Discussion Paper Series No.201

Sustainability of Public Debt:
Evidence from Pre-World War II JapanSHIZUME Masato

March

Kobe University

2007

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

Sustainability of Public Debt: Evidence from Pre-World War II Japan
Masato Shizume 1
Research Institute for Economics and Business Administration
Kobe University
Rokkodai 2-1, Nada-ku, Kobe 657-8501, Japan
E-mail: shizume@rieb.kobe-u.ac.jp
March 2007
[Abstract]
Japan defaulted on its public debts only once throughout its modern history, afterWorld War II (WWII). How did Japan lose its ability to sustain its public debts? This
paper explores the sustainability of public debts in Japan before and during WWII.
First, this paper reviews the brief history of pre-WWII public finance in Japan
with reference to some narrative evidence, data, and previous works.
Second, this paper conducts three stages of econometric analyses. It tests
Ricardian neutrality of public debt. It tests the dynamic efficiency of Japanese economy,
and it conducts Bohn’s tests for the relationship between public debt and primary fiscal
balance. The tests indicate that Japanese public debts were sustainable until 1931, andunsustainable in and after 1932.
Third, this paper interprets the results of quantitative analyses with narrativemodes of analysis. During the 1930s, Japan lost its fiscal discipline because of themilitary’s effective veto over budgetary processes and because of the absence of pressure
for sound fiscal policy from international financial markets.

JEL Classifications: E62, H63, N15

1 I would like to thank Takero Doi, Eisaku Ide, Yoichi Matsubayashi, Ryuzo Miyao,

Richard Smethurst, and participants in the Kinki Workshop of Socio-Economic History
Society of Japan, the Rokko Forum and RIEB Seminar at Kobe University, and the
Seminar at the Bank of Japan, for their helpful comments and discussions. Anyremaining errors are my own.

1. Introduction
Japan defaulted on its public debts only once throughout its modern history,
after World War II (WWII). Japanese yen-denominated government debts became
worthless during the rampant inflation between 1945 and 1948. How did Japan lose its
ability to sustain its public debts? This paper explores the sustainability of public debts
in Japan before and during WWII with quantitative and narrative analyses.
First, this paper reviews the brief history of pre-WWII public finance in Japan
with reference to some narrative evidence, data, and previous works.
Second, this paper conducts three stages of quantitative analysis. It tests
Ricardian neutrality of public debt for the pre-WWII Japan. The result indicates
non-neutrality. Then, it tests the dynamic efficiency of the pre-WWII Japanese economy,
and confirms it. These results indicate a need for another test for sustainability of
public debt, one which is proposed by Bohn [1998].
Bohn’s method tests the relationship between public debt and primary fiscal
balance. Bohn’s basic notion is that if a government improves its primary balance when
it sees an increasing public-debt/output ratio, then its public debts are sustainable in
the long-run. If not, public debts are not sustainable.
This paper conducts Bohn’s tests with a new dataset of the Japanese primaryfiscal balance from 1885 to 1943. The tests assuming structural changes within thesample period indicate that Japanese public debts were sustainable until 1931, andunsustainable in and after 1932.
Third, this paper interprets the results of quantitative analysis with narrativemodes of analysis. In doing so, it explores the governance of fiscal policy both from thedomestic and the international sides. It compares the policy responses during two
periods in which Japanese government faced financial difficulties, namely after the
Russo-Japanese War (1904-05) and in the early 1930s. The narrative modes of analysis
indicate that Japan lost its fiscal discipline during early 1930s because of the military’s
effective veto over budgetary processes and because of the absence of pressure for soundfiscal policy from international financial markets.
Section 2 reviews Japanese public finance before WWII. Section 3 conducts aquantitative analysis. Section 4 interprets the results in section 3 with a narrative
analysis. Section 5 contains some conclusions.
2. Japanese public finance before WWII
a. Some Narrative Evidence
Narrative evidence indicates several turning points in modern Japanese public

1

finance. First, Japan had established stable modern public finance with reforms before
the middle of 1880s. Second, the Russo-Japanese War in 1904-05 imposed a heavy
burden on its public finance. Third, rapid economic growth during WWI (1914-18)
reinforced Japanese public finance. And fourth, debt-financed fiscal stimulus policy
during the Great Depression of the early 1930s marked a drastic change in Japanesepublic finance.
Japan had established stable modern public finance before the middle of 1880s.
After the Meiji Restoration in 1868, the government conducted drastic fiscal reforms
during the 1870s. The reforms include Chiso Kaisei, the reform of land tax, Chitsuroku

Shobun, the repeal of stipends for ex-samurai, and the disposal of debts inherited fromfeudal governments. 2 Around the time of the Civil War in 1877, the fiscal balance
deteriorated and the monetization of the fiscal deficit caused inflation. In the 1880s,
Masayoshi Matsukata, the prominent Finance Minister, conducted a tight fiscal policy
to restore the fiscal balance, a policy which is often referred to as ‘Matsukata’s
deflationary policy.’ Under the leadership of Matsukata, Japan introduced the silver
standard in 1885, and moved into the gold standard in 1897. 3
The Russo-Japanese War, the first modern total war for Japan, imposed aheavy burden on Japanese public finance. Japan financed the war by borrowing from
Western investors through London and other international markets. After the war, thegovernment faced financial difficulty because the investors had doubts about the
government’s capability to repay the debt.
Rapid economic growth during WWI reinforced Japanese public finance.
Growth in nominal terms reduced the burden of previous debts. Japan also accumulated
a trade surplus and specie during WWI. Japan used these national assets to deal withbad loan problems and other fiscal demands during 1920s. Meanwhile, Japansuspended gold convertibility in 1917 following the Western countries and resumed it in
1930.
The gold embargo in the end of 1931 and the following debt-financed fiscal
stimulus policy marked a drastic change in Japanese public finance. A veteran Finance
Minister Korekiyo Takahashi initiated the policies. 4 The Japanese economy recovered
2 Nakamura [1971], Oomori [2001].
3 Matsukata became Finance Minister in 1881 for the first time, served four times as
Finance Minister until 1900 and twice as Prime Minister. During his career in public
service, he played the central role in building up a modern financial system including
the Bank of Japan and the gold standard.
4 Korekiyo Takahashi (1854-1936) joined the Bank of Japan (BOJ) in 1892 and served
as Governor of the Bank from 1911 to 1913. He then served as Finance Minister seventimes from 1913-36, and as Prime Minister once, from 1921-22. He was assassinated by2

faster than other economies in the midst of the Great Depression. Many observers
appraise Takahashi as a pioneer of the Keynesian counter-cyclical macroeconomic
policy (Nakamura [1971]).
Some observers blame Takahashi’s strategy for losing fiscal discipline and forpaving the way to rampant inflation after WWII because he initiated debt-financed
public spending. Ministry of Finance [1965] argues that his strategy resulted in theaccumulation of deficit-covering bonds and inflation. 5 Some blame Takahashi’s schemeof the underwriting of government bonds by the Bank of Japan (BOJ). They say that thescheme became an instrument of easy credit to the government by the central bank.
Shima [1983] says that “such easy instruments tend to be abused and to becomecommon practice.” 6Some observers defend Takahashi. Nakamura [1971] emphasizes that
Takahashi tried to cut government spending including military expenditures when therecovery became robust, and that Takahashi’s trial was cut short when he wasassassinated by a group of militarist in 1936. They blame Takahashi’s successor, Eiichi
Baba, for failing to control military expenditures. Fiscal deficits exploded during Baba’s
term.
When and how the sustainability of Japanese public debts was lost, is anempirical question. We will explore the question combining quantitative and narrativemodes of analyses.
b. Data on Public Finance
Figure 1 shows public-debts for fiscal 1885-1943. 7 This sample of 58 years
includes almost all periods from the establishment of modern Japanese public financesystem to the collapse of the system. The solid line indicates the long-term (over 1 year)
national debt. We take figures from the statistics of the Ministry of Finance (MOF).

a group of militarists on February 26, 1936. During his career in public service, heplayed the central role in fundraising in the Western countries during the
Russo-Japanese War. He solved a major financial crisis in Japan in 1927, and heconducted a drastic economic stimulus package during the Great Depression.
Smethurst [2007].
5 Ministry of Finance [1965], pp.129-142.
6 Shima [1983], p.119.
7 All figures are expressed in ratio to output (gross national products) and fiscal year
basis unless otherwise indicated. The output data are taken from Long-term Economic
Statistics (LTES).
3

Figure1.Japanese Public Debt
140

percent of GNP

120
100
sum of long-term national and local debts
80
60
total national debt
40
20
long-term national debt
01885 1890 1895 1900 1905 1910 1915 1920 1925 1930 1935 1940

Sources:

The Financial History of Meiji-Taisho Era, 11: National Debts; Reference Book ofFinancial Matters; LTES.

The average of long-term national debt over the sample period is 42 percent of
GNP, while the ratio shows some swings. It is stable under 30 percent until theoutbreak of the Russo-Japanese War in 1904. It soars during the war up to 65 percent in
the end of 1906. It remains at around 60 percent until the outbreak of WWI. It falls
during WWI to 21 percent in the end of 1919. It creeps up during the 1920s to 42
percent, the average level of the whole sample period, at the end of 1930. It jumps
during the first half of Takahashi’s term of 1932-36 and stays at the 50-60 percent level
for the rest of his term. It skyrockets after 1936.
Figure 2 shows fiscal-balances for fiscal 1885-1943. The solid line indicates theprimary balance, which is total revenue less payments not including interest payments.
Previously available data of fiscal balances in the General Account ismisleading because it does not include special accounts. Among others, the biggest
problems are related to war expenditures and debt consolidation. The government set
Special Accounts for Temporary War Expenditures four times with the Sino-Japanese
War in 1894-95 (the fiscal year for the account: June 1894-March 1896), theRusso-Japanese War (October 1903-March 1907), WWI (August 1914-April 1925), and
the Asia-Pacific War/WWII (September 1937-February 1946). 8 These War Expenditures
8 On July 7, 1937, Japan and China embarked upon an undeclared war. In this study,

we use the term “Asia-pacific War” to describe warfare in 1937-45 because Japanese4make big impacts on the overall fiscal balance without impacting the General Account.
The government established a Special Account for Government Debt Consolidation
Fund in 1906. The government often stopped or reduced the amount of transfers fromthe General Account to the fund when it faced financial difficulties.

Figure 2. Fiscal Balances
percent of GNP
10primary fiscal balance
0
-10
-20
-30
fiscal balance including interest payments
-40
-50
-60
1885

Sources:

1890

1895

1900

1905

1910

1915

1920

1925

1930

1935

1940

The Financial History of Meiji-Taisho Era, 11: National Debts, Ministry of
Finance Yearbook, LTES.

In this study, we have new estimates of fiscal balances. We calculate theoverall fiscal balance by subtracting the previous year’s long-term national debt fromthe present year’s. Then we calculate the primary fiscal balance by adding the present
year’s interest payments for the whole national debt to the overall fiscal balance. In
doing so, we count all government revenues and expenditures, including special
accounts. One disadvantage of this approach is that we cannot breakdown thedevelopments in fiscal balances into revenues and expenditures.
We see two troughs in the fiscal balance, namely during the Russo-Japanese
War and the Asia-Pacific War. During the Russo-Japanese War in 1904-05, theprimary-deficit/output ratio records double digit figures. In 1905, the deficit was 26
percent of GNP. The scale of deficit per year is equivalent to 1942. These two wars
induced a heavy burden on Japanese public finance. The difference between these twowars is the length of the trough. The trough in the Russo-Japanese War is short, andthe trough in the Asia-Pacific War is long. The Sino-Japanese War (1894-95) and WWI
public finance maintained continuity through this period.
5(1914-18) were not heavy burdens for Japanese public finance. Takahashi’s term in the
1930s also marks deficits while the scale is small compared to the two big wars.
We may interpret the relationship between public debt in Figure 1 and fiscal
balances in Figure 2 as a dynamic process. The two factors of determinants of public
debts are accumulated fiscal balances as numerator and nominal output growth asdenominator. Public debts increase when the government accumulates fiscal deficits.
This was the case during the Russo-Japanese War, Takahashi’s term, and theAsia-Pacific War. Public debt decreases when the output increases more than fiscal
deficit in nominal terms. This was the case during WWI.
Table 1. Revenues and Expenditures in the General and War Accounts(as percent of GNP)
Revenues

Expenditures Military

Others1885-93

8.7

6.1

2.3

3.9

1894-95

6.4

10.8

8.3

2.5

1896-1903

9.3

9.4

4.7

4.6

1904-06

12.2

22.9

18.8

4.1

1907-13

13.3

10.3

4.7

5.6

1914-18

10.3

8.1

4.6

3.6

1919-21

8.7

9.0

5.7

3.3

1922-31

9.5

9.0

3.2

5.7

Disarmament

1932-36

8.7

10.8

5.4

5.4

Takahashi’s term as FM

1931

10.2

9.4

3.4

6.0

1932

9.5

12.1

5.0

7.2

1933

9.4

12.2

5.4

6.8

1934

8.3

10.4

5.5

4.9

1935

8.1

9.9

5.6

4.3

1936

8.5

9.5

5.4

4.1

1937

9.4

18.3

13.8

4.5

1937-41

10.9

26.1

20.9

5.3

1885-1941

9.9

11.1

6.5

4.7

Notes.

Sino-Japanese War
Russo-Japanese War
WWI

1. Revenues exclude debt issues and borrowings, surplus from the previous year, andsurplus of Temporary War Expenditure Accounts.
2. Expenditures exclude debt servicing costs.

Sources

Events

MOF [1955], Ministry of Finance Yearbook.

6

Table 1 shows fiscal revenues and expenditures for fiscal 1885-1941. We takethe revenues from the General Account. We take the expenditures from the General andwar expenditure accounts. The military expenditures include war expenditures in theSpecial Accounts for Temporary War Expenditures, the expenditures of the Army andNavy in the General Account, and expenditures for mobilization in the General Account.
Although the figures in Table 1 are not consistent with Figure 2, we have anapproximation of the revenue/expenditure breakdown of fiscal balances, correctingsome problems of previously available data.
Table 1 confirms that the finance of military spending dominates in publicfinance in pre-WWII Japan. The military expenditures during the Russo-Japanese War
and during the Asia-Pacific War reach 20 percent of GNP while the average over the
sample period is 6 percent.
The government intended to finance the Russo-Japanese War mainly byraising taxes and by issuing debt rather than cutting expenditures. The revenues, mostof which were taxes, rose from 9 percent of GNP before the war to 12 percent during thewar. The revenues further rose to 13 percent after the war while military expenditureand the sum of other expenditures were higher than the pre-war level in 1906-08. The
government did not curb expenditures within the pre-war level until 1909.
Disarmament efforts such as the Washington Conference in 1921-22
distributed peace dividends to Japan. The military expenditure decreased to an averageof 3 percent of GNP in 1922-31. The government used the peace dividends for public
investments (Nakamura [1971], p.147) and bad-loan disposal (Itoh [1989], p.197). The
sum of other expenditures than military spending reached a record high of 6 percent of
GNP.
The deterioration in fiscal balances during and after Takahashi’s term in
1932-36 was mainly due to increase in military spending. Military expenditure soared
to 6 percent of GNP during 1932-36, and jumped to 14 percent in 1937. Other
expenditure increased to 7 percent in 1932-33, but fell below 5 percent afterwards.
3. Econometric Analysis for Sustainability of Public Debt
a. Methodology
How we should define sustainability of public debt? Hamilton and Flavin[1986] define this sustainability as that in which the “government budget must bebalanced in present-value terms.” 9 Bohn [2005] argues that present-value criteria is
9 Hamilton and Flavin [1986], pp.811-812.

7

based on the assumptions of infinitely-lived optimizing behavior of potential lenders
and complete financial markets, which guarantee a common pricing kernel for interest
rates. And, Bohn generalizes the conditions for sustainability as those in which “anagent’s ability to borrow is constrained by other agents’ willingness to lend.” 10 Bohn
[1998, 2005] derives a simple rule or a government’s reaction function for sustainablepublic debt by solving intertemporal optimization equations of private agents.
Doi and Nakazato [2004] present a three-stage method for testingsustainability of public debt. Figure 3 presents a flow chart of their method. They
propose testing the debt neutrality hypothesis first, to test the dynamic efficiency of theeconomy second, and to test the Bohn’s criteria third. They test the sustainability of
post-WWII Japanese public debt with the method. They conclude that the post-WWII
Japanese public debt was sustainable until the beginning of 1990s, and that the debt
was not sustainable from the middle of 1990s. 11
This study applies the three-stage method for analyzing sustainability of public
debt presented by Doi and Nakazato [2004] on pre-WWII Japan.
Figure 3. Methodology for Testing Sustainability of Public Debt
Debt neutrality holds?
Yes
Sustainable

No
Dynamic efficiency holds?
No

Yes

Sustainable

Bohn’s test
Yes
SustainableNo
Not sustainable

Source: Doi and Nakazato [2004].

b. Debt Neutrality
Debt neutrality hypothesis, also referred to as Ricardian equivalence theorem,
states that the domestic private agents recognize public debts held by the domestic
10 Bohn [2005], p.15.

11 There is only one previous study employing quantitative analysis on thesustainability of public debt in pre-WWII Japan. Asako et al. [1993] test if the amountof public debt diverges or not, and if the government’s revenue and expenditure
cointegrate or not. They employ the tests for the sample periods of 1885-1944 and
1885-1936. They conclude that pre-WWII Japanese public debt was not sustainable. But,
they do not indicate when the public debt became unsustainable.
8agents as future tax obligations and not as net wealth. 12 If this hypothesis holds, agovernment does not have to prepare for future repayments of the public debts held bydomestic private agents. In this case, the public debt is sustainable regardless of thegovernment’s behavior.
An important prerequisite for debt neutrality hypothesis does not hold for
pre-WWII Japan. If the public debt is held by foreign investors, the debt is not neutral.
Foreign investors held a substantial part of Japanese public debt. Figure 4 shows theratio of foreign holdings of the public debt. Foreign investors held more than 50 percentof the debt after the Russo-Japanese War until WWI. They held about 30 percent in
1920s and over 10 percent during the first half of 1930s.
Figure 4. Japanese Public Debt held by Foreign Investors
percent of total debt

70
60
50
40
30
20
10
0

1885 1890 1895 1900 1905 1910 1915 1920 1925 1930 1935 1940
Note:

Total of national and local debts.

Source:Fujino and Teranishi [2000], Nihon Kin'yu no Suryo Bunseki (Quantitative Analysis ofJapanese Finance).

Previous empirical works indicate that the debt neutrality hypothesis does nothold in many cases even when held by domestic agents. Bernheim [1987] reviews
previous studies on the U.S. and Canada, and concludes that public debts in thesecountries are not neutral. Honma [1996] and Ihori et al. [2001] test the hypothesis on
post-WWII Japan, and conclude that the hypothesis does not hold.
Bernheim [1987] theoretically interprets the above empirical evidence, arguing

12 Barro [1974].

9

that the hypothesis presumes strict conditions. 13 The conditions are “that (1) successive
generations are linked by altruistically motivated transfers; (2) capital markets either
are perfect, or fail in specific ways; (3) the postponement of taxes does not redistributeresources within generations; (4) taxes are nondistortionary; (5) the use of deficits
cannot create value (that is, through ‘bubbles’); (6) consumers are rational andfarsighted; and (7) the availability of deficit financing as a fiscal instrument does notalter the political process.” Shibata [1991] reviews these conditions and concludes thatthe debt neutrality does not hold when heterogeneous agents exist and when wealth isredistributed among them in some way.
We assume that the debt neutrality hypothesis does not hold in pre-WWII
Japan because an important prerequisite does not hold and because previous empiricaland theoretical works indicate difficulties in meeting conditions for the hypothesis.
c. Dynamic Efficiency
Abel et al. [1989] state that an economy is dynamically inefficient when theeconomy is consistently investing more than it is earning in profit. 14 If an economy is
dynamically inefficient, borrowers do not have to repay their debts in themacroeconomic sense. In such an economy, the government, typically the biggest
borrower, is allowed to run continuous deficits.
Abel et al. [1989] present a method to test the dynamic efficiency of an economy
by comparing cash flows going into and coming out of an economy’s production sector.
They argue that conventional models comparing growth rate and interest rate are
inadequate in a stochastic setting with uncertainty in profitability, the value of capital,
and growth rate. They argue that the net cash flow criterion, which they present, is anadequate way to test dynamic efficiency in a stochastic setting. 15
This study applies the net cash flow criterion presented by Abel et al. [1989] topre-WWII Japan. We estimate gross profit and gross investment from existing data, andcompare them. Figure 5 shows them in terms of output-ratio. Gross profit exceeds grossinvestment for the whole period of 1885-1940, indicating that Japanese economy has
been dynamically efficient. The average difference of gross profit and investment for
1885-1940 was 18.8 percent of GNP. 16
We assume dynamic efficiency of the Japanese economy with a large margin of
13 Bernheim [1987], pp.264-265.
14 Abel et al. [1989], p.1.
15 Abel et al. [1989], p.2.

16 Abel et al. [1989] reported post-WWII Japanese data, and the difference in 1960 was

17.6 percent, roughly equivalent to the pre-WWII level.
10difference between gross profit and investment.
Figure 5. Gross Profit and Gross Investment
percent of GNP

40
gross profit (P)3530

net outflow from nonfinancial
corporate sector (P-I)

25
20
15
10

gross investment (I)

5
0
1885

Sources:

1890

1895

1900

1905

1910

1915

1920

1925

1930

1935

1940

LTES; Ohkawa and Minami eds. [1975], Kindai Nihon no Keizai Hatten (Economic
Developments of Modern Japan);Emi and Shionoya eds.[1973], Nihon Keizai Ron (Japanese Economy).

d. Bohn’s Tests
The analyses above indicate a need for another test for sustainability of public
debt, one which is proposed by Bohn [1998].
Bohn’s method tests the relationship between public debt and primary fiscal
balance. Bohn’s basic notion is that if a government improves its primary balance when
it sees an increasing public-debt-to-output ratio, then its public debts are sustainable in
the long-run. If not, public debts are not sustainable. He also notes that the positive
relationship between primary balance and debts is not necessary for the sustainabilityof public debts when the debt-to-output ratio is low.
Bohn’s method is becoming a standard for testing sustainability of public debts.
Bohn [1998] applies the formula to the United States for 1916-95, and shows that thenation’s public debt was sustainable over that period. Bohn [2005] extends the test to
the U.S. for the period of 1792-2003, and shows that its public debt was sustainable formore than 200 years. Ihori et al. [2001] apply the method to Japanese national debt for
1956-98. They show that the Japanese national debt was not sustainable in recent years.
Doi and Nakazato [2004] extend the test to Japanese public debts including local
governments for the period of 1956-2000. They show Japanese public debt was
sustainable until the beginning of 1990s, and became unsustainable from the middle of111990s. Ghatak and Sanchez-Fung [2006] apply the method to test the debt
sustainability of developing economies, including Peru, the Philippines, South Africa,
Thailand, and Venezuela, for the period of 1970-2000.
We apply Bohn’s method to pre-WWII Japan with the new dataset of Japanese
primary fiscal balance, which has been presented in Section 2.b. The formula isexpressed by equation (1).

s t = α 0 + ρ ⋅ d t −1 + α G ⋅ GVt + α Y YVt + ε t ,st denotes primary fiscal surplus at time t, d t −1 denotes public debt at the end of time t-1,
GVt denotes temporary fiscal spending, and YVt denotes cyclical variables. We havepresented st and d t −1 in Figure 2 and Figure 1, respectively. We take national debt as(1)

public debt because of data constraints in local governments’ debts and because ofsimilarity in movements of data between national debt and total debts including local
governments’ debts. We take GVt , temporary fiscal spending, from direct militaryspending by MOF estimates. 17 The definition of the MOF estimates is close totemporary parts of military spending in Barro [1986] and Bohn [1998] in a sense that
MOF, Barro, and Bohn intend to separate big swings in military spending from otherfiscal spending. We derive YVt , a cyclical variable, by taking a deviation from the trend
value in real output (GNP) in logarithm. 18 All variables other than YVt are normalizedby output ratio. YVt is expressed as ratio to the real trend output. The sample period is
1886-1943.
The sign and the statistical significance of ρ , the coefficient of d t −1 , is criticalfor our purpose. Table 2 shows the regression results. We employ the ordinary
least-square method (OLS) in (a1) and (b1) regressions. We employ the two-stage
least-square method (2-SLS) with one-period lagged explanatory variables as
instrument variables in (a2) and (b2) regressions. We use long-term debt as the public
debt in (a1) and (a2) regressions. We use total debt including short-term debts such astreasury bills as the public debt in (b1) and (b2) regressions. Different regressions yield
qualitatively the same results. ρ has positive signs as expected in all regressions.

ρ is statistically significant by 5 percent level in 2-SLS regressions while ρ is notstatistically significant even by 10 percent level in OLS regressions.

17 Ministry of Finance [1955], pp.4-5.
18 The trend value is calculated by HP filter (λ=100) for 1885-1943.

12

Table 2. Estimation Results (Bohn's Test)dependent variable: primary fiscal surplus
sample period: 1886-1943
Number of observations: 58
estimationst = α 0 + ρ ⋅ dt −1 + αG ⋅ GVt + αY YVt + ε tformula:d: long-term debt

a1)

α0

2.647

( 3.48

) ***

2.101

( 2.51

) **

ρ

0.031

( 1.41)0.061( 2.39) **αG-0.874( -18.66) ***-0.962( -16.13

) ***

αY

-12.51( -1.18)-9.856( -0.58)

adj. R2

0.904

0.897

DW

1.87

1.75

d: total debt

b1)

b2)

α0

2.816

( 3.45

) ***

1.835

( 1.98

) *

ρ

0.023

( 1.04)0.066( 2.44) **αG-0.865( -17.96) ***-0.975( -15.47

) ***

αY

-13.514( -1.25)-8.733( -0.50)

adj. R2

0.908

0.892

DW

1.89

1.75

Notes.

a2)

1. Figures in parentheses are t-values. * represents 10 percent significance, ** represents 5 percent
significance, and *** represents 1 percent significance.
2. Estimated by the ordinary least-square method (OLS) in (a1) and (b1) regressions. Estimated by
the two-stage least-square method (2LS) with one-period lagged explanatory and dependent
variables as instrument variables in (a2) and (b2) regressions.

e. Bohn’s Tests with Structural Changes
Narrative evidence suggests a structural change or changes in thegovernment’s behavior in terms of fiscal policy and debt management within the sample
period. Japanese public debt became unsustainable at some point in time and ended
with rampant inflation after WWII. Candidates for events incurring such structuralchanges are the Russo-Japanese War, WWI, and Takahashi’s debt-financed spending
policy.
We employ Bohn’s method with a structural change to explore the timing and13

properties of the structural change. First, we employ the stepwise Chow tests to find thetiming of the structural change. Second, we employ Bohn’s tests with dummy variables
to explore the properties of the structural change. Third, we estimate recursive
t-statistics for the coefficient ρ to explore within-sample developments of ρ .
The Chow test is to check if the OLS regression with dummy on constant andcoefficient of all explanatory variables is better in terms of explanatory power than thecorresponding regression without dummy. A better explanatory power of the regression
with dummy indicates the existence of a structural change. The stepwise Chow tests
explore if a structural change exists within the sample period, and when, if at all, thestructural change occurs, by moving the starting period of dummy.
The result of the stepwise Chow tests on equation (1) indicates a structuralchange at the 5 percent significance level either in or around 1906, 1917, or 1932
(Figure 6). The result is consistent with narrative evidence. The timings of possible
structural changes indicated by the stepwise Chow tests coincided with the events
which had a big influence on the Japanese public debt. 1906 is the first year after the
Russo-Japanese War. 1917 is the midst of the rapid economic growth during WWI. 1932is the first year of Takahashi’s debt-financed fiscal policy.

Figure 6.Stepwise Chow Testdependent variable: primary fiscal balance(F-statistics)
4.0

3.0

2.0

significant at 5
percent level (2.56)

1.0

0.0
1890

1895

1900

1905

1910

1915

1920

1925

1930

1935

1940

Table 3 shows descriptive statistics of explanatory variables of equation (1) for
the full-sample period and for sub-sample periods derived from the stepwise Chow tests.
In 1885-1905, the public debt and the primary deficit are lower than the full-sample

14

average, indicating a stable fiscal position. In 1906-16, the public debt is higher than
average while the primary surplus is recorded, indicating a remarkably tight fiscal
policy for repaying wartime debts. In 1917-1931, the public debt and the primary deficit
are lower than average, indicating a stable fiscal position. During this period, thetemporary spending is the lowest among sub-sample periods, indicating the effects ofdisarmament. In 1932-43, the public debt, the primary deficit, and the temporary
spending are the highest among sub-sample periods, indicating deterioration in fiscal
position.
Table 3. Descriptive Statistics
Sample period

1885-1905

1906-16

1917-31

1932-43

1885-1943

Number of obs.

21

11

15

12

59

Long-term debt

24.54155.73931.47470.47741.463( 8.992) ( 9.053) ( 6.715

24.581) ( 22.579

28.08358.62233.03273.03444.178( 10.747) ( 8.913) ( 6.571

24.837) ( 22.775-1.5461.023-0.111-12.101-2.849( 6.431) ( 3.818) ( 1.209

10.107) ( 7.721

5.742

5.338

3.848

17.8947.656( 5.964) ( 2.076) ( 1.085

13.970) ( 8.837

Total debt
Primary surplus
Temp. expenditure

)
)
)
)

(
(
(
(

Note. Figures are average as percent of GNP. Figures in parentheses are standard deviations.

The formula of Bohn’s tests with dummy variables is expressed by equation (2).
(2)

st = (α 0 + α π ⋅ Dτ ) + ( ρ 0 ⋅ d t −1 + ρπ ⋅ d t −1 ⋅ Dτ ) + (α G 0 ⋅ GVt + α Gπ GVt ⋅ Dτ ) + ε t ,Dτ has a value of zero before period τ and a value of one in and after period τ. We run
regressions for three cases of τ=1906, 1917, and 1932. We excluded YVt , cyclicalvariables, from the regressions because YVt is insignificant for all regressions aboveand because we want to have as many degrees of freedom as possible.
Table 4 shows the regression results. ρπ , the coefficient of dummy for public
debt is significant in all regressions, implying a structural change at the timing
indicated by the stepwise Chow tests.

15

)
)
)
)

Table 4. Estimation Results with Dummy Variables: Case 1(Bohn's Test)dependent variable: primary fiscal surplus
sample period: 1886-1943
Number of observations: 58
estimationst = (α0 + απ ⋅ Dτ ) + (ρ0 ⋅ dt −1 + ρπ ⋅ dt −1 ⋅ Dτ ) + (αG0 ⋅ GVt + αGπ ⋅ GVt ⋅ Dτ ) + εtformula:d: long-term debt
Dummy1906

Dummy1917

Dummy1932

No Dummy

α010.870

(

3.75

)

***

3.675

απ

-9.576

(

-3.05

)

***

-

ρ0

-0.290

(

-2.32

)

**

0.043

(

2.14

)

**

0.049

(

2.26

)

**

0.038

ρπ

0.347

(

2.70

)

***

-0.092

(

-3.71

)

***

-0.098

(

-3.48

)

***

-

α G0
α Gπ

-1.002(-11.69)***-1.030(-13.29)***-0.985(-12.57)***-0.884

0.120

(

1.16

)

0.343

(

2.99

)

***

0.327

(

2.76

)

***

-

adj. R2

0.916

0.921

0.919

0.904

DW

1.74

2.15

2.08

1.78

Notes 1.
2.

(

4.38

)

***

2.842

(

3.16

)

***

-

2.408

(

3.28

)

***

(

1.86

)

*

(

-19.16)***-

Dτ takes value of zero before period τ, and value of one in and after period τ.
Estimated by OLS. Figures in parentheses are t-values. * represents 10 percent significance, **represents 5 percent significance, and *** represents 1 percent significance.

In the case of τ=1906,

ρ 0 = -0.29, and ρπ =0.35, implying that the coefficientof d t −1 changed from -0.29 to 0.06=-0.29+0.35 in 1906, the result implies the governmentchanged its attitude to public debt and moved towards a tighter direction, improving thesustainability of public debt. Table 3 reports that the level of public debt is low before
1906 and high afterwards. The regression result is consistent with narrative evidence oftightening fiscal policy in the wake of ballooning public debt during and right after
Russo-Japanese War.
In the case of τ=1917,

ρ 0 = 0.04, and ρπ =-0.09, implying that the coefficientof d t −1 changed from 0.04 to -0.05=0.04-0.09 in 1917, the result implies the governmentchanged its attitude to public debt and became slacker, worsening the sustainability of
public debt.
In the case of τ=1932,

ρ 0 = 0.05, and ρπ =-0.10, implying that the coefficientof d t −1 changed from 0.05 to -0.05=0.05-0.10 in 1932, the result also implies governmentchanged the attitude to public debt to easier direction, worsening the sustainability of16

public debt.
In which year, 1917 or 1932, did the sustainability of public debt deteriorate
more? In other words, which structural change is more significant? To answer thisquestion, we run the regression below.

st = α 0 + ( ρ 0 ⋅ d t −1 + ρπ 1 ⋅ d t −1 ⋅ Dτ 1 + ρπ 2 ⋅ d t −1 ⋅ Dτ 2 )+ (α G0 ⋅ GVt + α Gπ 1GVt ⋅ Dτ 1 + α Gπ 2 ⋅ GVt ⋅ Dτ 2 ) + ε t ,(3)

Dτ 1 has a value of one in 1917-31 and a value of zero otherwise. Dτ 2 has a value of one
in 1932-43 and a value of one otherwise. The sample period is 1906-43. We take theperiod of 1906-16 as the baseline in which period the government conducted a soundfiscal policy to make public debt sustainable. And we compare the divergence of fiscal
policies in 1917-31 and 1932-43 from the baseline period of 1906-16.
Table 5. Estimation Results with Dummy Variables: Case 2 (Bohn's Test)dependent variable: primary fiscal surplus
sample period: 1906-1943
Number of observations: 38
estimation formula:st = α 0 + ( ρ 0 ⋅ d t −1 + ρπ 1 ⋅ d t −1 ⋅ Dτ 1 + ρπ 2 ⋅ d t −1 ⋅ Dτ 2 ) + (α G 0 ⋅ GVt + α Gπ 1 ⋅ GVt ⋅ Dτ 1 + α Gπ 2 ⋅ GVt ⋅ Dτ 2 ) + ε t
d: long-term debt
α0

2.146

( 0.66

)

ρ0

0.072

( 1.14)ρπ1-0.056( -1.03)ρπ2-0.105( -2.33) **α G0
α Gπ 1α Gπ 2-0.995( -3.07

) ***

0.290

( 0.52)0.318( 0.91)adj. R2

0.937

DW

1.94

Notes 1.

Dτ1 takes value of one in 1918-31, and value of zero otherwise.
Dτ2 takes value of zero in and before 1931, and value of one in and after 1932.

2.

Estimated by OLS. Figures in parentheses are t-values. ** represents 5 percent
significance, and *** represents 1 percent significance.

17

The regression result shows that the structural change in 1932 is more robust
than in 1917 and that the Japanese public debt become unsustainable in around 1932

ρ π 2 , the coefficient of the dummy for 1932-43 is statistically significant,while ρπ 1 , one for 1917-31 is not. The absolute value of ρ π 2 is greater than ρπ 1 . The(Table 5).

central estimate of the coefficient of d t −1 is 0.07 for the period of 1906-16, 0.02 for 1917-31,
and -0.03 for 1932-43, implying that the coefficient changes from positive to negative in
1932.
Ghatak and Sanchez-Fung [2006] employ the recursive t-statistics approach to
explore within-sample developments of the debt sustainability of the post-WWII
developing economies. Bohn’s method tests if the sign of coefficient of public debt issignificantly positive or not. They fix the starting period and test Bohn’s method,
extending the ending period year by year from late 1970s to 2000. They report changes
in signs and absolute values of t-statistics for the coefficient of public debt in different
sample periods.
We fix the starting period in 1886 and run the regression for equation (1),extending the ending period year by year from 1918 to 1943.
Figure 7. t-statistics for the Coefficient of Public Debt
2.0
significant at 10
percent level (1.69)
1.5

1.0

0.5

0.0
1918

1923

1928

1933

1938

1943

The regression results suggest that Japanese fiscal policy become less soundduring Takahashi’s term of 1932-36 (Figure 7). The inclusion of data from the 1920s and1931 makes ρ statistically more significant. The inclusion of data of 1932-36
makes ρ statistically less significant. ρ is statistically different to zero by a 10 percent
significance level for the sample period of 1886-1926 through 1886-1932. ρ is not18

statistically different to zero by a 10 percent significance level for the sample period of
1886-1933 through 1886-1943.
f. A Review of Quantitative Analysis
The Bohn’s tests assuming a structural change within the sample period
indicate that Japanese public debts were sustainable until 1931, and unsustainable inand after 1932.

Figure 8. Public Debt and Primary Fiscal Balance
10

percent of GNP
primary fiscal balance/vertical axis

5
31

0

32

-5

6

-10
4

-15
-20
-25

5
-30

long-term national debt, end of previous fiscal year
/horisontal axis

-35
0

20

Sources:

40

60

80

43
100

120
％

See footnotes of Figure 1 and 2.

We review the results of Bohn’s tests with a scatter diagram of public debt in
the horizontal axis and primary fiscal balance in the vertical axis (Figure 8). The bottom
line of Bohn’s argument is that an upward-sloping relationship between these twovariables indicates sustainability of the public debt. A government manipulates
primary fiscal balance, seeing the level of public debt in the end of previous fiscal year.
The rule of thumb for sustainable public debt is that if the government sees an increasein public debt, it tightens the budget. If it sees a decrease in public debt, it loosens thebudget. The results of quantitative analysis indicate that Japanese public debt andprimary fiscal balance kept an upward-sloping relationship until 1931, and moved intoa downward-sloping relationship from 1932. We see a small reversal in 1934-36 toward
an upward-sloping, but the reversal is not statistically significant.
The quantitative analysis above supports the view that Japan lost its

19sustainability of public debt in the first half of 1930s, or in the beginning of Takahashi’s
term. This is consistent with views presented by the Ministry of Finance [1965] andShima [1983].
Why did Japan’s public debt become unsustainable in the first half of the
1930s? The quantitative analysis above says very little about it. We should not conclude
that Takahashi’s strategy of debt-financed fiscal spending resulted in “accumulation of
deficit-covering bonds and inflation” only with the quantitative analysis. Narrativemodes of analysis shed light on this question.
4. Narrative Analysis of Developments in Fiscal Policy
We explore the developments which drove Japanese public debt unsustainable
in the first half of 1930s. We focus on the governance of fiscal policy, both from domestic
and international sides. From the domestic side, we focus on the coordination problemof political institutions under the Meiji Constitution. From the international side, we
focus on the fiscal discipline associated with the international financial markets under
the gold standard system. We explore the cases after the Russo-Japanese War, during
the 1920s, and on the eve of Takahashi’s debt-financed fiscal spending policy. And, we
explore the logic and the reality of Takahashi’s debt-financed spending policy. We
review previous works and look at new archives to employ the case study.
a. The Political Institutions under the Meiji Constitution
The conduct of fiscal policy is different from other macroeconomic policy, i.e.
monetary policy, from the viewpoint of political economy. Historically, fiscal policy has
not been decided by a single entity, e.g. MOF and/or the Cabinet, which is primarily
responsible for public finance. Fiscal policy has been decided by negotiations on budget
among various political players, including MOF, the Cabinet, political parties, andother various interested groups. In contrast, monetary authority has been concentrated
in a small group, either in the central bank and/or in MOF even if pressures fromoutsiders are harsh. The crucial element of monetary policy is the relationship with theparticipants in the financial markets in a broad sense.
The political institutions under the Meiji Constitution of 1889 conditioned thebudgetary process of pre-WWII Japan. The Cabinet had a very limited capacity tocoordinate political players. Under the Meiji Constitution, various entities withauthorities were directly linked to the Emperor. Such authorized entities include theHouse of Lords, the House of Representatives and political parties, bureaucrats, the20

Privy Council, Army, Navy, and the Cabinet. 19 The Cabinet had to make any decisionby unanimity. If a single member of the Cabinet, e.g. Army Minister or Navy Minister,
disagreed with other members, the Cabinet had to resign. The Senators, who wereappointed by the Emperor as informal advisers with no provision in the Constitution,
acted as the behind-the-curtain coordinators from time to time. But, the Senators’capacity for policy coordination was also limited. 20
The Army and Navy had an effective veto in the budgetary process. The Armyand Navy served under the supreme command of the Emperor, and had the authority to
decide the long-term national defense plan and day-to-day military operations
independent of the Cabinet. A Prime Minister was allowed to look at the national
defense plan only after ratification by the Emperor. The Cabinet and MOF devoted theirefforts to negotiations with the Army and Navy in the annual budgetary process.
Sometimes they reached compromises with the military. Sometimes they failed to do so,and the Cabinet resigned.
b. The Case after the Russo-Japanese War: Maintaining Sustainability (1)We explore the political economy of the sustainability of Japanese public debt
after the Russo-Japanese War. Participation in the international financial markets
under the gold standard worked as a governance mechanism for keeping thesustainability of Japanese public debt while coordination problems under the Meiji
constitution put the sustainability in question.
Joining the gold standard was a choice of policy regime. Under the gold
standard regime, a country enjoyed easy access to international financial markets whenit needed to borrow large amounts of money, for example, during wartime. In return,the government sacrificed the needs of the domestic economy in order to maintain an
external balance and gold parity in ordinary times. Sound fiscal policy was prerequisite
for joining the gold standard. In this regard, Bordo and Rockoff [1996] argue thatadherence to the rules of the gold standard signaled prudent fiscal and monetary
policies of the country, and provided improved access to capital from the core Westerncountries.
The late 19th and early 20th centuries were the heyday of the international gold
standard. Japan adhered to the principles of sound fiscal policy even before joining the
19 Nakamura [1993], pp.10-13; Muramatsu and Ito [2001], p.82.

20 Emperor Mutsuhito the Great, on the throne in 1867-1912, appointed nine Senators

during his reign. His successors appointed no one. As a standard practice, the Emperor
appointed a Prime Minister in accordance with the Senators’ advice. Nakamura [1993],
pp.12-13.
21

gold standard, and joined the gold standard in 1897. Before joining it, there was a great
deal of opposition from the business community, which argued that staying on silver
would make Japanese products more competitive in the international markets thanmoving into gold. The then Prime Minister and Finance Minister Matsukata went
ahead with joining the gold standard.
Adherence to the Gold Standard enabled Japan to finance the Russo-Japanese
War by borrowing money in Europe and North America. The war expenditure amounted
to 1,826 million yen or 187 million pound, 60 percent of Japanese GNP in 1904. Japanissued bonds of 1,045 million yen or 107 million pound (in face value) in London andother overseas markets in 1904-05 to finance the war. Eiichi Shibusawa, adistinguished business leader and a principal opponent against the gold standard before
joining it, later said, “I realized several years later (of joining the gold standard) that itwas crucial for Japan. And, I sincerely admired Lord Matsukata for rejecting my
opinion.” 21
Participating in the international financial markets was consistent with othernational goals. Japan intended to expand in Asia in cooperation with theAnglo-American alliance. 22 Foreign Minister Jutaro Komura asked for the support ofthe British and American governments when the war with Russia became inevitable.
He emphasized that the purpose of war was to liberate Manchuria from Russia, andthat the war met the national interests of Britain and the United States. Komura asked
President Theodore Roosevelt to mediate for peace. Korekiyo Takahashi, then Vice
Governor of BOJ, cooperated with the British and American financial leaders to sell
Japanese public bonds to the Western investors.
The sustainability of Japanese public debt was put into question after the
Russo-Japanese War. Both international and domestic investors were worried about thecountry risk of Japanese government bonds. They were concerned with the burdens ofJapan’s wartime debt and increasing fiscal spending for promoting Japanese strategicand economic interests in China and Korea. Prices of Japanese government bonds(JGBs) in secondary markets dropped and new issues of JGBs suffered from a slump insales. 23
Japan restored the credibility of its bonds by tightening its fiscal policy. The

21 “Speech at the Dinner of 20th Anniversary of the Gold Standard in Japan,” November

1, 1917, reprinted in BOJ [1958], p.703.

22 Metzler [2006] and Smethurst [2007] provide extensive narrative evidence thatJapanese political leaders recognized the importance of cooperation with
Anglo-American alliance and pursued it.
23 Kamiyama [2000], p.48.
22

Japanese policymakers, including the military, agreed to limit government spending
within the range of maintaining gold parity. The first Saionji Cabinet (1906-08)
committed to reduce new bond issues in 1906 with the request of Takahashi, who was
negotiating with Western financial leaders on the refinancing of war bonds. 24 The
second Katsura Cabinet (1908-11) announced the principle of a balanced budget in 1908.
These two Cabinets increased taxes and postponed military and other spending. 25 And,the prices of JGBs recovered in 1908. 26
Political players, including the military, reached a consensus on tight fiscal
policy because they recognized the importance of the credibility of public debt forachieving national goals. In the early stages of negotiation, MOF pursued a balanced
budget while the military insisted strengthening their potential for promoting Japanese
strategic interests. The Army insisted on an increase of divisions, and the Navy insisted
on an increase in fleet size. A Senator, Kaoru Inoue, insisted on tighter fiscal policy torestore the credibility of Japanese bonds. 27 Kinmochi Saionji and Taro Katsura
persuaded the military and reduced their budget requests. 28
The case after the Russo-Japanese War indicates a kind of governancemechanism worked through the international financial markets under the gold
standard. Japan’s case during this period is a perfect example of Bordo and Rockoff’s
argument. The Japanese government proved their commitment to the gold standard.
And they were rewarded by the cheaper cost of fundraising in the international
markets.
c. The Case during 1920s: Maintaining Sustainability (2)The participation in the international financial markets worked as agovernance mechanism for keeping the sustainability of Japanese public debt evenwhen Japan had suspended the gold standard during 1920s.
Japan suspended the gold standard in September 1917, following the Westerncountries, and tried to return to the gold standard in the 1920s. Incidents such as theGreat Kanto Earthquake in September 1923 and the Financial Panics in the spring of
1927 hindered the government’s final decision. Japan finally returned to the gold
standard in January 1930.

24 Kamiyama [2000], pp.42-43.

25 The principle of the second Katsura Cabinet is called hibosai-shugi, literally “theprinciple of no new bond issue.” Kamiyama [2000], p.56.
26 Kamiyama [2000], p.57.
27 Kamiyama [2000], pp.54-55.
28 Masumi [1988], pp.140-172.
23

When Japan was off gold, Japan once issued foreign bonds in February 1924 in
London and New York, with expensive servicing costs. The yield was 7 percent. 29 The
purpose of the issue was to refinance a part of the Russo-Japanese War bonds due on
1926 and to finance the earthquake reconstruction. People called the bonds “the bondsof national disgrace” because the terms were against Japan. 30
The Hamaguchi Cabinet (1929-31) committed to returning to the gold standard
and to disarmament. Tight fiscal policy was consistent with these goals. Prime Minister
Hamaguchi declared that, “We will take decisive actions for fiscal austerity of thecentral and local governments. We will restrict the budget of the Army and Navy to an
extent that will not to affect national defense. By doing so, we will promote businessrestructuring and thrift to the people.” 31 Japan returned to the gold standard inJanuary 1930, and concluded the London Naval Treaty in April. Japan ratified thetreaty in October though hardliners in the Navy were opposed to the ratification. In
November, MOF and the Navy reached agreements on budgetary treatment on thisissue.
Hamaguchi gained political support from the public and from the Senator
Kinmochi Saionji. 32 Hamaguchi dissolved the House of Representatives in January 21,
1930, the opening day of the London Naval Conference and one week after returning to
the gold standard. The Ruling Minsei-To Party overwhelmingly won the generalelection. Senator Saionji publicly supported Hamaguchi’s policy of cooperation with theUnited States and Britain. 33
Eigo Fukai was a distinguished economist, served as Vice Governor of
BOJ(1928-35) and Governor (1935-37), and became one of primary policy advisers to
Korekiyo Takahashi during Takahashi’s term in 1932-36. Fukai argued thus for thepolitical economy of macroeconomic policy in favor of the gold standard in his book in
1928:“It is generally difficult to establish adequate standards for monetarycontrol. And even if established, it is difficult to maintain them. The gold
standard defines a currency to be exchanged with a certain amount of gold. This
constraint set the extent and the direction of monetary control naturally though
29 The coupon for Sterling bonds was 6 percent and the issue price was 87.5 pounds forthe face value of 100 pounds. The coupon for dollar bonds was 6.5 percent and issue
price was 92.5 dollars for the face value of 100 dollars. MOF [1940], p.450.
30 Nakamura [1993], p.75.
31 “Statement by Prime Minister Osachi Hamaguchi,” Government Gazette, July 10,
1929, reprinted in BOJ [1968], p.394.
32 In the late 1920s and early 1930s, Saionji was the only Senator alive.
33 Masumi [1988b], p.10.
24

not automatically. Even if the discretion of policymakers is defective, theadverse effects will not go too far under the gold standard.
Recently, policymakers need the consent of the public in order to conductmonetary policy. From the perspective of immediate benefits, an abundantmoney supply may be the best bet both for fiscal and macroeconomic policy
objectives; nonetheless, the money supply needs to be properly controlled to
avoid future setbacks. It is, however, difficult to persuade the public simply byexplaining monetary theories or standards for monetary control. The
explanation that money should not be issued excessively because it must bebacked by a certain amount of gold would immediately convince the public. With
the restrictions under the gold standard, policymakers could keep sound andsecure money.” 34
Returning to the gold standard paid off in a sense even though the domestic
economy fell into depression. Japan issued foreign bonds in May 1930 in London and
New York with the yield of 6.2 percent, a substantial reduction in servicing costs
compared to the 1924 issues. Again, the purpose of the issue was to refinance a part of
the Russo-Japanese War bonds due in January 1931. Juichi Tsushima, Vice Minister ofFinance for International Affairs, later told about the importance of returning to thegold standard for issuing bonds in the international markets. He said, “Before returning
to the gold standard, bankers in Britain and the United States insisted with one voicethat issuing bonds in the international markets was difficult with the unstableexchange rate of the yen. They insisted that Japan should stabilize the currency first,
and issue bonds in the international markets next.” 35 Itoh [1989] argues that the
Hamaguchi Cabinet hurried to return to the gold standard partly because they needed
to refinance the war bond before its redemption. 36
The case during the 1920s indicates the enduring governance mechanism
through the international financial markets under the gold standard. The Japanese
government restored the commitment to the gold standard, and was paid off withcheaper cost of fundraising in the international markets.
d. The Turning Point: Losing Sustainability, September 1931
Two events in September 1931 were critical for the governance of Japanese

34 Fukai [1928], pp.302-303.
35 Tsushima [1965], p.65.
36 Itoh [1989], p.213.

25

fiscal policy. The first is the Mukden Incident, or Manchuria Incident, which began on
September 18. Another one is the British departure from the gold standard on
September 21. The Mukden Incident heightened the domestic coordination problems
among political players under the Meiji Constitution, and the British departure fromthe gold standard eroded the governance mechanism through the international
financial markets.
The Japanese government lost the ability to govern military spending during
the Mukden Incident. The Kwantung Army 37 escalated the operation without theconsent of Tokyo. The commander of the Unit of the Imperial Japanese Army in Korea
sent his troops to Manchuria without permission. Although the government originallysaid that it would not expand the military operation, the military undermined this byextending operations. The government later confirmed that it would pay the costs forsending troops from Korea. Heightened military tensions with China provoked tensions
with the United States, and the military demanded a larger budget for dealing withthese tensions.
The British departure from the gold standard eroded the rationale for staying
on the gold standard. For peripheral countries, including Japan, sound fiscal policy andadherence to the gold standard did not ensure easy access to the international financial
markets any more. Fukai later wrote in his memoirs, “In retrospect, it would have been
sensible for Japan to have departed from the gold standard immediately because the
British departure was a change in the global situation.” BOJ first tried to suppress
capital outflows to support the gold standard, raising the official discount rate twice in
October and in November. Market participants anticipated that Japan would follow
Britain as with other countries row, inducing massive capital outflows. Japan departed
from the gold standard on December 13, 1931, under the leadership of Korekiyo
Takahashi, who returned to the position of Finance Minister on the day.
Two events in September 1931, the Mukden Incident and the British departurefrom the gold standard, indicate that the governance mechanism for sustainable public
debt was already lost when Takahashi returned as Finance Minister in December of theyear.
e. The Logic and the Reality of Takahashi’s Debt-Financed Spending Policy
We explore the logic and reality of Takahashi’s debt-financed spending policy

37 The Kwantung Army was a unit of the Japanese Imperial Army based in Kwantung

Peninsula, northern China.
26

with his addresses at the Diet and other archive materials. 38
Takahashi emphasized the temporary nature of the increasing fiscal deficit
and justified the increased public debt with the logic of intertemporal tax smoothing. He
said, “We will finance the whole fiscal gap in 1933 with debt. This is because primaryfactors of increase in expenditures are temporary, too large to finance with increase intaxes and other revenues, and because increase in taxes and other revenues would
break the budding economic recovery. This is not yet the right time for tax increase.” 39
Takahashi mentioned that if public debt becomes unsustainable, the symptoms
appear in the financial markets. He said, “How should we measure the limit of public
debt? If a government tries to issue more bonds and print more money than that theprivate sector is able to manage, bad inflation would follow. The other possibility is thatpeople would not credit the currency. In this case, symptoms would appear in theexchange rates.” 40
Takahashi was worried about depreciation in the exchange rates rather thaninflation. He said, “How much has the government had BOJ underwrite public debt? It
is about 1.7 or 1.8 billion yen. Now, BOJ only holds 0.2 billion yen. This indicates that
bad inflation is remote at this time. I am worried about [the depreciation of] theexchange rates, which would hurt the public reputation of the Japanese currency.” 41
Eigo Fukai, then the Vice Governor of BOJ and one of the primary policy
advisers to Takahashi, handed a short memo to Takahashi on the sustainability of
public debt in September 1934. 42 It is likely that Takahashi consulted Fukai aboutpublic-debt management, and that Takahashi’s talks in the Diet in the beginning of1935 were based on the opinion of Fukai. The logic of Takahashi’s talks in the Diet wasalmost the same as Fukai’s memo. Presumably, Fukai explained monetary theories andtheir application to debt management to Takahashi by the memo.
Fukai regarded the policy instruments of the underwritings of government

38 Among others, Ide [2006] provides extensive narrative evidence on this issue.
39 “Speech by Finance Minister on Debt Management in Fiscal 1933 Budget, An

Explanatory Session, General Meeting of House of Representative, 64th Assembly,
January 21, 1933,” reprinted in MOF [1954], p.575.
40 “Rejoinder by Finance Minister to the Question by Gotaro Ogawa, Budget Committee,
House of Representative, 67th Assembly, Janurary 31, 1935,” reprinted in MOF [1954],
p.583.
41 Ibid. p.583.
42 A copy of the memo, “An Opinion of the Vice Governor on the Capacity of Government
Bond Issue,” is included in “Documents on Capacity of Government Bond Issue,
January 1933-August 1935,” BOJ Archive No. 1895. The document is written on
business stationery of Research Department of BOJ. On the top of the document, a notesays, “This is copied by staff personally.”
27

bonds and the selling operations of these bonds by BOJ as convenient facilities forextending the capacity of the government to finance debt. Fukai wrote, “Public issues ofgovernment bonds induce a tightening of financial markets. If BOJ underwrites
government bonds, fiscal spending precedes the selling operations of BOJ, inducing aneasing of the money markets and a decrease in interest rates.” He continued, “The limitof public debt under the facilities [underwritings of government bonds and the selling
operations of these bonds by BOJ] depends on how far we can continue these kinds ofoperations.”
Fukai concluded the memo by emphasizing two dangers for the sustainabilityof public debt. He emphasized the dangers of suspicion about future repayment of the
public debt by market participants and of anticipation about the declining value of thecurrency by them. Fukai wrote, “The most alarming thing would be incapacity of
government bond issue either from suspicion about future repayment of the public debt
or from anticipation about declining value of the currency. If this happens, it would
cause problems in fiscal policy, and at the same time, it would have disturbing
consequences on economic and social institutions. If people anticipate the declining
value of the currency, interest rates will soar. The incapacity of government bond issue
is the result of the anticipation, and at the same time, it foments the anticipation. Thatis a vicious circle. One would say that I am worrying over nothing because we see nosuch symptoms up to now. But, we should watch out for the danger because if we once
get into a vicious circle, we will be swept away too fast to deal with it. Though our policy
objective [the management of public debt] is a part of the national strategies forsupreme national goals, we should look at it in the most prudent manner in terms offiscal, monetary and exchange rate policies. I dare to mention exchange rate policy
because anticipation of the declining value of the currency often appears in theexchange rate markets.”
Fukai intuitively understood Bohn’s notion that “an agent’s ability to borrow isconstrained by other agents’ willingness to lend.” Fukai argued that symptoms
appeared in the financial markets as soaring interest rates on government bonds and/or
falling exchange rates when investors had doubts about the sustainability of public debt.
He insisted on policies avoiding these situations in the financial markets. Fukai learned
from the experience of hyperinflation in Central Europe after WWI. 43
MOF tried to reduce fiscal deficit under Takahashi’s leadership. They
negotiated with the military and other ministries about the postponement of
43 Fukai wrote a number of articles on the hyperinflation in Central Europe. Fukai[1929], pp.1-64, Fukai [1938], pp.317-325, Fukai [1941], pp.250-255.
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expenditures and transfers from special accounts to the General Account. They
achieved some reduction in the amount of new issues of government bonds in fiscal 1936,
but the reduction was far from enough. The negotiation increased tensions with themilitary, paving the way to the assassination of Takahashi on February 26, 1936 by agroup of militarists.
MOF also introduced regulations to prevent free falls of the exchange rates.
The Foreign Exchange Control Law was proclaimed on March 1933 and came into effecton May. Under the law, the regulations on foreign exchange transactions were
substantially extended and tightened. Almost all the transactions related tointernational capital flows were subject to regulation. At the same time, speculations on
foreign exchange were forbidden by finance ministry ordinance.
f. Sustainability of Public Debt: After the Russo-Japanese War and during the Early
1930s
In both periods, the sustainability of government debts was in question. The
government accumulated foreign and domestic debts during the Russo-Japanese War,and the government faced new needs for fiscal expenditures after the War. In the early
1930s, Japan departed from the gold standard, and initiated debt-financed fiscal
spending in the midst of the Great Depression.
On the domestic side, the political institutions under the system of the Meiji
Constitution of 1889 made governance of fiscal policy difficult. This was the case both
after the Russo-Japanese War and in the 1930s. The cabinet’s political power was
limited when it came to coordination among various political entities.
The political institutions gave the military an effective veto in the budgetaryprocesses. The military had authority to create their own spending plan without
consulting with other cabinet members or with the budgetary branch, and then tonegotiate with the Ministry of Finance to finalize the annual budget. If the military
disagreed with cuts in military spending, they could reject the budget at the cabinet
meeting.
On the international side, financial constraints under the international gold
standard enforced fiscal discipline after the Russo-Japanese War. This mechanism
lasted until the 1920s. This was not the case when the international gold standard wasin trouble during the early 1930s.
In the 1930s, the military did not agree to limit military spending within thelimits necessary to maintain gold parity. The international gold standard was falling
into chaos after the departure of Britain in September 1931. Japan could not expect29

easy access to the international financial markets, even if it adhered to the principles of
the gold standard. Rather, the adherence to the gold standard worsened economic
conditions. Japan departed from the gold standard in December 1931, following Britain,
and initiated debt-financed fiscal spending.
During the 1930s, Japan lost fiscal discipline because of the military’s effective
veto over budgetary processes, and because of the absence of pressure for sound fiscal
policy from international financial markets. The budgetary process during the 1930s
failed to restrict fiscal expenditures. And no monitoring mechanism of Japanese publicfinance existed any more.
When Japan was losing the ability to sustain its public debts, fiscal andmonetary authorities introduced a new method for financing public debts, theunderwriting of government bonds by the Bank of Japan. Though trying to prevent thecollapse of the securities markets, they were only able to delay the collapse. And they
were forced to depend on this method more and more in the absence of fiscal discipline.
5. Concluding Remarks
In this study, quantitative analysis shows that Japan lost the sustainability of
its public debt in around 1932. Narrative analysis indicates that Japan lost its fiscal
discipline because of the military’s effective veto over budgetary processes, and becauseof the absence of pressure for sound fiscal policy from international financial markets.
The turning point was September 1931.
In this study, we have explored some aspects of the governance of the fiscal
policy of Japan by focusing on the domestic political institutions and the international
financial markets. We need more research on related topics to draw complete pictures.
Future topics include the impact of domestic socio-economic conditions such as
depressions in rural areas, developments in financial markets which enableddebt-financed fiscal policy, and the impact of international geopolitical conditions suchas growing tensions in Asia-Pacific region induced by Japanese expansion.

30

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