both cases, policies explicitly designed to reverse
the downward movement in prices reduced the economic and financial distress in thosecountries compared to the United States.
The paper draws implications from the historical record for Bank of Japan policy andsuggests that more aggressive action would have been appropriate in the 1990s and thatfurther institutional change toward inflation targeting should be considered.
Key words: Bank of Japan; Central bank independence; Deflation; Federal Reserve;
Great Depression period; Inflation; Inflation targeting; Riksbank

University of Nevada, Reno
Appreciation is expressed to Thomas Mayer, Elliott Parker, and Shigenori Shiratsuka for reading an early draft ofthis paper, and for comments by Mårten Blix and Shin-ichi Fukuda, the two formal discussants of the paper. The
opinions expressed in this paper are those of the author.

113

I. Introduction
Japan’s economic and financial distress in the 1990s is unprecedented among theindustrial economies in the postwar period. First, the economic and financial distressthat started in 1990 followed a postwar record of stability and growth impressive by
any standard.1 Second, the economic and financial distress in the 1990s has been
pervasive and reached crisis proportions in late 1997, when Japan came close to a
deflationary spiral and the financial system was on the verge of insolvency. Japan’s
macroeconomic performance brought comparisons with the 1930s and rekindled old
debates about the effectiveness of monetary policy, deflation, and liquidity traps.
Third, institutional and attitudinal reform in the 1990s has been unprecedented
in postwar Japan. The “new” Bank of Japan was established in 1997 with enhanced
legal independence from the Ministry of Finance. The “new” financial regulatory
and supervisory regime was established in the second half of the 1990s by a series
of institutional changes. The role of the Ministry of Finance was reduced, theDeposit Insurance Corporation was restructured, the Financial Supervisory Agency
and Financial Reconstruction Commission were established, and new guidelines
referred to as Prompt Corrective Action were adopted for dealing with troubled
financial institutions.
The economic and financial landscape changed significantly in the 1990s, and in
the process Bank of Japan policy has been a prominent and much debated feature.
The Bank’s May 1989 decision to raise the discount rate was criticized as coming toolate. The Bank’s focus on limiting yen appreciation in the second half of the 1980s
accommodated asset inflation and made it difficult to achieve a soft landing in 1989.
The Bank was criticized for overly tight policy in the first half of the 1990s. Once
policy shifted to ease after 1994, the Bank was criticized for not more aggressively
increasing monetary growth and preventing a slow downward drift in prices overthe decade (Alexander [1999]; Bernanke [2000]; Cargill, Hutchison, and Ito [forthcoming]; Ito [1999]; Krugman [1999]; Meltzer [1999]; Posen [1998, 1999]; andWeinstein [2000]).2 Critics argued Bank of Japan policy should have adopted a moreaggressive policy in the 1990s, especially in the latter part of the 1990s, to achieve a
low but positive inflation rate. The deflation process prolonged Japan’s recovery bydeteriorating balance sheets and postponing spending and borrowing.3 Some critics
argued for additional institutional change in the form of an inflation-targeting policy
framework. The majority of critics argued for more aggressive policy and the need toconsider policy channels not tied to the bank finance model such as open market
operations in government securities.
Bank of Japan policies have been defended in technical papers by staff economists
expressing their unofficial views and statements of official Bank of Japan policy made1. Cargill, Hutchison, and Ito (1997) review Japan’s financial and monetary policies from the end of World War II
to November 1996. In a forthcoming book, they focus on financial and central bank policy from November 1996
to the end of 1999.
2. McKinnon (1999) has been one of the few observers to agree with the Bank of Japan’s policy stance.
3. The critics have not ignored nonmonetary policy problems such as policy failures by the Ministry of Finance,
both in regard to failing to resolve financial distress and the decision to raise the consumption tax in 1997, as
contributing the Japan’s poor macroeconomic performance in the 1990s.

114 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Policy, Deflation, and Economic History: Lessons for the Bank of Japanby the Governor, Deputy Governors, and Board members. The defense of the Bank’s
policy has emphasized three issues. First, targeting interbank rates to almost zero is
the most appropriate policy to prevent deflation, and as of the first part of 2000 is an“extremely accommodative policy,” according to Governor Hayami in a speech on
March 21, 2000. Even at a zero interest rate target, financial institutions have notsubscribed to the full amount of funds offered by the Bank of Japan. The zero rate
policy provides the Bank at any time with the ability to supply any increase indemand for liquidity or excess reserves on the part of banks. The Bank further argues
that interest rates are the proper focus of policy. According to Deputy Governor
Yamaguchi in a speech on October 19, 1999, “it is generally known that when an
economy is susceptible to financial shocks, including a financial system crisis, financial conditions can better be gauged by interest rates rather than quantity.” Second, amore explicit inflation policy or “reflation” would not stimulate the economy.
According to Governor Hayami in his March 21, 2000 speech, “inflation is no solution to economic problems” because it would not have the intended positive effect.
Interest rates would increase by the expected inflation and hence leave the real rateunchanged, and in addition, inflation would generate uncertainty and interest rates
would likely increase by more than the expected inflation. Third, staff economists
have emphasized that balance-sheet constraints and concerns over fiscal responsibility
limit the Bank’s ability to pursue nonstandard open market operation in government
bonds (Okina [1999a, 1999b] and Fujiki, Okina, and Shiratsuka [2000]). In any
event, these policies are not required, since the zero interest rate policy is appropriate
for the situation in 1999 and 2000 and there is no clear evidence of serious deflation.
If the economy experienced a clear deflation process on a par with what happened in
the 1930s, aggressive and nontraditional policies would be adopted.
The discussion deserves attention for at least four reasons. First, it focuses on
the actions of one of the more important central banks and the world’s second
largest economy. Second, the openness and technical nature of the discussion
are unprecedented, especially when compared to some of the past debates theFederal Reserve has had with academics. Third, the context of the discussion interms of Japan’s economic and financial environment in the 1990s is unprecedented
in the postwar period and reminiscent of the 1930s. Fourth, the discussion
has brought important issues of central bank policy into perspective with
implications beyond the Bank of Japan. The discussion has brought into focus
that price stability means preventing deflation as well as preventing inflation, that
central bank policy instruments may need to depart from the bank finance model
to maintain price stability, and that the benefits of central bank legal independence
may be over-advertised.
This paper does not attempt to evaluate the current debate; rather, it draws on
the historical experiences of the United States, Sweden, and Japan in the 1930s
to draw some tentative implications for Bank of Japan policy in the 1990s. This is ahazardous undertaking, and it is only stating the obvious to stress that any implications drawn from these three historical cases are tentative at best. At a minimum,
there is a sharp structural and quantitative difference between Japan in the 1990s andthe 1930s environment.

115

At the same time, this paper takes the position that there are qualitative similarities
which cannot be ignored. Both periods were characterized by financial distress in theform of insolvent financial institutions and large amounts of outstanding nominal
debt. Downward price trends in both periods aggravated the problems by increasing
the real debt burden, deteriorating balance sheets, postponing spending, and raising
real interest rates. Central bank policy was a focal point of debate in both periods,
and the economy responded differently according to which central bank made aconcerted effort to prevent deflation. In both periods, traditional central bankinstruments tied to the bank finance model limited the willingness to adopt alternative policies to increase the monetary base. In both periods, legal independence was aconstraint to adopting nonstandard policy such as aggressive open market operations,and in both periods central banks defended their actions by stressing nonmonetary
structural problems, balance-sheet considerations, and fiscal responsibility concerns.
The paper first reviews the development of views about policy targets from the
1930s to the present to show how price stability has reemerged as the primary policy
target. The context, however, has been to define price stability as preventing
inflation. The paper then presents evidence on the success central banks have achievedin this regard, and places Japan’s inflation record in international perspective to showthat claims (Economist [1999]) that central banks have overemphasized controllinginflation at the expense of deflation are incorrect with the exception of Japan. The
paper then reviews the role of the Federal Reserve in the 1930s to show that failure toprevent deflation during the critical 1929–33 period had adverse impacts on theeconomy and resulted in rendering the Federal Reserve de facto dependent on thegovernment despite its legal independence. The paper then considers the experiencesof Japan and Sweden in the 1930s that provide counter-examples to how the U.S.
economy might have responded to central bank policy designed to prevent deflation.
In both cases, policies explicitly designed to reverse the downward movement in prices
reduced the economic and financial distress in those countries compared to the UnitedStates. The paper draws implications from the historical record for Bank of Japan
policy in the 1990s, and a short concluding comment ends the paper.

II. Evolution of Monetary Policy in the Postwar Period
The second half of the 20th century witnessed four stages in the evolution of views
regarding monetary policy objectives: (1) the end of World War II to the mid-1960s;(2) the mid-1960s to the late 1970s; (3) the late 1970s to the late 1980s; and (4) thelate 1980s to the present. While some will debate the dating of the four stages, there
should be little debate over the stages themselves.
A. Monetary Policy Is Impotent: The End of World War II to the Mid-1960s
The events and interpretation of the Great Depression of the 1930s strongly
influenced views about the importance of money and the ability of monetary policy
to influence economic activity. The failure of the Federal Reserve to prevent the
decline after 1929 and limit its severity once started led to the conclusion that

116 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Policy, Deflation, and Economic History: Lessons for the Bank of Japan

monetary policy was impotent in a deflationary spiral and more aggressive monetary
policy was like “pushing on a string.”4 This view was endorsed by the Federal Reserve
during the 1930s and in the early years of the postwar period by former Federal
Reserve officials such as Goldenweiser (1951) and found its way into a large numberof textbooks in the 1950s and 1960s.
B. Monetary Policy Is Important and Should Focus on Activist Stabilization
Goals: The Mid-1960s to the Late 1970s
In the 1970s, money and monetary policy were again recognized as important
influences on economic activity and the debate shifted to how central banks should
conduct policy. Monetary policy assumed an activist role, with many arguing that
central banks were capable of “fine-tuning” the economy based on a predictabletrade-off between inflation and employment, short and/or predictable policy lags,and detailed structural models of how monetary policy influenced the economy.
Modigliani in 1977 best expressed this view when he argued there was no longer
any debate over the importance of money, but only a debate over how central
banks should conduct policy. Based on the practical message in the General
Theory, Modigliani argued “that a private enterprise economy using an intangible
money needs to be stabilized, can be stabilized, and therefore should be stabilized
by appropriate monetary and fiscal policies” (Modigliani [1977], p. 1).
C. Monetary Policy Is Neutral in the Long Run and Activist Policy Is Inherently
Inflationary: The Late 1970s to the Late 1980s
The ability of central banks to achieve the goals advocated by Modigliani came into
doubt in the late 1970s and 1980s. High inflation rates experienced by manyindustrial economies during the 1970s and 1980s and the associated financial
and real disruptions were attributed to activist monetary policy. There emerged aconsensus that monetary policy was capable of achieving only ephemeral changes inreal output and that efforts to change the actual performance of the economy fromits long-run equilibrium level would fail with higher inflation as the only predictableoutcome. Long and variable policy lags, lack of an exploitable and permanent tradeoff between inflation and employment, and recognition of the time-inconsistency
problem led to the conclusion that the primary goal of monetary policy should belong-run price stability rather than short-run stabilization.
D. Institutional Design of Central Banking and Price Stability: The Late 1980s
to the Present
The late 1980s to the present witnessed increasing attention devoted to institutional
design of central bank policy that would best contribute to long-run price stability.
The emphasis however, was on preventing inflation rather than deflation. This period
witnessed renewed emphasis on central bank independence based on a flurry of
empirical papers showing that a statistically significant relationship existed between
4. Meltzer (forthcoming, chapter 6) traces the phrase “pushing on a string” to Marriner S. Eccles, Governor of theFederal Reserve Board in 1935, who used it to summarize his views of why more aggressive monetary policy would
have been futile.

117

high levels of central bank independence and low inflation. Interest in inflationtargeting also increased as a further means to prevent inflation. Few seriously now
argue that monetary policy can “fine-tune” the economy, and even those willing to
use monetary policy to offset shocks in the short run emphasize that price stability—that is, preventing inflation—is the long-run policy target of the central bank.

III. Inflation Policy Outcomes, and Japan in International
Perspective
The new emphasis on price stability has been reflected by a significant reduction in
the inflation rates of many industrial economies. Table 1 presents average annual
inflation rates based on quarterly consumer price index (CPI) data for 20
Organisation for Economic Co-operation and Development (OECD) countries forselected periods from 1975/I to 1999/III, including Japan. In virtually every country,
there is a downward trend in the CPI inflation rate after 1985. The average inflation
rate for the 1995/I–1999/III period excluding Japan is 1.82 percent. Japan’s average
CPI inflation rate for the same period is 0.49 percent and is the lowest inflation rateof all the other countries, and in 1999 the CPI inflation rate was negative. Figure 1
provides a broader measure of Japanese price movements the 1990s. The GDP
inflation rate also shows a downward trend in prices.
Three implications can be drawn from Table 1. First, there has been a decline in the
average inflation rate in most countries over the entire period. The overall average
inflation rate remained at about the same high level between the 1975/I–1979/IV and1980/I–1984/IV periods, but declined steadily over the next three periods. Second, theaverage inflation rate in the context of the well-known bias in the CPI index for all
countries in Table 1, omitting Japan, still suggests a positive inflation rate of about
1 percent. This is as close to price stability as one is likely to achieve, and at least on thisbasis does not indicate a widespread deflation problem. Third, Japan is an outlier in
two respects. Japan exhibited the lowest inflation rate of the countries listed in Table 1
in all five periods, and Japan’s inflation rate in the 1995/I–1999/III period most likely
indicates deflation considering that estimates of the CPI index bias are about 1 percent
for Japan.5 Again, this paper takes the position that the deflation experienced by Japanin terms of the CPI or GDP deflator in the second half of the 1990s is not comparable
on a quantitative basis with the deflation experienced by many countries in the 1930s.
The effects of deflation and solution to deflation, however, are qualitatively similar.

IV. Historical Lessons from the Great Depression: The Federal
Reserve
The influence of the Great Depression on views of monetary policy and public policy
cannot easily be overstated. It led to the rejection of the classical nonactivist regime of
5. Shiratsuka (1999) concluded that the overall bias in the CPI was about 0.9 percentage point per year, butemphasized the tentative nature of this result given the lack of existing studies for Japan.

118 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Policy, Deflation, and Economic History: Lessons for the Bank of Japan

government policy and generated an extensive system of government regulation,
supervision, and stabilization policy that dominated the second half of the lastcentury. The failure of Federal Reserve policy supported a generation of economic
Table 1 Average CPI Inflation Rates in Industrial Countries, 1975/I–1999/III
1975/I–1979/IV 1980/I–1984/IV 1985/I–1989/IV 1990/I–1994/IV 1995/I–1999/III
Australia

10.72

9.02

7.82

3.05

1.97

Austria

5.02

5.52

2.16

3.44

1.40

Belgium

6.31

7.41

2.40

2.85

1.44

Canada

8.40

8.73

4.30

2.79

1.58

Denmark

9.94

9.49

4.34

2.08

2.10

Finland

10.59

9.73

4.91

3.21

1.04

France

9.75

11.21

3.57

2.55

1.25

Germany

3.70

4.54

1.27

3.31

1.36

Iceland

37.79

54.97

23.79

6.46

1.96

Ireland

13.12

14.99

3.72

2.68

1.92

Italy

15.52

16.55

6.22

5.28

3.02

Netherlands

5.96

5.05

0.70

2.83

2.05

New Zealand

14.25

12.47

11.32

2.76

1.75

Norway

7.79

10.12

6.57

2.71

2.15

Spain

19.42

13.61

6.90

5.58

2.88

Sweden

9.74

10.27

5.62

5.79

0.75

Switzerland

1.93

4.41

2.13

3.90

0.76

United Kingdom

13.57

9.64

5.27

4.63

2.87

United States

7.78

7.51

3.61

3.65

2.35

Average

11.12

11.85

5.61

3.66

1.82

Japan

6.38

3.92

1.15

2.01

0.49

Note: Inflation rates are calculated in each quarter from the same quarter in the previous year basedon Organisation for Economic Co-operation and Development data for the consumer price index.

Figure 1 Percentage Change in GDP Deflator from Same Quarter in the Previous
Year: 1991/I–1999/II

3

Percent

2
1
0
–1
–2
1991/I
1991/II
1991/III
1991/IV
1992/I
1992/II
1992/III
1992/IV
1993/I
1993/II
1993/III
1993/IV
1994/I
1994/II
1994/III
1994/IV
1995/I
1995/II
1995/III
1995/IV
1996/I
1996/II
1996/III
1996/IV
1997/I
1997/II
1997/III
1997/IV
1998/I
1998/II
1998/III
1998/IV
1999/I
1999/II–3

Note: GDP deflator based on Organisation for Economic Co-operation and Development data.

119

thinking that “money was not important.” On a broader scale, the Great Depression
and associated monetary collapse, especially in the United States, adversely impacted
Germany and helped bring Hitler to power (Kindleberger [1995]).
Table 2 presents the basic real and nominal features of the U.S. economy during
the 1930s. The Great Depression period consists of four stages based on National
Bureau of Economic Research (NBER) cycle reference turning points: the great
contraction period from August 1929 to March 1933; recovery from March 1933 to
May 1937; sharp contraction from May 1937 to June 1938; and a more substantial
recovery after June 1938. The first stage is the most critical and set the tone for theremainder of the decade. During the critical 1929–33 period, nominal GDP declinedby 46 percent, real GDP declined by 29 percent, and the GDP deflator and CPI
both declined by 24 percent.
Almost from the start of the Great Depression until the early 1960s, the view was
widely held that the Federal Reserve had, on balance, pursued an easy monetary
policy and that only two policy errors could be identified. The Federal Reserve may
have overreacted to Great Britain’s departure from the gold standard in September
1931 when the discount rate was increased, and the doubling of reserve requirements
in 1937 to eliminate excess reserves held by the banking system may have been too
drastic for the conditions of the time.
The Federal Reserve view did not go unchallenged (Warburton [1966]); however,it was Friedman and Schwartz (1963) rather than Warburton who proved persuasive.6
Friedman and Schwartz attributed the August 1929 downturn to the Federal Reserve’s
desire to curb the stock market boom, but more importantly, attributed the length andseverity of the Great Depression to restrictive monetary policy. These policy failures
Table 2 U.S. Economic Performance in the 1930s
NominalGDP
level

NominalGDPchangeGDP
deflatorlevel

GDPdeflatorchange12.5

Real GDP Real GDP
levelchange
824.8

CPI

CPI
change

1929

103.1

1930

90.4

–12.3

12.1

–3.2

747.1

–9.4

17.1
16.7

1931

75.8

–16.2

11.0

–9.1

689.1

–7.8

15.2

–9.0

1932

58.0

–23.5

9.7

–11.8

597.9

–13.2

13.7

–9.9

1933

55.6

–4.1

9.5

–2.1

585.3

–2.1

13.0

–5.1

1934

65.1

17.1

10.3

8.4

632.0

8.0

13.4

3.1

1935

72.3

11.1

10.6

2.9

682.1

7.9

13.7

2.2

1936

82.7

14.4

10.6

0.0

780.2

14.4

13.9

1.5

1937

90.8

9.8

11.2

5.7

810.7

3.9

14.4

3.6

1938

84.9

–6.5

10.9

–2.7

778.9

–3.9

14.1

–2.1

–2.3

1939

90.8

6.9

10.8

–0.9

840.7

7.9

13.9

–1.4

1940

100.0

10.1

11.0

1.9

909.1

8.1

14.0

0.7

Note: Based on data from the Economic Report of the President, Council of Economic Advisors, 1994
and Bureau of Labor Statistics, Department of Labor.
6. Warburton was an economist at the newly established Federal Deposit Insurance Corporation in 1934 and wrote a
series of papers through the early 1950s blaming the Federal Reserve for the deflation and depression of the 1930s.
Many of his more important papers are reprinted in Warburton (1966). Cargill (1979) provides a review of
Warburton’s work.

120 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Policy, Deflation, and Economic History: Lessons for the Bank of Japan

during the 1929–33 period resulted in a drastic decline in the money supply, pricelevel, and real output.
Friedman and Schwartz have not been without critics. Some argue monetaryfactors were important, but not through the money supply and money demandframework used by Friedman and Schwartz; for example, Bernanke (1995) focuseson disruptions to the bank intermediation channel and Eichengreen (1995) emphasizes international financial channels. In contrast, Temin (1976) minimizes monetaryfactors and argues that even if the Federal Reserve had adopted a more expansionary
policy the course of events would have been little affected.
It has been almost four decades since Friedman and Schwartz published theirchallenge to the Federal Reserve view. Their major thesis stands for all practical
purposes. Whaples (1995) provides some notion of the consensus on Friedman and
Schwartz. Whaples surveyed a sample of economic historians and economists on anumber of questions concerning economic history:Through the contractionary period of the Great Depression, the Federal
Reserve had ample powers to cut short the process of monetary deflation
and banking collapse. Proper action would have eased the severity of thecontraction and very likely would have brought it to an end at a much earlier
date (Whaples [1995], p. 1453).
Thirty-one percent of the historians and 32 percent of the economists agreed
with the statement, while another 47 percent of the historians and 43 percent of
the economists agreed with provisos. Thus, only 22 percent of the historians and25 percent of the economists disagreed with the statement.7
There is a need to understand the policy errors of the Federal Reserve in the
1930s beyond documenting the historical record. The Federal Reserve’s experience
provides important lessons for central bank policy in general. It emphasizes the needto prevent deflation, the bias central banks may have toward preventing inflation
rather than preventing deflation, and the tendency of central banks to understate
their power to prevent deflation. It emphasizes the tendency of central banks to
become constrained by technical considerations and concern over the quality of theirbalance sheets. It emphasizes the limits of legal independence and the need to ensure
an institutional design that does not limit the central bank’s willingness to takeunprecedented action in unprecedented economic circumstances.
A. Federal Reserve Policy
The Federal Reserve was established in 1913 and achieved considerable recognition
for handling war finance during World War I, ensuring a short and stable transition
to peacetime, and providing a stable monetary environment to support sustained
7. Despite this consensus on a critical event in economic history, Cargill and Mayer (1998) found that a sample ofmajor U.S. history textbooks ignored this finding. The textbooks attributed the Great Depression to the stock
market crash, underconsumption, and an unequal distribution of income. It is noteworthy that Governor Eccles,
as head of the Federal Reserve System, testified before a Senate committee that the economic decline was a
problem of “distribution” and advocated a “more equitable distribution of wealth” to increase spending as part ofthe solution (Meltzer [forthcoming], chapter 6).

121

economic growth in the 1920s. The CPI index was virtually constant from 1921 to1929. Friedman and Schwartz refer to the 1921–29 period as the “high tide” of theFederal Reserve System.
The Federal Reserve regarded the economic collapse that started after August
1929 and accelerated in late 1930 as the result of nonmonetary forces and beyond
the influence of central bank policy. In their view, the economy was paying for theexcesses of the late 1920s and the deflation and output decline were needed to purge
the economy of weak and inefficient firms. The large number of bank failures in1930 resulted from poor management and past excessive lending in speculative
equity and land markets. The Federal Reserve also adopted the popular view at thetime that the depression was the result of underconsumption due to an unequal
distribution of income.
The Federal Reserve’s stance was that it did everything possible during the great
contraction period to reverse the decline. It stood ready to discount eligible paper
presented by member banks, and the discount rate was lowered from 6 percent inearly 1930 to 0.5 percent in the first part of 1931. The only departure from a policyof ease occurred when the discount rate was raised in response to Great Britain’s
abandonment of the gold standard in September 1931. The Federal Reserve argued it
was constrained by the real bills doctrine embedded in the Federal Reserve Act frommaking more loans to member banks because there was no legitimate demand forbank credit. The Federal Reserve further argued that it was unable to conduct open
market operations in any significant scale because of the “free gold problem.”8After March 1933, the economy recovered and entered an expansion phase. RealGDP and nominal GDP increased by 8.0 and 8.4 percent in 1934, respectively.
Despite this rapid growth, real GDP had not yet achieved its 1929 level by 1937.
In addition, the unemployment rate remained at about 20 percent and investment
spending did not recover. The Federal Reserve adopted a passive policy after 1933.
The money supply expanded in response to banking reforms that increased the
public’s deposit-currency ratio, especially the establishment of Federal Deposit
Insurance, and in response to significant inflows of gold because of devaluation andcapital flight from Europe.
The Federal Reserve did change policy in 1937 in response to increasing levels ofexcess reserves held by the banking system and their concern that this reduced theability to control the amount of bank credit. The Federal Reserve regarded the highlevels of excess reserves as proof that more aggressive monetary policy would merely
be pushing on a string. As a result, the Federal Reserve doubled reserve requirements
8. The Federal Reserve Act required a 40 percent reserve of gold behind Federal Reserve notes and 60 percent ofeither eligible paper or gold. The Federal Reserve did not possess sufficient eligible paper to meet the 60 percent
reserve requirement, and as a result additional gold in excess of the 40 percent reserve had to be devoted to thenote requirement. Free gold equaled total gold reserves less the amount devoted to meeting the legal reserve
requirement for notes. The amount of eligible paper decreased as the economy declined, and outstanding Federal
Reserve notes increased because of deposit withdrawals from banks and consequently, the system’s stock of freegold declined. The Federal Reserve argued that if it conducted open market operations, the reserves would havebeen used to reduce outstanding debt to the system and thus reduce free gold even further, because the reserves
would be used to pay off loans rather than lend to the general public.
Friedman and Schwartz ([1963], pp. 399–406) effectively show that the free gold problem was not a serious
constraint, but only came into prominence as a constraint as the Federal Reserve in later years justified its actions
during the early 1930s in such places as Goldenweiser (1951).

122 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Policy, Deflation, and Economic History: Lessons for the Bank of Japanon demand and time deposits for all banks from August 15, 1936 to May 1, 1937. In
response to the Federal Reserve’s action, the economy experienced a sharp recession
and banks actually increased the level of excess reserves by the end of 1938 (Meltzer[forthcoming], chapter 6). The reserve requirement change, however, was not the
only influence on the money supply, since the Treasury’s gold-sterilization program
1937 and 1938 contributed to the monetary contraction.
The economy recovered with a rapid increase in the growth of money after June
1938, and while the Federal Reserve reduced reserve requirements and the discountrate in 1938, the inflow of gold from Europe was the primary source of monetary—and hence economic—expansion.
B. Failure of Federal Reserve Policy
Why did the Federal Reserve fail to conduct an easy monetary policy and prevent the
rapid decline in prices and real economic activity? There are several perspectives on
this question, many of which have been addressed by Warburton, Friedman and
Schwartz, and Meltzer.
First, the Federal Reserve failed to appreciate the effects of its policies on themoney supply and the price level. Real and nominal demand fell sharply after 1929
in response to the decline in the money supply. The decline in the price level from
1929 to 1933 had major adverse effects on the economy by increasing the real
burden of debt and depreciating the value of assets. The Federal Reserve conducted
policy almost entirely in terms of the discount rate and associated monetary ease or
restriction with the absolute level of the discount rate and other short-term interest
rates. Yet real rates increased steadily as deflation accelerated.
This point cannot be overemphasized. The Federal Reserve paid virtually no
attention to the money supply during the entire decade. Friedman and Schwartz([1963], p. 523) could find only one reference to the money supply in their review
of discussions between 1930 and 1940 at the Federal Reserve Bank of New York’s
directors’ meetings, as recorded in the George Leslie Harrison Papers.
This conclusion is verified in a letter written by Irving Fisher to Warburton in 1946.
The letter refers to Fisher’s inside experience with the Federal Reserve during the 1930s(Cargill [1992]),9 and is of historical importance because it provides insight into theactual Federal Reserve thinking as recounted by a major economist of the day.
Fisher recounts to Warburton an incident in 1931 when he called on Eugene
Meyer, chair of the Federal Reserve Board, that clearly shows a lack of interest in themoney supply.
I said: “I am getting alarmed to see demand deposits diminish. It seems to me
this may make great trouble.”
He said: “What did you call the figure?”
Amazed, I said: “The full name is individual deposits subject to checkwithout notice.”
9. Friedman and Schwartz were unaware of the letter when they wrote A Monetary History of the United States:
1867–1960, and in private correspondence with the author, Friedman indicated that had they been aware of theletter it would have been cited in their study.

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He rang a bell and asked his assistant to bring in the last controller’s report
open to the page where the figures were given for individual deposits subject tocheck without notice. In a few minutes the report came in and I pointed andsaid: “You see that during the last several call dates there has been a continuous
reduction.” He said, “Yes, I see it.”
Of course his main object should have been to see it all along and long
before his attention was called to it.
Second, the Federal Reserve was clearly aware of the decline in the price level, but
did not place as high a priority on preventing deflation as it did on preventing
inflation and had an asymmetrical view of its ability to prevent either. Even at thetime the Federal Reserve Act was being drafted, there was opposition to including
any type of price level responsibility. There were several efforts during the 1930s,
which the Federal Reserve opposed, to require the Federal Reserve to raise the pricelevel to pre-1929 levels. Price stability was thus not a specific mandate in the Federal
Reserve Act, and in the view of the Federal Reserve it was more important to adhere
to the real bills doctrine and assume that prices would adjust accordingly. Not only
was the Federal Reserve resistant to any type of price level or inflation targeting,documents suggest that the Federal Reserve confused the general price level withspecific prices (Meltzer [forthcoming], chapter 6) on occasion.
This point is emphasized in Fisher’s letter:
So you see I quite agree with you as to the fact that those who have beenrunning the system had more power than they would admit or realize and did
not understand what they were doing concerning the price level. Many ofthem do not know there is a distinction between a price level and a price.
Third, the Federal Reserve focused on legal and technical issues as excuses formore aggressive action, while possessing adequate powers to reverse the monetarydecline at any point. The Federal Reserve Act provided the authority to purchasegovernment securities. In hindsight, none of the technical issues presented a serious
challenge if the Federal Reserve was intent on aggressive lender-of-last-resort policy
and expanding the money supply. These were ex post excuses for policy inaction
attributable to other factors.
Fourth, the lack of any specific mandate, such as price stability, made it difficult
to hold the Federal Reserve accountable and permitted the Federal Reserve to pursue
other agendas contrary to providing a stable financial and monetary framework. The
adverse effect of the absence of explicit policy goals and/or targets is evident in theevents related to policies advocated by Benjamin Strong, head of the Federal Reserve
Bank of New York. Monetary policy outcomes in the late 1920s and early 1930s may
have been influenced by personality clashes and disputes over turf.
Strong argued for aggressive open market operations to prevent a monetarycollapse and made it clear that he would go against the Federal Reserve System ifnecessary to prevent such a collapse (Friedman and Schwartz [1963], p. 412). His
views were not welcomed by other Federal Reserve officials, and his death in October

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Monetary Policy, Deflation, and Economic History: Lessons for the Bank of Japan

1928 left a power vacuum and his policies were not implemented. George Harrison,
who replaced him as head of the New York Federal Reserve Bank, and his technicaladvisors—Carl Snyder in particular—did not have the strength to push the conceptof expansionary policy on the Board. In addition, the Board and other Federal
Reserve banks had developed a dislike of Strong, which biased them against an
objective analysis of his policies. According to Fisher’s letter:I have always believed that had Governor Strong lived, we would not have had
the tragic depression following the stock market crash in 1929 or so big a crash
to start with . . . The trouble was that those who understood these policies did
not have the personalities or perhaps the courage to play the dominating partwhich Strong had played. He had sometimes gone down to Washington androuted members of the Federal Reserve Board out of their beds to
get them to do what he wanted. They did not like being bossed by theirunderlings and doubtless when he died such a resentment prevented thecontinuation of Strong’s work. Strong, before he died, told me he nearly
resigned from resentment because when he was away in Europe, the Federal
Reserve Board summarily dismissed or dissolved the informal and unofficial
open-market committee which he had created for stabilization purposes . . . andimmediately reconstituted the same committee officially as a committee of theFederal Reserve Board and responsible to it.
Fifth, the legal independence of the Federal Reserve may have constrained its
willingness to expand the money supply in subtle ways. The Federal Reserve was underintense pressure to take a more aggressive stance to inflate the economy. Large-scalepurchases of government securities would have been viewed by the Federal Reserve as
an abandonment of its independence. Adoption of policies recommended by Congress
and the administration might be viewed as inconsistent with the independence of theFederal Reserve. Open market purchases would be viewed as supporting the administration’s aggressive use of fiscal policies. Concerns about legal independence provided
an incentive for the Federal Reserve to use the technical “free gold” problem as an excuse
for not pursing aggressive open market operations. Friedman and Schwartz rebutted
the Federal Reserve’s use of the “free gold” argument, but an additional point can be
added. If in fact the Federal Reserve really viewed it as a serious constraint, the Federal
Reserve could have gone to the administration and/or Congress and easily achieved
revision of the Federal Reserve Act to change reserve requirements on Federal Reserve
notes. Fear that such an action would make the Federal Reserve appear dependent on
the government may have been a constraint.
The irony was that the Federal Reserve for all practical purposes became de facto
dependent on the government. After 1933, the Federal Reserve became passive inthe face of Treasury actions to increase the price level (not sterilizing gold inflows
encouraged by devaluation), and after World War II the Federal Reserve was required
to support prices of government securities until 1953.
Sixth, the Federal Reserve was excessively concerned about the quality of its
balance sheet as well as technical and legal limitations to more aggressive action.

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Adherence to the real bills doctrine was frequently cited as a constraint; however,even after the real bills constraint was removed, the Federal Reserve did not expand
credit. The Federal Reserve consistently emphasized credit quality concerns. The
decision to raise reserve requirements in 1937 was based on the view that the excess
reserves were undesired and reflected the lack of quality credit demand by the public.
Monetary growth after 1933 was almost entirely the result of administration policy
and events in Europe that resulted in gold inflows and expanded the monetary baseand money supply.
C. What Was the Appropriate Policy?
The evidence is clear that Federal Reserve policies during the Great Depression,
especially during the critical great contraction phase, were inappropriate in
two respects.
First, the Federal Reserve should have aggressively injected reserves via its
lender-of-last-resort function to reverse the bank runs. Instead, the currency-deposit
ratio increased significantly and, combined with a decline in the monetary base,contributed to a 25 percent decline in the money supply from 1929 to 1933 andassociated declines in the price level.
Second, the Federal Reserve should have provided whatever liquidity was needed
to reverse the rapid fall in prices after 1929. It had the power to prevent the money
supply from declining, and there is no evidence that past relationships between
money and prices had disappeared in the 1930s. The rising real value of debt caused
widespread bankruptcies, which in turn deteriorated the quality of banks’ balance
sheets and contributed to the collapse of the banking system. The deflation also
raised the real hourly wage rate since nominal wages fell less than prices.
Support that these policies would have been appropriate comes from twothen-contemporary experiences that provide the basis for a counterfactual scenario of
how events might have unfolded in the United States had the Federal Reserve
pursued a expansionary policy to end deflation in the early stages of the decline.
Sweden, and to a lesser extent, Japan provide counter-examples to the policies
followed in the United States. Sweden and Japan’s experience in the 1930s have been
investigated by Berg and Jonung (1999) and Patrick (1971), respectively.
Sweden is the most important of the two cases because Sweden’s central bank
explicitly adopted an inflation target, adapted policy to achieve the target, andachieved identifiable policy outcomes. In addition, Sweden attracted the attention ofFisher, who ended his letter to Warburton by referring to Sweden as an example of howmonetary policy should have been conducted in the United States during the 1930s.
It is interesting to note that Sweden sent representatives over to learn from
Strong the use of the open-market operation for stabilizing the price level andthey officially adopted it, with success, in Sweden . . .

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Monetary Policy, Deflation, and Economic History: Lessons for the Bank of Japan

V. Historical Case Studies: Sweden and Japan10
A. Swedish Price-Level Targeting in the 1930s
The evidence is clear that had the Federal Reserve pursued an inflation policy rather
than permit deflation, the economy would have positively responded and the courseof the Great Depression would have been much different than what actuallyoccurred. Even at the time, there was evidence that an inflation policy would have
had a positive effect on the economy. The response of output to the open market
operations conducted by the Federal Reserve in 1932 supports this view. More
important, the then-current response of Sweden’s economy to dramatically different
policies followed by the Riksbank suggests that had the Federal Reserve focused on
price stability the course of the depression would have been much different.
In contrast to the United States, Sweden left the gold standard in the fall of 1931
and adopted an explicit price level target (Berg and Jonung [1999]). This policy
response came at the onset of the Great Depression with the objective of stopping
price deflation, unlike in the United States, when the Federal Reserve raised thediscount rate in 1931 to maintain the gold standard and aggravated the decline in
the price level. Abandonment of the gold standard was a signal that the government
was not prepared to allow deflation, and the price-level targeting framework was asignal that the government would not permit inflation to mitigate concerns thatabandonment of the gold standard would eventually lead to rising prices.
Swedish consumer prices had been falling gradually, and wholesale prices sharply,
since late 1928 as the workings of the interwar gold standard transmitted deflationarypressures to Sweden. Industrial production declined by 21 percent during 1929–31(compared to a fall of 46 percent in the United States during this period), andunemployment rose sharply. Against this background, the Swedish Minister ofFinance announced in September 1931 that the Riksbank was relieved of its legal
obligation to convert domestic currency notes into gold upon demand and given the
new objective of preserving the purchasing power of the domestic currency.
Berg and Jonung present evidence that Swedish policy makers at the time believedthat an institutional commitment to price stability could act as a coordinating device
and anchor expectations. To this end, key features of the program included a clear
and transparent objective, communicated to the public through several channels.
The Riksbank published a consumer price index as part of its monetary program but
also relied on other price indices. The central bank’s concern was also “underlying
inflation,” in that it emphasized the need to disregard temporary factors like seasonal
effects and customs duties in evaluating the price level. The Swedish Parliament andits Banking Committee supervised and monitored the Riksbank’s activities and issued
regular reports. The Governor of the Riksbank was questioned annually by the
Banking Committee, and monitoring of the central bank was an open politicalprocess known to the public. In addition to annual examinations by the Banking

10. This section is taken from Cargill, Hutchison, and Ito (forthcoming), which in turn draws directly from Bergand Jonung (1999) and Patrick (1971) for the Swedish and Japanese case studies, respectively.

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Committee, two major evaluations of the Riksbank’s price-targeting program wereconducted in 1933 and 1937.
Sweden’s price-targeting program in the 1930s was modified as economic
conditions worsened. No legal backing was given to the Swedish program and,
although the price-stability objective was maintained, adjustments and additional
goals were added by requests from the Parliament and Minister of Finance. In
particular, in 1932 the original goals was adjusted as both import prices and domestic
market prices were allowed to increase. The Riksbank was also asked to keep interest
rates as low as possible and to link monetary policy with fiscal policy measures tocombat unemployment.
By most measures, price-level targeting in Sweden in the 1930s was an effective
way to stop price deflation and mitigate the depression. CPI and wholesale priceindex (WPI) movements followed similar patterns, but the WPI was much more
extreme. The CPI declined between 1928 and 1932–33 and then turned upward.
The WPI fell sharply from January 1928 to September 1931 and then remainedroughly constant, with a minor decline, until spring 1933. The WPI then began a
gradual rise until 1937.
The depression in Sweden did not abruptly stop with the introduction ofprice-level targeting, but the output declines appear to have been mitigated andrecovery enhanced by the monetary program. Swedish unemployment rose sharply in
1930–31 and then drifted upward slightly until peaking at over 30 percent in spring
1933. Unemployment then began to fall, reaching a 15 percent level by 1937.
Industrial production reached a low point in mid-1932, declining roughly 20 percent
from the 1928 level. By the end of 1933, however, Swedish industrial production had
recovered to the 1928 level and climbed an additional 28 percent by the end of 1934.
Industrial production in the United States, by contrast, fell by almost 50 percent
at its trough in 1932 and did not reach the 1928 production level again until theend of 1936.
B. Japan in the 1930s
Japan’s experience during the worldwide depression of the 1930s was generally
favorable once its temporary return to the gold standard was abandoned. The newJapanese government in July 1929 announced the decision to return to the gold
standard, at the prewar par value, at the earliest possible date. Since Japan’s wholesale
price level was substantially above (by 65 percent) the prewar level and higher thanthat in the United States and England, a deflation was likely. Austere fiscal measuresand somewhat restrictive monetary policy were adopted to reduce prices, but in early
1930 the worldwide depression and its effects on Japanese exports resulted in output
declines and rapid deflation. The continued loss of reserves forced Japan in
December 1931 to abandon the gold standard.
Patrick ([1971], p. 256) describes what followed Japan’s decision to leave the gold
standard as “one of the most successful combinations of fiscal, monetary, and foreignexchange rate policies, in an adverse international environment, that the world has everseen.” Without the external constraint (fixed exchange rate), large-scale deficit financing and an easy monetary policy were implemented. From 1931 to 1933, government

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Monetary Policy, Deflation, and Economic History: Lessons for the Bank of Japan

spending rose 26 percent and net domestic product increased at a comparable rate.
Expansionary fiscal policy accommodated by monetary policy, together with exchange
rate depreciation, generated a boom in domestic demand, encouraged exports anddiscouraged imports. The economy once again started to grow quickly.
Most of the rise in government spending was deficit financed and, from 1932 on,
the Bank of Japan underwrote the government’s bond issues. It purchased outrightthat portion not subscribed by the Ministry of Finance Deposit Bureau. Patrick(1971) explains how government deficit-financed spending resulted in an increase incommercial bank deposits, and that banks were eager to purchase government bonds
from the Bank since private lending was so limited.
Japan’s decision to leave the gold standard and pursue expansionary fiscal andmonetary policy allowed the economy to expand vigorously through most of the
1930s. There was no commitment to price-level targeting as in Sweden. But allowing
the exchange rate to depreciate effectively stopped domestic deflation. After falling
about 30 percent in 1930–31, wholesales prices rose 28 percent in Japan over the
next two years (1932–33).
The success of Japan’s economic stabilization policy, however, was short lived.
The inflation rate accelerated after 1935 in response to monetization of government
deficits. The CPI index increased by 20.9 percent from 1935 to 1938. This might beviewed as a negative outcome of the inflationary policy in the first part of the 1930s
in the sense that the expansionary policies of the central bank reduced government
discipline even after the economy recovered once the government became
accustomed to high rates of liquidity growth. In this regard, the Swedish case suggeststhat an explicit inflation policy may need to be accompanied by an institutional
constraint or limit, such as an explicit inflation or price target, to ensure that the
expansionary policy does not end up generating high rates of inflation once recovery
is achieved. In any event, the rapid increase in government spending and monetization of government deficits in Japan in the second half of the 1930s were driven byintense war mobilization efforts. It may thus be difficult to argue that expansionary
policy in the face of deflation would normally induce fiscal irresponsibility, and more
important, the potential for fiscal irresponsibility does not deny the positive effectsof the expansionary policy in stopping the deflation and initiating economic recovery.
It only means that the inflationary policy needs to be accompanied by otherconsiderations to prevent fiscal irresponsibility.

VI. Implications for Bank of Japan Policy in the 1990s
The historical record suggests four implications for the discussion over Bank of Japan
policy in the 1990s, especially the late 1990s.
A. Preventing Deflation Is at Least as Important as Preventing Inflation
Central bank policy needs to be concerned with preventing deflation as well as withthe traditional concern of preventing inflation. In fact, preventing deflation may
be more important in the current environment with large amounts of nominal debt

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and the zero floor on nominal interest rates. The willingness of the Federal Reserve
to permit a sharp decline in the price level for a three-year period had drastic andnegative consequences on the economy. In contrast, the Riksbank and the Bank ofJapan followed much different policies designed to prevent deflation. The Swedish
and Japanese economies did not experience the same degree of economic decline andstarted the recovery process sooner than in the United States in large part becauseof their success in reversing the deflation process. The price decline in Japan in
the 1990s is not on a par with the price declines in the United States, Japan, andSweden in the 1930s, but nonetheless the slow downward drift in prices in Japan has
aggravated Japan’s financial and economic distress. A more aggressive policy designed
to generate a low but steady inflation rate, especially after 1995, would have been
preferable to what was actually followed.
B. Legal Independence Has a Constraining Influence on Central Bank Policy in
Certain Instances
Legal independence may not be sufficient to ensure price stability (prevent deflation
as well as inflation), and under certain circumstances may impede appropriate central
bank policy. As stated in Cargill, Hutchison, and Ito (forthcoming), central banks
may find themselves in an “independence gap” in which concern with legal independence limits willingness to adopt new policies to deal with economic and financial
distress. This phrase is reminiscent of an observation attributed to Paul Samuelsonthat the Federal Reserve was a “prisoner of its independence.”11 Samuelson’s characterization offers an insight into the actions of the Federal Reserve in the 1930s. The
Federal Reserve’s reluctance to cooperate with the Treasury and resistance to open
market operations were likely rooted in its concern with maintaining the appearance
of independence. Resistance to recommendations to adopt any type of inflation
target such as discussed in Fisher’s letter was also rooted in the Federal Reserve’s
concern with formal independence. In contrast, the willingness of the Bank of Japanand the Riksbank to adopt different policies required a more cooperative and lessindependent policy than that acceptable to the Federal Reserve.
The Bank of Japan’s reluctance to engage in aggressive open market operations ingovernment bonds may reflect attitudes similar to those of the Federal Reserve in the
1930s. The Bank dismisses this argument by emphasizing technical and balancesheet constraints to open market operations. Its argument is not without merit given
the significant increase in government debt projected for the Japanese economy in
the coming years (Rhee [2000]); however, the Bank did not object to the balancesheet problems generated by extensive loans to troubled financial institutions in the
1990s. The Bank would likely argue that the two situations are different; that is, thesocial benefit of limiting systemic risk is greater than the cost of exposing the central
bank to credit risk, and thus limiting systemic risk more than offsets a balance-sheet
problem. In contrast, the social cost of fiscal irresponsibility is so large that the Bank
cannot afford to weaken its balance sheet. Nonetheless, the fact that aggressive open
market operations would involve some cooperation with the government may reduce
11. See Mayer (1990), p. 6.

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Monetary Policy, Deflation, and Economic History: Lessons for the Bank of Japanthe Bank’s enthusiasm for such a policy, and thus the “independence gap” argument
has merit.
The rejection of an inflation-targeting framework may also be rooted in the same
attitude. The Bank of Japan would not likely support such a framework aside fromtechnical considerations. The Bank has been legally independent only since April 1,
1998, and an inflation target would be viewed as a restriction on goal independence
since it would require a more formal definition of price stability than that containedin the Bank of Japan Law. In addition, revision of the Bank of Japan Law was
the outcome of complex political maneuvering by the Ministry of Finance that had
nothing to do with correcting past Bank of Japan policy.12 The Ministry foundcentral bank independence a convenient way to divert attention from its failure todeal with the nonperforming-loan problem.
C. Central Banks Have the Power to Prevent Deflation
Deflation, like inflation, is ultimately a monetary phenomenon, and long-term
downward price movements in the absence of clear and widespread shifts in productivity are the outcome of monetary policy decisions. Irrespective of technicalarguments and balance-sheet constraints raised by central banks, central banks
possess the power to prevent long-term downward price movements. Econometric
evidence (e.g., Meltzer [forthcoming]) shows that the Federal Reserve had the power
to stop or slow the deflation process in the 1930s, and the then-current experiencesof Japan and Sweden show that the central banks had the power to stop the deflation
process. Likewise, the Bank of Japan has the power to stop the slow downward
drift in prices and maintain a low but positive inflation rate. The Bank is correctthat further increases in liquidity through the banking system are not likely to be
simulative, but open market operations would most likely increase aggregate demand
and reverse the price trends exhibited in the 1990s.
D. Benefits of an Inflation-Targeting Framework
Inflation targeting has been offered as an institutional reform designed to limit
inflation; however, there is no inherent reason why an inflation-targeting regime
would be any less successful in preventing deflation. As with Sweden in the early
1930s, the objective would be to provide a credible and transparent nominal anchor
so that the private sector expected a low but positive rate of inflation. While Japan in
the 1930s did not adopt an inflation target, the end result was similar—the Bankof Japan adopted a policy of increasing the price level and rising inflationary
expectations. In fact, the subsequent inflation in the second half of the 1930s mightsuggest that inflation targeting is a desirable approach to prevent both deflationand inflation. In contrast to either Japan or Sweden, the Federal Reserve failed tofollow any type of inflation target and its policies generated expectations that it was
prepared to allow a deflation process. As a result, the U.S. economy remained inserious recession much longer than that of either Sweden or Japan.
12. The Bank of Japan did achieve a significant increase in formal independence as a result of the revision in the
Bank of Japan Law that became effective April 1, 1998. See Cargill, Hutchison, and Ito (forthcoming) for a
detailed discussion of the “old” and “new” Bank of Japan Law.

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The Bank of Japan, with the exception of the early 1970s, achieved a low rate of
inflation in the postwar period despite being one of the most formally dependent
central banks in the world through 1998. For example, regressions between inflationand measures of central bank independence show that Japan’s dependence ranking
predicts inflation rates several times higher than Japan’s actual inflation rate. Cargill,
Hutchison, and Ito (1997), however, argue that the Bank, despite its formal
dependence, had achieved a degree of de facto independence after 1975, and Cargill(1995a and 1995b) questions the reliability of the empirical studies linking inflation
outcomes with measures of central bank independence. Irrespective of these issues,
however, there is no doubt that the Bank of Japan has operated with an implicit
low-inflation policy target.
Thus, inflation targeting does not appear needed to achieve low inflation rates
in Japan; nevertheless, it may be a method to prevent the type of price declines
experienced in the 1990s. It would not be a panacea, however. Inflation targeting,for example, would have prevented the slow downward movement in prices in the
1990s, but it would not have prevented the excessively easy monetary policy followedin the second half of the 1980s, since inflation was low during that period.
This, however, is not an argument to reject inflation targeting, but only a caveat
emphasizing that targeting would not eliminate all policy failures.
There are political economy considerations indicating that inflation targeting may
not be the best institutional change to recommend for the Bank of Japan at this time,since significant institutional change was achieved only two years ago. Institutionalchange in that direction in the future, however, is worthy of consideration.
Irrespective of the long-run benefits of further institutional change toward an
inflation-targeting framework, the Bank has sufficient power and legal foundation to
adopt a more aggressive anti-deflation policy without an explicit inflation-targeting
framework. The new Bank of Japan Law clearly places responsibility on the Bank tomaintain price stability. The Bank merely has to make clear to the public that pricestability means preventing deflation and take appropriate steps in that direction suchas open market operations in government bonds. History offers important lessons to
the Bank in this regard. Failure to prevent deflation has serious consequences on
the real economy, and just as inflation is inherently a monetary phenomenon,
deflation is an inherently monetary phenomenon. Central banks are faced with many
constraints, but ultimately have the power to prevent deflation, and rather than
accept technical constraints as limits to appropriate policy, central banks shouldfind ways to work around these constraints even if it requires seeking new powers
or cooperating more closely with the government. Concern with independence,
however, may limit the willingness to seek such a solution, and ultimately as in thecase with the Federal Reserve, lead to a loss of independence.

VII. Concluding Comment
There are significant differences between Japan and the situation faced by many
countries in the 1930s; however, the similarities are also clear. The Bank of Japan

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Monetary Policy, Deflation, and Economic History: Lessons for the Bank of Japan

has allowed a slow deflation process to continue. Combined with the large amountof nominal debt, a more aggressive policy would have reduced the economic andfinancial distress that characterized the 1990s. Newly independent, the Bank has
been open in defending its position, but on close examination many of thearguments against more aggressive policy are reminiscent of those of the Federal
Reserve in the 1930s. The Bank of Japan has resorted to technical constraints,
concern with the quality of its balance sheet, and concern with fiscal responsibility asarguments against more aggressive open market operations. Like the Federal Reserve,
the Bank emphasizes the low interest rates and lack of legitimate demand for credit asevidence that more aggressive action is unwarranted. It is also clear that the Bank
may be caught in an “independence gap” in the sense that the newly achieved legal
independence provides an incentive for an overly conservative approach to preventing
deflation. Ironically, such a policy could generate a loss in independence as evidenced
by increased conflict between the Bank and the government in the summer of2000 over the Bank’s move to raise interest rates and depart from the zero-rate policy(Wall Street Journal [2000]).

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Comment

CommentMÅRTEN BLIX13
Sveriges Riksbank

I. Introduction
Thank you very much for inviting me this conference. I am not an expert on theJapanese economy, but I come from a central bank that has had an inflation target inforce since 1995, and that pursued a price level target in the 1930s. What I would
like to do here is draw on the experience from those two periods to make somecomments and pose some questions. I should add that the experience of inflation
targeting is to a considerable extent a collective experience: the inflation-targeting
central banks widely share methods and analysis in a collegiate way. For example,
the Riksbank has received important input notably from the Bank of Canada, theReserve Bank of New Zealand, and the Bank of England. We also receive important
input on our understanding of monetary policy from academic economists.
I mention this to make the point that inflation targeting is no longer uncharted
territory. There is a wealth of inflation-targeting experience to draw from. Monetary
policy aiming at price stability has worked well. In my view, there is no inherent
reason why it should not work for Japan.

II. Summary of the Main Points of the Paper
Let me quickly summarize the main points of the paper. The paper discusses
historical episodes from the United States, Sweden, and Japan to draw someconclusions for Japanese monetary policy today. In particular, four main conclusions
are made:(1) Preventing deflation is at least as important as preventing inflation.
(2) Legal independence has a constraining influence on central bank policy incertain instances.
(3) Central banks have the power to prevent deflation.
(4) The paper suggests an inflation-targeting framework for the Bank of Japan.

III. Comments
Let me comment on some of these issues. But before going into details, let me firstclearly state that I am convinced that inflation targeting would be a good idea for the
Bank of Japan. However, I am not going to discuss why inflation targeting in general
13. I am grateful to Gustaf Adlercreutz, Claes Berg, Magnus Jonsson, and Martin Ådahl for useful suggestions. The
opinions expressed in this note are those of the author and should not be interpreted as reflecting the views of the
Executive Board of Sveriges Riksbank.

135

is a good idea, as the arguments are well known in the literature. Let me instead focus
my comments on the historical parallels addressed in the paper.
First, how relevant are the historical episodes discussed for Japan’s current situation? This is the main thread of the paper. I think the U.S. experience in the 1930s
certainly suggests that prolonged deflation is a bad thing. This is uncontroversial. I
also believe the Swedish experience in the 1930s suggests that price level targeting cansuccessfully prevent deflation (Berg and Jonung [1999]). Sweden as a small economy
achieved price stability at a time when the U.S. price level fell by about 25 percent.
By contrast, Japan today faces a positive “world inflation” rate and thus runs no riskof importing deflation. All other things equal, this factor should make it easier tointroduce an inflation target than the Swedish price level target in the 1930s.
In general, I think using historical parallels is a good idea; we should use them so
as to learn from past mistakes. I believe the episodes discussed in the paper are useful,but the parallels to the current Japanese situation go a bit too far. Although the paper
states that there are big quantitative differences, it is argued that the qualitative
aspects cannot be ignored. True, both episodes were characterized by failing financial
institutions and deteriorating balance sheets. But in the United States in the 1930s,
the price level fell by about 25 percent and money supply by about 35 percent; inJapan, by contrast, the price level has not changed dramatically and money supply
has increased by about 20 percent in the period. I would characterize this also as aqualitative difference between the episodes.
I agree with the author that central banks have the power to prevent deflation,and they have the power to prevent inflation from rising. But central banks do not
operate the economy in a vacuum: the fiscal environment is important for monetary
policy. With a zero interest rate and significant public spending, why are Japaneseprecautionary savings so high? Does this suggest that there are structural reforms, forexample, in the pensions and social security systems that would lower the need forhigh precautionary savings? How does the rising deficit affect expectations of futurefiscal policy? On these issues historical parallels may be useful, but are not directlydiscussed in the paper.
Let me also comment on the argument that an independent central bank may insome circumstances be a constraining influence. Even if this is a possibility, it seems
to me that having an official inflation target would solve the problem. The central
bank pursues its inflation target and is held accountable to the parliament for achieving that target; its policies are evaluated on the basis of how successful they are inachieving the target.

IV. The Signaling Channel
One important experience of inflation targeting—historically and in the current
situation—that I think is somewhat neglected in the paper is the signaling channel,
which may be of relevance for the Bank of Japan.
In Sweden, an explicit announcement was made for the goal of monetary
policy—both in the 1930s and the 1990s. Neither was entirely credible at the time of

136 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Comment

announcement. In the early 1990s, inflation expectations were considerably above
the inflation target; inflation risk premia from forward curves were not small. Thisis perhaps not surprising given that the average inflation rate in 1970–92 was about
8 percent. Why should it suddenly come down to just below 2 percent, which isnevertheless what actually happened? Clearly the monetary stance is crucial, but I
believe the communication strategy is also instrumental. It consists of explaining
what the goal of policy is and how the bank intends to achieve that goal. For thispurpose, the Riksbank publishes quarterly inflation reports that outline the prospects
for future inflation, explaining in some detail demand and supply and international
factors, as well as uncertainties, which culminate in an inflation forecast relative tothe target. If the Riksbank cannot credibly explain why inflation would stay ontarget, this might affect inflation expectations in the private sector.
Thus, to summarize this point, I believe some important elements of a successfulcommunication strategy, particularly if credibility is low, consist of a clear goal forpolicy and a clear explanation of how the goal is to be achieved.

Reference

Berg, Claes, and Lars Jonung, “Pioneering Price Level Targeting: The Swedish Experience 1931–1937,”
Journal of Monetary Economics, 43, 1999, pp. 525–551.

Comment
SHIN-ICHI FUKUDAThe University of Tokyo
The paper provided several interesting historical experiences of the United States,
Sweden, and Japan in the 1930s and tried to draw some implications for the Bank ofJapan (BOJ) in the 1990s. Historical lessons drawn from the Federal Reserve’s policyin the 1930s were negative ones. The paper concluded that the Federal Reserve failed
to conduct easy monetary policy because it did not place a priority on preventing
deflation. It also pointed out that the legal independence of the Federal Reserve
without accountable policy goals made the situation worse. In contrast, a previous
version of the paper evaluated the historical experiences of Sweden and Japan inhighly positive ways. In particular, the author stressed the importance of price-leveltargeting or inflation targeting to avoid a deflationary environment.
Needless to say, there is a sharp structural and quantitative difference between
Japan in the 1990s and the 1930s environment. Thus, the implications drawn
from the historical experiences may not be directly applicable to the current
Japanese economy. But, as was mentioned in the paper, there exist some qualitative
similarities between Japan in the 1990s and the 1930s environment. Therefore,
it may be undesirable for policy makers to ignore the historical lessons described in
the paper.

137

Since I am not familiar with the historical experiences of the United States andSweden in the 1930s, I will make comments based on the historical experience of Japanin the 1930s and on the implications for Japan in the 1990s. I have two comments.
My first comment is on the evaluation of Japan’s experience in the 1930s.14 In July
1929, the Japanese government announced that it would return to the gold standard
from January 1930. After the announcement, the Japanese economy experienced
a serious recession and deflation. An adverse international environment made thesituation worse, and the serious recession continued until 1931 (Figure 1). Private
equipment investment was most seriously damaged, and its decline was about
45 percent from 1929 to 1931. Deflation also prevailed in those days, and the annual
inflation rate of the wholesale price index (WPI) was almost equal to –50 percent in1930 (Figure 2).
The situation, however, changed drastically when Korekiyo Takahashi became
Minister of Finance in December 1931. Soon after he became minister, he decided toleave the gold standard and started highly expansionary monetary and fiscal policies.
Government spending rose 26 percent from 1931 to 1933, and the low interest rate
policy was adopted with strict international capital controls. The expansionary
policies were successful in stimulating the economy. Aggregate prices rose rapidly,
and the inflation rate of the WPI nearly equaled 10 percent in both 1932 and 1933.
Real interest rates turned negative because of high inflation rates and the low interest
rate policy (Figure 3). Consequently, private equipment investment doubled for two
years from 1931 to 1933.
However, in discussing the success story, we need to note that most of the rise ingovernment spending was deficit financed and, from 1932, the BOJ underwrote
almost all of the government’s bond issues. When the economy was still in recession,
the expansionary monetary and fiscal policies might not have caused any serious
adverse effects. But even after the economy recovered and started posting steady
growth, the expansionary monetary and fiscal policies were never stopped. Instead,the growth rates of government spending and money supply were accelerated after
Takahashi’s assassination, and price levels kept going up for a long period (Figure 2).
In sum, I agree that the expansionary monetary and fiscal policies were successfulin stimulating the deeply recessionary Japanese economy in the early 1930s. But the
expansionary policies caused a WPI inflation rate of 10 percent, which may havebeen less costly in the early 1930s but would have been highly costly had they been
adopted in the 1990s. More importantly, it seems that the expansionary policies during the recession period caused a serious loss of government discipline even after the
economy recovered and brought very high costs of persistent inflation and budget
deficits throughout the 1930s. In discussing the Japan’s experience in the 1930s, weshould also draw these negative lessons.
My second comment is on the implications for central bank independence. The
paper presented a paradoxical but interesting proposition that the legal independenceof the central bank can be harmful for economic stability under some circumstances.
It provided historical evidence that the legal independence of the Federal Reserve
14. The following arguments, including Figures 1, 2, and 3, are partly based on Shima (1983).

138 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Comment

Figure 1 GNP and Private Investment in the 1920s and 1930s
The end of
the gold standard
The beginning of
the gold standard¥ millions, log scale
320

Inoue Takahashi
Nominal GNP
160
Real GNP
80
Private consumption

Government expenditure

40
Imports
20
Private investment
10
Exports
5
1915

20

25

30

35

Figure 2 Price Levels and Inflation Rates in the 1920s and 1930s

Price indexes (level)

170
160
150
140
130
120
110
100
90
80
70
60

WPI

The end of
the gold standard
The beginning of
the gold standard

Price indexes (1914–15 = 100)

Inoue Takahashi
GNP deflator

Percent

Inflation rates+20

GNP deflator

+10
0
–10

WPI
–20
1915

20

25

30

35

139

Figure 3 Real Interest Rate in the 1920s and 1930s
The end of
the gold standard
The beginning of
the gold standard

Percent
30

Inoue Takahashi

20
10
0
–10
Effective lending rate – inflation rate of WPI
–20

1915

20

25

30

35

may have constrained its willingness to expand the money supply during the Great
Depression in the 1930s. It also proposed that, with the exception of the early 1970s,
the BOJ successfully achieved a low rate of inflation in the postwar period despite
being one of the most formally dependent central banks in the world up to 1998.
It is true that Japan had the lowest average consumer price index (CPI) inflation
rates among the industrial countries after the mid-1970s. However, in evaluating theoutcome of the BOJ’s independence, the use of CPI inflation rates is misleading, atleast in the latter half of the 1980s. The CPI inflation rates were quite stable in Japanthroughout the 1980s. But stock prices as well as land prices went up dramatically,
and the asset price bubble emerged in the late 1980s. It is now widely recognized thatthe BOJ’s easy monetary policy was one of the factors that generated the asset pricebubble in the late 1980s. In particular, as Okina, Shirakawa, and Shiratsuka (2001)
have discussed, the process of the BOJ’s easy monetary policy in the latter half ofthe 1980s was strongly affected by political pressures, particularly pressure frominternational policy coordination and pressure in favor of preventing the appreciationof the yen and reducing the current account surplus.
Of course, it is difficult to judge whether the BOJ would have avoided adopting
an easy monetary policy in the late 1980s if it had been more legally independent.
However, at least in terms of evaluating whether the Bank had achieved a degree ofde facto independence or not, CPI inflation rates would not have been a satisfactoryindex in the latter half of the 1980s.

140 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

General Discussion
References

Okina, K., M. Shirakawa, and S. Shiratsuka, “The Asset Price Bubble and Monetary Policy: Japan’s
Experience in the Late 1980s and the Lessons,” Monetary and Economic Studies, 19 (S-1),
Institute for Monetary and Economic Studies, Bank of Japan, 2001, pp. 395–450 (this issue).
Shima, K., “Iwayuru ‘Takahashi Zaisei’ ni Tsuite (On the ‘Takahashi Fiscal Policy’),” Kin’yu Kenkyu(Monetary and Economic Studies), 2 (2), Institute for Monetary and Economic Studies, Bankof Japan, 1983, pp. 83–124 (in Japanese).

General Discussion
Responding to Shin-ichi Fukuda’s comment on the benefits of central bank independence, Thomas F. Cargill argued that excessive simplification in prior researchoverstated the value of central bank independence. However, Lars E. O. Svensson
thought that it was desirable for central banks to have strong independence, provided
that this be accompanied by (1) a clear mandate, (2) instrument independence, and(3) accountability.
Donald L. Kohn expressed some doubts about the additional merits of inflation
targeting compared to quantitative easing in a deflationary environment (where
economic growth is below the potential growth rate) such as Japan faced, since theonly means to achieve targeted inflation would be quantitative easing. Svensson,
however, emphasized the importance of “anchored expansion” in preventing the
economy from falling into an uncontrollable state as a side effect of quantitative
expansion policies taken to overcome deflation, and White endorsed his view. Tiff
Macklem commented that announcing an inflation target would send a strong
message that the Bank of Japan would do everything in order to achieve that target.
J. Alfred Broaddus, Jr., and Jack H. Beebe emphasized the role that inflation targeting
could play in improving the accountability and credibility of the central bank.
Grant Kirkpatrick pointed out that a practical problem in implementing inflation
targeting is the difficulty of accurately forecasting inflation when economic data are
not that reliable. Svensson acknowledged this difficulty, but stressed that neverthelessthe best thing central banks could do is to conduct a forward-looking monetary
policy based on its forecasts.
On the relationship between the central bank and government, Marvin
Goodfriend pointed out that desirable relations between the two depend on economic conditions and brought up the problem of “responsibility without authority”:
he argued that it is not easy for the central bank to play a proactive role in issues
over which it is not given authority but only responsibility. Goodfriend andSvensson underlined the need for an arrangement between the government andthe central bank to guarantee the consistency of decision-making on monetary
policy and foreign-exchange policy, since the two cannot be separated under freecapital movement.
Masaaki Shirakawa reflected on the BOJ’s recent experiences of central banking
policy, including the lender of last resort function, in avoiding systemic crisis, andexpressed his sympathy for Goodfriend’s view: he argued that it was a kind of141

“responsibility without authority” that the BOJ had to adopt measures that wereperhaps not necessary if proper structural policy, in particular those to deal with thenonperforming-loan problem, had been undertaken in a timely fashion.

142 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001