Masaaki Shirakawa: Revisiting the philosophy behind central bank policy
Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Economic Club of
New York, New York, 22 April 2010.
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Introduction
Thank you for your kind introduction. It is a great pleasure and an honor to have the
opportunity to speak today at the Economic Club of New York, with its over one hundred
years of history at the heart of the world's financial markets. 1907, the year this esteemed
Club was founded, is also remembered as the year when the United States was struck by a
nationwide banking crisis. There had been a few unsuccessful attempts to set up a central
bank before the crisis, but in the aftermath of the Panic of 1907, the momentum to establish
one strengthened, and the Federal Reserve System was created in 1913. Interestingly
enough, the Bank of Japan, the Federal Reserve and the Economic Club of New York have
had ties since the early days. Mr. Benjamin Strong, the first President, or at that time the
Governor, of the Federal Reserve Bank of New York spent three months in Japan in 1920,
developing a strong personal bond with the then Governor of the Bank of Japan, Junnosuke
Inoue1. On his return to the United States, Governor Strong donated many volumes of books
to the Bank of Japan on the US financial system and the Federal Reserve. One of those
books was, "A History of Currency in the Unites States", written by the first Chairman of this
Club, Mr. Barton Hepburn2. The book can still be found in our Bank's library, and by
observing the red underlines on the pages of the book, I can comprehend that my
predecessors had thoroughly read this book to study how the US had dealt with the financial
crisis.
Speaking of financial crises, Japan experienced a severe financial crisis in the 1920s, and
this led to the introduction of on-site examinations of financial institutions by the Bank of
Japan, which continues to be a valuable source of information for the central bank today. For
several decades after this crisis, the Japanese financial system did not face serious strains to
its stability. However, from the mid-1990s to the early part of the 2000s, we were once again
hit by a major financial crisis. In the case of the US, the current financial crisis which started
in August 2007 is the worst crisis since the Great Depression-era. I assume many of you who
are sitting here today had known of past financial crises, but did not expect to actually
experience a crisis of this scope and magnitude during your life times. When we were
experiencing our own bubble more than twenty years ago, I myself certainly did not
anticipate the severity of the crisis which we were to experience. Japan experienced its crisis
more than ten years ago, but watching the US-triggered financial crisis unfold and spread
across the global financial system, I cannot but help feel a sense of déjà vu. There are a
number of similarities between these two episodes, for example, optimism immediately after
the bursting of the bubble, delay in implementing some key policy measures, a prolonged
economic downturn, hostility towards financial institutions, criticism aimed at supervisors,
regulators and central bankers, to name some.
The current crisis has not reached the end of its cycle yet. However, as far as I can see at
the moment, two pressing issues have emerged. First, we must bring the global economy
back to a sustainable growth path. Second, we must prepare measures to prevent the
recurrence of such a crisis. The Bank of Japan is making our utmost efforts to tackle these
two challenges, working in cooperation with the Federal Reserve and other authorities. If we
were to find a silver lining in the financial crisis, it would be that it has given all of us,
including financial institutions, non-financial corporations and policymakers, the opportunity
to rethink the validity of the mindset upon which business strategies are developed, and of
the philosophy behind the policy conduct that we had become so accustomed to. In what
follows, I would like to elaborate on these issues.
Why do financial crises repeatedly occur?
Why do financial crises, and for that matter bubbles which precede them, occur repeatedly?
Many reasons are given - lax risk management, excessive leverage, existence of financial
institutions which are perceived to be too-big-to-fail, failure of supervision, excessively
accommodative monetary policy and the list goes on. I generally agree with such
assessments, but we also need a holistic perspective which cannot be captured just by
focusing on individual causes. From this perspective, I would like to emphasize that, what
one could term as a "cycle of confidence" which evolves over a very long time horizon, plays
a decisive role. Success breeds confidence which unfortunately turns into over-confidence or
even arrogance. Complacency also sets in. The collapse of the bubble based upon this
overconfidence leads now to under-confidence, which is followed by rebuilding efforts. Then the
cycle begins once again.
During the latter half of the 1980s, Japan's economic performance stood out among the
advanced economies. While growth in the other G7 countries averaged 3.4%, the Japanese
economy grew at an annual rate of 5.1%. The inflation rate measured by CPI was on
average 3.9% in the G7 countries excluding Japan, while it was 1.1% in Japan. Although
inflation targeting became popular later in the 1990s, if one were to apply the criteria used by
countries adopting inflation targeting, Japan would have received an "A+" during the latter
half of the 1980s. Externally, through a continuously large current account surplus, Japan
became the world's largest net creditor nation. In this benign environment, the Japanese
became over-confident. Of course, there were worrying signs. The extension of credit
increased sharply and asset prices boomed in the latter half of the 1980s. However, an
"irrational bull sentiment" engulfed society, drowning out such concerns. With regard to land
prices, the belief that land prices would never fall overwhelmed people's mind. Naturally, the
need for monetary policy to switch to a tightening mode was discussed. In fact, excluding
one source of information, all of the economic data such as high growth, tight labor markets,
surge in bank lending, and bloated asset prices were pointing to the need for withdrawing
accommodative monetary policy. The only exception was the rate of inflation. Stable prices
were a strong rebuttal against the Bank of Japan, which was trying to take away monetary
ease. Entering into the 1990s, the landscape changed dramatically with the bursting of the
bubble, and the Japanese economy came up against huge difficulties. The average growth
rate fell from 5.1% in the latter half of the 1980s to 1.5% in the 1990s. As a result, extreme
pessimism containing irrational elements, or what one can call "irrational bear sentiment",
emerged. There are multiple reasons for the sluggish performance of the Japanese economy
in recent years and it would be inappropriate to over-emphasize the impact of the bursting of
the bubble or asset deflation. However, there is no doubt that the bubble and its ensuing
collapse had major implications for the long-term health of the Japanese economy.
This "cycle of confidence" seems to apply not only to the Japanese economy, but also to the
US economy. Since the mid-1960s, the performance of the US economy started to
deteriorate, and the late-70s and early-80s were the worst period, facing both high inflation
and low growth, or in another word, stagflation. However, policy efforts to revitalize the US
economy began precisely during this testing time. Chairman Volcker's efforts to tame
inflation and deregulation under the Reagan administration, both were set in motion during
this difficult period, and the efforts gradually began to bear fruit over a long period of time.
The rate of growth of the US economy accelerated from 3.1% in the 1980s to 4.0% in the
latter half of the 1990s. This economic expansion briefly paused at the beginning of the new
century due to the collapse of the IT bubble, but accelerated once again after a relatively
short period. There was much discussion regarding the macro economy and how to interpret
the decrease in the volatility of the growth rate and inflation rate. The phrase "Great
Moderation" was repeatedly mentioned. In this environment, a very bullish view regarding the
economic outlook prevailed. There was much debate about whether the rise in house prices
was a bubble or not. However, the basic messages we repeatedly heard from both
policymakers and academia here in the United States were, that "there will not be a
nationwide decline in house prices" and that "even if a bubble were to burst, it would be
manageable through aggressive monetary easing". With regard to the financial system, the
presumption was that the risk management of US and European banks were much more
sophisticated and efficient than that of Japanese banks3. Unfortunately, as we all know now,
such optimistic views proved to be wrong. Both the Japanese case and US case show how
damaging over-confidence can be.
Why couldn't policy makers put on the brakes?
I have taken you through a quick assessment of the recent bubbles in Japan and the United
States from the perspective of a "cycle of confidence". But looking around the globe, such
episodes are not confined to these two cases. Just looking back at the last quarter of a
century, there was the bubble and its collapse in the Nordic countries during the 1980s, and
the Asian Miracle followed by the Asian currency crisis in the 1990s, to name a few. Human
beings know that sometimes we become over-confident and our actions become excessive.
That is why we have developed pre-set mechanisms to put on the brakes. The private sector
has various devices. For example, financial institutions have internal risk management
sections. Market discipline is extended by shareholders, creditors and counterparties to
guard against excesses by senior management of financial institutions. Meanwhile, central
banks and financial regulators and supervisors also function as a braking device.
Unfortunately, in these crisis episodes, the devices in both the private and public sectors
failed. The failure of these two sets of devices entails very important issues, but in the
interest of time, I will focus only on the public-sector device. As a central banker, I believe we
need to examine critically and thoroughly the failures of central banks and financial
regulators and supervisors.
Conduct of monetary policy
First of all, let me touch upon the conduct of
monetary policy. There has already been
considerable debate about the relationship between monetary policy and emergence of
bubbles. One thing is clear: over-confidence is the core factor which breeds a bubble. In that
sense, bubbles do not transpire from expectations of a continuation of low interest rates
alone. This is, however, only a half of the truth. The other half is that bubbles do not
materialize without expectations that low interest rates will continue. For me, the key
question, which applies to many central banks including both the Bank of Japan and the
Federal Reserve, is that, why we, as central banks, maintained interest rates at such a low
level, in spite of the uneasiness we felt at that time toward the bubble-like symptoms. There
are three possible reasons.
First, the economic environment has evolved in a way that imbalances in the economy do not
readily show up in the form of changes in the price of goods and services. The success in
attaining price stability lent support to public confidence in the central bank's conduct of
monetary policy. As a result, inflation expectations of private sector economic entities
became well-anchored to a low target inflation rate. Thus, imbalances in the economy began
to appear in forms other than inflation of goods and services. Imbalances materialized in
different forms such as increases in asset prices and growth of credit extension.
Second, some political, economic and social dynamics influenced central bankers, and it
became difficult for them to conduct monetary policy based on factors other than the inflation
rate. This mechanism is quite subtle. The logic that price stability is a precondition for
economic stability and that the independence of the central bank is necessary for price
stability, became gradually but firmly established in the 1990s. At the same time, the granting
of independence naturally called for the strengthening of accountability. An easily identifiable
benchmark was desired. The framework which best fulfilled such needs was inflation
targeting. However, under an inflation targeting regime, the debate tends to center on the
relationship between the target inflation rate and the actual or expected inflation rate. As a
result, the cost of justifying adjustments in monetary policy becomes quite high in the eyes of
central bankers, when such adjustments are aimed to deal with imbalances which appear in
forms other than price indices. Economists focused their attention to the linkage between the
output gap and the inflation rate, while awareness toward financial imbalances was limited.
Factors which could not be captured through movements in the price of goods and services
fell through the cracks. Institutional changes to transfer the responsibility for financial
regulation and supervision away from the central bank also accelerated this trend.
Third, the meaning of the danger of slipping into deflation was not necessarily correctly
understood in a well balanced manner. In this context, Japan's so-called "lost decade", the
experience after the collapse of the bubble, was often cited as an evident example,
emphasizing the harmful effects of the continuous decline in the price of goods and
services4. However, the serious difficulties that Japan faced were overwhelmingly caused by
the fall in asset prices rather than the drop in the general rate of inflation. In the Japanese
case, real estate prices in major metropolitan areas dropped by 70 to 80 percent from their
peaks, while the cumulative fall in CPI was three percentage points between 1997 and 2004.
Nonetheless, the Japanese experience was misinterpreted. The prevalent mood at that time
can be easily noted in documents such as the IMF's World Economic Outlook released in
April 20035 and the transcripts of the 2003 Jackson Hole Economic Symposium hosted by
the Federal Reserve Bank of Kansas City6. When the Federal Reserve reduced the target for
the federal fund rates in June 2003, the aim to avoid "an unwelcome substantial fall in
inflation" was provided as the reason for its action. Looking back, during this period, while the
risks of deflation were highlighted quite strongly, the subtle role of interest rates to
dynamically allocate resources tended to be disregarded. And it was exactly during this
period that the seeds of the crisis were sown in the form of the expansion of credit and
leverage, and the increase in maturity mismatches.
Financial regulation and supervision
Let me now move on to financial regulation and supervision. Since the mid-2000s, central
banks and supervisors had sent out warning signals on the perceived excesses of various
transactions through financial stability reports and speeches. However, beyond such steps,
too few remedial actions were taken vis-à-vis individual financial institutions. Of course, it is
always quite difficult to take preemptive action on individual financial institutions. But going
beyond such general comments, I believe the following reasons can be given for this
constraint.
First, confidence in the effectiveness of private sector self-regulation or the disciplinary
mechanisms built into financial markets may have been too strong. The continued benign
conditions of the macro economy also had an effect. In the "Wealth of Nations", Adam Smith
emphasized the benefits of free competition. However, it seems he was also concerned
about leaving market forces alone to dictate all aspects of economic activity. Case in point is
the area of finance. He noted that if the rate of interest were to become too high, the greater
part of the money would be lent to prodigals and projectors, and money would be kept out of
the hands of sober people7. Before the current crisis, I had not made much of these words by
Smith, but now I have come to feel that I need to assess its implications more carefully.
Second, authorities became more cautious about the discretionary use of their supervisory
powers. Regulation is a necessary tool in maintaining financial stability, but it is not possible
to design regulation beforehand which can be applicable to all future situations. Therefore,
effective supervision becomes important. What becomes necessary is a form of supervision
which is adaptable to each financial institution's unique risk profile. Naturally, such
supervision must involve some elements of discretion. However, as the pressure for stringent
and prompt accountability increased, supervisors became more cautious about exercising
such discretionary powers.
Third, both central banks and supervisory agencies were lacking the perspective of
assessing the risks of the financial system as a whole. The traditional philosophy of
regulation and supervision was that if the health of individual financial institutions is
maintained, the stability of the financial system will also be preserved. However, as the crisis
has shown, the interactions among financial institutions as well as between the financial
system and real economy played a critical role. In that sense, it was crucial to assess and act
against the risks to the financial system as a whole. However, such a macro-prudential
perspective was not well established.
Revisiting the philosophy behind policy
I have examined the reasons why both monetary policy and regulatory and supervisory
policy were not successful in putting on the brakes. Through such considerations, one feels
afresh the strong influences of the policy philosophy of policymakers, and furthermore, of the
conventional wisdom surrounding policymakers which influence their behavior. As Keynes
pointed out, "sooner or later, it is ideas, not vested interests, which are dangerous for good or
evil"8. It is perhaps time that we revisit the philosophy behind monetary policy and financial
regulation and supervision which we have become so accustomed to in recent years.
Currently, my views on the direction for reassessment which I find necessary are the
following three points.
First, the importance of the objective of central bank policy. Usually, the objective of
monetary policy is defined as price stability. In fact, such a definition seemed to be totally
reasonable until recently. However, it has now been acknowledged that the role expected of
central banks does not match one-to-one with price stability. The experience of the bubble
shows that even when prices are stable, the economy can experience huge swings. What is
expected of central banks is the attainment of a stable financial environment which provides
a basis for sustainable growth. Price stability is certainly one important element of the
stability of monetary conditions. However, it is not confined to this. Rather, when a central
bank becomes too fixated on short-term price stability, this may complicate the attainment of
the ultimate objective of sustainable growth.
Second, the importance of effectively gauging the stability of the financial environment.
Central banks need to pay attention to a broad range of financial indicators, encompassing
credit, leverage, and maturity mismatches. A "stable financial environment" is an abstract
concept and there is no single indicator which can totally capture economic and financial
conditions. However, I would say the same is also true for prices. Measuring prices of goods
and services enabled by new technology is really daunting task. Price of a search engine is a
good example. Even if we seem to have found a single effective indicator, given that it
cannot provide a complete picture of continuously changing economic and financial
conditions, we must continue to review carefully a wide range of indicators. It is a demanding
task, but we must undertake this challenge.
Third, the importance of a healthy amount of discretionary powers. The public sector needs
appropriate discretionary powers, both in the area of monetary policy and financial
supervision. In spelling out the conditions for exercising the "lender of last resort" function of
the central bank, Gerald Corrigan used the words "constructive ambiguity"9 when he was
President of the Federal Reserve Bank of New York. In recent years, the pendulum had
swung substantially toward transparency. However, at the end of the day, the role of central
banks, regulators and supervisors is to prevent instability of the economy and financial
markets, which could materialize if simply left to the free-market competition. If actions of
policy makers were based on mechanical rules which could be fully incorporated into the
behavior of market participants, this may rather end up being a source of instability for the
market and economy. I believe it is time to bring the pendulum back, at least to some extent,
toward allowing more room for discretionary measures.
Concluding remarks
The points I have raised today mean going back to the basics of central banking. But, this
does not mean returning to central banks of the past. The raison d'être of the central bank to
achieve stable financial environment which would enable the achievement of sustainable
growth remains unchanged. However, both the economy and financial markets are evolving
continuously. After the end of World War II, until relatively recently, a stable financial
environment was almost synonymous with price stability. Also, we were quite used to a
financial system structure where the health of commercial banks was almost synonymous
with financial system stability. However, having experienced the current crisis, we have come
to realize that such understandings are now outdated.
When central banks are celebrating success, new problems may be beginning to emerge in
the private sector quietly. By the same token, when central banks are facing difficult
challenges, the green shoots to resolve the problem may already be beginning to grow in the
private sector. Risks always materialize but in new appearance. In this regard, central banks
need to continuously be in a learning mode. As with private-sector economic entities,
complacency is the most dangerous risk for central banks. We need to be humble as
numerous challenges await the global economy. My colleagues and I at the Bank of Japan
will continue to come to grips with these challenges, working in cooperation with fellow
central bankers, and financial supervisors and regulators. In finishing my remarks, I would
like to request you in the private sector for your continued support and assistance, so that
central banks can continue to progress.
Thank you very much for your kind attention.
References
Corrigan, E. Gerald, "Statement before the United States Senate Committee on Banking,
Housing and Urban Affairs," Washington D.C., May 3, 1990.
Federal Reserve Bank of Kansas City, Symposium proceedings "Monetary Policy and
Uncertainty: Adapting to a Changing Economy", 2003.
A History of Currency in the United
Hepburn, A. Barton, States, New York: Macmillan, 1915.
International Monetary Fund, World Economic Outlook, April 2003.
Keynes, John Maynard, The General Theory of Employment, Interest and Money, 1936.
Shirakawa, Masaaki, "Way Out of Economic and Financial Crisis: Lessons and Policy
Actions," Speech at Japan Society in New York, 2009, available at
http://www.boj.or.jp/en/type/press/koen07/ko0904c.htm.
An Inquiry into the Nature and Causes of the Wealth of Nations,
Smith, Adam, 1776.
Strong, Benjamin, "Speech by Benjamin Strong, Governor of the Federal Reserve Bank of
New York, at the Tokyo Ginko Club, May 24, 1920," Papers of Benjamin Strong, file 1000.4,
Federal Reserve Bank of New York Archive.
Tett, Gillian, Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was
Corrupted by Wall Street Greed and Unleashed a Catastrophe, Simon & Schuster, 2009.