Masaaki Shirakawa: 150 years of innovation and challenges in monetary
control
Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, in celebration of the
150th anniversary of German-Japanese diplomatic relations, Frankfurt am Main, 8 March 2011.
* * *
I. Introduction
I am honored to have the opportunity today to speak at Goethe University
(GoetheUniversität Frankfurt am Main) in celebration of the 150th anniversary of German-Japanese
diplomatic relations. I would first like to express my thanks for the warm words of welcome
from Dr. Hölscher, Permanent Undersecretary of the Ministry of Finance of Hessen,
Dr. Raettig, Deputy Mayor of the City of Frankfurt, and Mr. Shigeeda, Consul-General of
Japan. I also extend my sincere gratitude to Professor Gerlach of the Institute for Monetary
and Financial Stability, who has made today's speech possible.
The Bank of Japan (Slide 1) stationed its representative in Berlin from 1919, just after World
War I, and established its representative office here in Frankfurt in 1956. Frankfurt is a
unique city in the world, with two central banks, the Deutsche Bundesbank and the European
Central Bank (ECB) (Slide 2). The Bank of Japan has been developing very close ties with
both of them. I would like to express my gratitude to the Bundesbank, the ECB, and
everyone here in Germany for your support of the Bank of Japan's Frankfurt representative
office.
About 150 years ago, in 1860, a Prussian expedition to East Asia visited Edo, now Tokyo,
and in 1861 concluded a treaty of amity and commerce, which became the foundation of the
subsequent close relationship between Germany and Japan. This was in fact quite an
interesting period in Japan's financial and economic history. In the 1850s, the price of gold
relative to silver in Japan was set considerably lower than in international markets and as a
result there were massive outflows of gold in a short period of time. In response, the
Japanese government issued new gold coins with a much lower gold content. In the process,
inflation rose rapidly due to the expansion of the money stock. There is a caricature drawn in
Japan in 1861 that vividly illustrates the economic turmoil at the time (Slide 3). It shows the
scene of a battle between two armies - a "currency army" with a gold coin as general, and a
"commodities army" with a straw rice bag as general - with one shouting, "Prices, we will
defeat you!" and the other replying, "No, we will not be defeated!" It could thus be said that
Japan at the end of the premodern era found itself suddenly thrown into the currents of
international financial markets, and I am sure that the Prussian expedition was able to
observe the resultant turmoil Japan's economy experienced.
While there certainly has been some progress over the past 150 years in the area of
monetary control, we probably have not made as much progress as we would like, as shown
by the recent global financial crisis. Monetary control is critical for the stability of the
economy. Thus, today I have chosen to talk about "150 Years of Innovation and Challenges
in Monetary Control," drawing on examples from Germany - and Europe more generally - as
well as Japan, from the perspective of a central bank governor.
II. Four innovations in monetary control
In the history of economic activity, the invention of money itself of course represents an
extremely important innovation. Since then, there have been numerous innovations in
monetary control. In what follows, I would like to start with four innovations that I consider
particularly important in modern times.
The invention of central banks
The first and greatest innovation was the invention of institutions called central banks. In
Germany, the first central bank was set up with the establishment of the Reichsbank in 1876,
while the Bank of Japan was established in 1882.1 At that time, there were still only about a
dozen central banks in the world. Of course, most countries today have a central bank. The
establishment of central banks meant that the supply of money was not necessarily
influenced by gold discoveries and other vagaries anymore, and it became possible to
actively control money in a systematic manner through transactions in financial markets.
The invention of a "lender of last resort"
The second innovation is the idea of central banks as a "lender of last resort." In 1861, the
year that the treaty of amity and commerce between Germany and Japan was concluded,
Walter Bagehot became editor-in-chief of The Economist magazine in England. As you
probably know, he later wrote a famous book, Lombard Street, a treatise on the best central
bank practices, providing the first-ever systematic analysis of the roles of a central bank.
In the book, he formulated what came to be called Bagehot's rule, namely that, to prevent
disruption in the financial system in times of crisis, the central bank should act as a lender of
last resort, providing unlimited funds at punitive rates.2 The practical application of Bagehot's
rule has been modified in line with changes in financial market structures, and in the recent
global financial crisis, central banks - including the ECB and the Bank of Japan -
aggressively provided funds to the markets as the lender of last resort, thereby preventing a
collapse of the financial system. The establishment of the principle of the lender of last resort
is of significant importance.
The invention of monetary policy
The third major innovation I would like to mention, although it may sound somewhat strange,
is the "invention of monetary policy." While I will touch later on the issue of how to define
monetary policy, for the time being I will use the term in the conventional sense of "policy that
aims at actively influencing the inflation rate or the economic growth rate by controlling the
level of short-term interest rates." Under the gold standard, the quantity of money was
constrained by gold holdings and thus the central bank could not influence the price level and
economic activity in an active manner. In this sense, central banks had limited room to
deploy monetary policy. In fact, monetary policy was not discussed in Bagehot's book.
Monetary policy worthy of the name started only with the transition to a fiat money system.
Nowadays, appropriate monetary policy conduct has become one of the key tools
contributing to macroeconomic stability.
The introduction of the concept of central bank independence
Finally, the fourth innovation has been the idea of central bank independence. While it is only
relatively recently that central bank independence has become firmly established in countries
around the world, interestingly, in Europe active discussions on the enhancement of central
bank independence already took place in the wake of World War I. For example, at the 1922
Genoa International Economic Conference, which aimed at restructuring the international
economic and financial system in the post-World War I period, in the resolution concerning
currency there was a proposal that "banks, and especially banks of issue, should be free
from political pressure."3 It goes without saying that, in subsequent decades, the German
public and the Bundesbank played a significant role in establishing the concept of central
bank independence at an early stage. Let me note that, when stationed in Berlin early in his
career, Mr. Hisato Ichimada - who later became the Governor of the Bank of Japan for eight
years immediately after the end of World War II - witnessed the so-called "miracle of the
Rentenmark" (or "Wunder der Rentenmark") that ended hyperinflation in Germany in the
post-World War I period. It is said that he utilized this experience when he conducted
monetary policy in Japan's post-World War II period (Slide 4).
The idea of central bank independence has begun to become firmly established in countries
around the world since the early 1990s. For instance, the Maastricht Treaty signed in 1992
stipulated central bank independence as one of the conditions for joining the euro, while in
Japan the Bank of Japan's independence in the conduct of monetary policy was stated in law
through the revision of the Bank of Japan Act in 1998. As central banks gained
independence in their monetary policy, this made it legally possible for them to serve as a
medium- to long-term anchor for money.
There have been various other innovations in monetary control apart from the four I just
mentioned. Money supply targeting is one of them. While the Bank of Japan did not adopt
money supply targeting, many central banks in the advanced economies, including the
Bundesbank, adopted it from the 1970s through the first half of the 1980s. However,
subsequently, as the stable relationship between money supply on the one hand and the
inflation rate and economic activity on the other broke down due to technological innovations
in finance, money supply targeting became ineffective and was consequently abandoned. In
this regard, the Bank of Canada Governor Gerald Bouey famously stated that "we did not
abandon money supply targets, they abandoned us." It could thus be said that the specific
methods of monetary control have changed as a result of technological innovation.
Since the latter half of the 1980s, many central banks have adopted inflation targeting -
excluding, however, the Federal Reserve, the ECB, and the Bank of Japan. This approach
has been effective in containing inflation or entrenching inflation levels that had already come
down. However, it seems that this framework, or the focus on the stability of general prices
underlying it, now faces new challenges. From the viewpoint of price stability, economic
performance was benign for a prolonged period through the mid-2000s, giving no apparent
cause for concern, but a large-scale credit bubble built up, culminating in the global financial
crisis. As a result, numerous advanced economies are currently experiencing severe
balance-sheet adjustments associated with the bursting of the bubble. These developments
are having a subtle impact on how inflation targeting and, for that matter, monetary policies
are managed.
Having said that, I am by no means arguing that there is no point in money supply targeting
or inflation targeting. In my view, history seems to suggest that - be it with regard to the
lender of last resort function or monetary policy - it is necessary to constantly review
measures of monetary control in light of changes in the environment. In other words,
constant innovation is necessary.
III. Central banks' policy responses following the global financial crisis
Next, from this perspective of constant review and innovation, I would like to move on to
various unconventional policy measures that major central banks took in the course of the
recent severe financial crisis. While the term "unconventional policies" can be understood by
different people in a number of ways, in what follows I will talk about unconventional policies
by dividing them into two categories: first, measures taken in the midst of the recent financial
crisis as part of central banks' lender of last resort function and aimed at ensuring the
stability of the financial system, and second, measures taken in less difficult times, after the
crisis had settled, that aim at stabilizing economic activity.4
As for the former, the measures were, in essence, in line with the lender of last resort
principle emphasized by Bagehot. However, naturally, the financial system in the
21st century is not quite the same as that in the 19th century when Bagehot lived. Central
banks around the world have faced new challenges he never imagined, and have worked
with considerable ingenuity.
Resolving the issue of stigma
In the course of the recent financial crisis, the first challenge was to resolve the stigma
attached to receiving emergency funds from the central bank. While aggressive liquidity
provision is critical in a crisis, financial institutions might hesitate to borrow funds even in an
emergency and try to raise funds in the market at all costs out of fear that their perceived
creditworthiness will decline if it becomes known that they received emergency funds. As a
result of such collective behavior, the liquidity shortage will accelerate further and interest
rates will rise.
Under the mechanism described by Bagehot, it is assumed that liquidity is provided based on
negotiations with individual financial institutions, which, however, would stigmatize such
institutions. To overcome this problem, major central banks have introduced new measures.
For example, the Federal Reserve in 2007 introduced the Term Auction Facility (TAF), under
which the range of financial institutions eligible for funds-supplying operations was
substantially broadened, the duration of funds provided was significantly lengthened, and
interest rates on funds were determined by auction. And the ECB in 2008 fixed the rate for its
operations to the policy rate and initiated monetary control that provides unlimited funds upon
request from financial institutions.
Responding to the evaporation of market liquidity
The second challenge was to respond to the evaporation of market liquidity. When writing
about declining liquidity, Bagehot also referred to liquidity in the government bond market in
a crisis, but in his time there were neither the kind of complex financial products nor the
derivatives transactions we see today. Therefore, in his day, systemic risk referred mainly to
a contagious bank run on deposits. However, as a result of financial globalization and
technological innovations, the forms in which systemic risk manifests itself have become
more complex and diverse. If counterparty risk heightens, that is, market participants become
concerned about the creditworthiness of counterparties, this can result in an "evaporation of
market liquidity," in which counterparties disappear from the market. If fire sales of assets
spread and market prices start to plunge, the capital position of a large number of financial
institutions may erode due to valuation losses on assets, which could develop into a solvency
problem of financial institutions. To avoid such a situation, liquidity provision through
traditional lender of last resort measures alone will not be sufficient. Instead, someone needs
to serve as a trusted counterparty standing between market participants that no longer trust
each other. During the crisis, it was central banks that played this role.
In this situation, major central banks implemented measures that in essence directly provided
liquidity to fund-raisers in markets where market functioning had deteriorated significantly.
For example, in 2008, the Federal Reserve introduced a policy measure to lend to
CP issuers and holders of asset-backed securities (ABSs). The Bank of Japan also
purchased CP, asset-backed commercial paper (ABCP), and corporate bonds in order to
cope with the rapid decline in liquidity in these markets, which were the main funding sources
for large firms that were directly hit by the financial crisis.
Provision of foreign currency liquidity
The third challenge was the provision of foreign currency liquidity. In Bagehot's day, liquidity
meant liquidity in the home currency for domestic transactions and gold for international
transactions. There is a reference in Bagehot's book to a situation in which the Bank of
England did not sufficiently carry out its lender of last resort function due to concerns over a
shortage of gold. During the recent financial crisis, liquidity in the U.S. dollar funds market
declined significantly and dollar funding became an extremely pressing issue, especially for
private financial institutions whose home currency was not the dollar. In order to ensure that
central banks could smoothly provide dollars to home financial institutions, financial
institutions needed to have a sense of security that central banks themselves could provide
unlimited amounts of dollars. To this end, major central banks, including the ECB and the
Bank of Japan, secured dollar funds by making currency swap arrangements with the
Federal Reserve and then introduced dollar funds-supplying operations domestically. The
currency swap arrangements were made not only for the dollar but also for other currencies.
For example, the ECB and the Swiss National Bank established a currency swap
arrangement for Swiss franc funding, and the Bank of Japan and the Bank of Korea
established a currency swap arrangement for yen funding, both of which contributed to
restoring stability in foreign currency funding markets.
Unconventional monetary policies
Since the recent financial crisis, major central banks have also been implementing
unconventional policies that aim at stabilizing economic activity. These are intended to deal
with the challenge of achieving monetary easing effects to return the economy to a stable
recovery path when nominal short-term interest rates are already near zero. One example is
the increase in the government bond purchases decided by the Federal Reserve in the
autumn of 2010, which aimed at absorbing interest risks in the private sector and lowering
long-term interest rates. Another example is the comprehensive monetary easing decided on
by the Bank of Japan in the autumn of 2010, which includes various unconventional
measures. The measure is quite exceptional in that the eligible assets for monetary policy
operations were expanded to include not only government bonds but also CP, corporate
bonds, exchange-traded funds (ETFs), and real estate investment trusts (REITs). The Bank
of Japan's purchases aim at stimulating economic activity through a reduction in various risk
premiums, as there is little room for a decline in short-term interest rates.
IV. The Bank of Japan's policy response after the 1990s: the bursting of Japan's
asset bubble
Looking at the outcome, it can be said that the unconventional measures to deal with the
global financial crisis have been effective. At the same time, though, the measures pose new
challenges. Before discussing these new challenges in detail, let me digress slightly and talk
about the unconventional policies that the Bank of Japan hammered out from the latter half
of the 1990s in response to the bursting of the asset bubble. This experience meant that the
Bank of Japan had to deal with the consequences of the bursting of a bubble and the
ensuing economic and financial difficulties ahead of other countries. There is not sufficient
time to elaborate today on this point, but let me note that the Bank of Japan has been a
lonely forerunner in terms of the adoption of unconventional policies such as the introduction
of quantitative easing and of a policy duration commitment in 2001. In the course of the
current financial crisis, many other central banks have implemented measures that are in
essence similar to the Bank of Japan's, although they may differ in detail. This shows that
what we are experiencing during the current global financial crisis is not a special case but
reflects changes that are more or less universal. With this in mind, let me explain some of the
unconventional policies pursued by the Bank of Japan, focusing on three measures in
particular.5
Fund provisioning to Yamaichi Securities
The first measure is the provision of loans as a lender of last resort to a securities company
whose solvency could not be judged clearly. In the autumn of 1997, massive
off-balancesheet liabilities were suddenly revealed at Yamaichi Securities, one of the biggest securities
companies in Japan at the time, and it was decided to liquidate the company. However, the
company had bank subsidiaries in Europe, and at that time other Japanese financial
institutions held a large amount of impaired assets. Thus, it was judged that an immediate
legal liquidation would very likely pose a systemic risk. The Bank of Japan, therefore,
decided to provide Yamaichi with an unlimited amount of liquidity to support the orderly
closure of its business operations. However, because the disclosure of off-balance-sheet
liabilities occurred suddenly and financial markets were unstable, there remained uncertainty
about the value of Yamaichi's net assets. The premise of Bagehot's rule is that the
counterparty financial institutions are solvent so that they can submit good-quality collateral.
Since this was not the case, it was all the more difficult for the Bank of Japan to decide the
proper course. Regrettably, at Yamaichi's subsequent legal bankruptcy proceedings, it was
determined in 2005 that part of the loans by the Bank of Japan to Yamaichi were
unrecoverable. However, it should be noted that a situation like the one after the failure of
Lehman Brothers, when real quarterly GDP contracted at a double-digit rate on a
year-onyear basis, was avoided. In other words, the measure prevented the worst-case scenario of
having Japan's financial crisis in the latter half of the 1990s trigger turmoil in the global
financial system.
Operation twist to facilitate foreign currency funding
The second policy measure pursued by the Bank of Japan concerns foreign currency
liquidity. In the latter half of the 1990s, Japanese banks, amid serious concern about their
soundness, faced difficulties in raising U.S. dollar funds, especially longer-term ones. In this
situation, the Bank of Japan, as part of its funds-supplying operations, provided longer-term
yen funds. Japanese banks exchanged these yen funds for dollar funds in the foreign
currency swap market with foreign banks as their counterparties. Viewed from the foreign
banks' side, such transactions were dollar loans using yen funds as collateral. Therefore,
even under the zero interest rate environment, they accepted the trades as long as yen
funding rates were negative, despite the deteriorated creditworthiness of Japanese banks.
However, foreign banks had to find safe investment opportunities for their yen funds. In this
regard, interest-bearing bills issued by the Bank of Japan to absorb shorter-term yen funds
became suitable investment opportunities. Bills sold were safe and had no default risk. This
string of trading ultimately had the effect that the Bank of Japan became the counterparty of
both Japanese and foreign banks, thereby promoting smooth dollar funding for Japanese
financial institutions.
The stock purchasing program
The third measure, introduced in 2002, is the Bank of Japan's purchase of stocks held by
commercial banks. At that time, Japanese banks held large amounts of stocks on their
balance sheets. Therefore, market risk associated with stock price volatility was a major risk
for Japanese banks, and the adverse feedback loop of falling stock prices, restrained
lending, and a deterioration in the real economy became a problem. In these circumstances,
the Bank of Japan decided to purchase stocks held by commercial banks. This measure was
very unorthodox, but was an effective tool in ensuring stability in the financial system and the
real economy through the reduction of market risk associated with banks' stockholdings. The
credit easing and the large-scale asset purchase (LSAP) programs adopted by the Federal
Reserve during the current financial crisis are very similar to the Bank of Japan's stock
purchasing program in that in both cases the central bank absorbs private-sector risks and
thereby aims at improving financial conditions.
V. New challenges
As shown by the examples I have mentioned, central banks in the major economies - in their
role as monetary policy authorities - have been implementing innovative policy measures,
though they adopted the measures at different times: since the latter half of the 1990s in the
case of the Bank of Japan and the current global financial crisis in the case of the Federal
Reserve and the ECB. These policy measures have helped to prevent a depression as deep
as the one that occurred in the 1930s. At the same time, however, as central banks stepped
outside the framework of conventional behavior, they have been confronted with new
associated challenges.
The division of roles between the government and the central bank
The first challenge is the division of roles between the government and the central bank.
When acting as the lender of last resort in a crisis, the central bank must judge whether the
problem it is dealing with is a liquidity problem or a problem concerning financial institutions'
solvency. If the problem is one of a shortage of liquidity, it is the central bank that should act,
based on Bagehot's rule. In contrast, if the problem concerns the solvency of one or more
financial institutions, it is the government that needs to act by, for example, injecting public
funds. However, in reality, and especially during a crisis, it is often difficult to distinguish
between these two problems, as shown by the case of Yamaichi Securities mentioned
earlier. Moreover, even if it is possible to tell the difference, the decision of injecting public
funds tends to be delayed because it is politically unpopular. However, a financial crisis does
not allow us to wait for such a political decision.
The problem of the division of roles between the government and the central bank remains
even after the acute symptoms have disappeared. At present, policy rates in major
economies are virtually zero and these economies face balance-sheet constraints due to the
bursting of the bubble. For example, in the United States, unemployment continues to be
high on the back of balance-sheet adjustments in the household sector. In this situation, the
Federal Reserve has announced that it would purchase 600 billion U.S. dollars in longer-term
Treasury securities until June 2011. The Bank of Japan started comprehensive monetary
easing in the autumn of 2010, and as part of this, has purchased corporate bonds, REITs,
and ETFs. In a zero interest rate environment, if a central bank aims to stimulate economic
activity through monetary policy, one option is to seek a reduction in risk premiums through
purchases of assets with relatively high credit risk. So far, such policy measures have been
relatively effective. At the same time, it cannot be ruled out that central banks eventually
incur losses through these measures. Moreover, there is an increasing possibility that central
banks will no longer be seen as neutral institutions, partly due to their stronger intervention in
resource and capital allocation at the micro level. If this happens, public confidence in central
banks - the very foundation for policy implementation - could be undermined.
The reason why central banks are granted independence is fundamentally that their mission
is to provide liquidity. The more policy measures become involved in the micro-allocation of
resources and capital, the more these measures have the flavor of quasi-fiscal policy.
However, in a democracy, fiscal policy is and should be decided by parliament. At the same
time, however, central banks need to act flexibly in response to a crisis to maintain economic
and financial stability. I do not think there is a universally applicable answer to the problem of
the division of roles between the government and the central bank. The Bank of Japan has
been addressing this problem by making tough decisions based on, for example, the severity
of economic conditions, the legal framework for the central bank, and society's tolerance of
central bank involvement.
What should the role of monetary policy be?
As we consider these difficult issues, it is stating the obvious that the most important thing is
to take preemptive measures to avoid falling into such a situation in the first place. In this
regard, it is critical to take a deep look at the role monetary policy should play.6 It seems to
me that in the past two decades, no other issue has been as frequently discussed as how
monetary policy should respond to a bubble. The orthodox view prior to the recent global
financial crisis, put simply, was that monetary policy should not respond to a bubble and that
any resulting problems could be resolved if central banks took aggressive policy measures
after the bubble had burst. In this context, Japan's "lost decade" tended to be simply
dismissed as mainly due to the delayed policy response of Japanese authorities. However,
we are now entering the fifth year since the bursting of the housing bubble in the United
States and real GDP there has hardly increased in the meantime. Thus, I think few today
would support the optimistic view that any problems resulting from the burst of a bubble can
be easily resolved through aggressive policy measures after the fact.
The first lesson that could be drawn from the experience of the past two decades is that,
while price stability is important, this alone does not guarantee that the economy is stable.
Looking back at the causes of the recent financial crisis, we find that financial imbalances in
various forms, such as the rise in asset prices, the increase in credit, the increase in
leverage, and the increase in maturity mismatches, had built up to an extent that became
unsustainable. The causes of these financial imbalances are complex, and although failures
in financial institutions' risk management and a delay in adequate regulation and supervision
have no doubt played a role, this is not all. At the root of the financial imbalances was the
expectation that interest rates would remain low. The subdued inflation seen in many
advanced economies in the run-up to the global financial crisis gave rise to expectations that
accommodative monetary conditions would continue for an extended period into the future.
Of course, bubbles are not generated by expectations for protracted low interest rates alone,
but it is also true that bubbles do not arise without such expectations. While price stability is
important, paying too much attention to the near-term inflation outlook could impair the
stability of the financial system, which is critical from the viewpoint of economic stability - the
ultimate goal of price stability.
The second lesson is the danger of monetary policy swinging too far in the direction of
finetuning. Of course, it would be ideal if fine-tuning were possible, but in my view, monetary policy
has a more important role to play, namely ensuring economic and financial stability in the
medium to long term. In his famous presidential address to the American Economic
Association in 1967, Milton Friedman stated that "the first and most important lesson that
history teaches about what monetary policy can do - and it is a lesson of the most profound
importance - is that monetary policy can prevent money itself from being a major source of
economic disturbance." Seeing the significant decline in the level of real GDP in advanced
economies following the collapse of Lehman Brothers and continuing high unemployment, I
keenly feel it is important to prevent money itself from becoming a major source of economic
disturbance.
While it is not easy to apply these lessons in practice, policy authorities must tackle the
challenges I have mentioned, and in fact they are already making various efforts to do so. In
this regard, in terms of the conduct of monetary policy, the ECB and the Bank of Japan seem
to be taking similar approaches. The ECB has adopted a "two-pillar approach" - consisting of
economic analysis that focuses on economic and financial developments and assesses the
short- to medium-term determinants of price developments, and of monetary analysis that
examines medium- to long-term price developments from a monetary perspective - and then
cross-checks the results. Similarly, the Bank of Japan's monetary policy conduct is based on
a "two-perspective approach." The first perspective focuses on economic and price
conditions one to two years ahead and examines whether, in the Bank of Japan's baseline
scenario, the economy follows a sustainable growth path with price stability. The second
perspective also includes a longer time horizon and, from the viewpoint of achieving
sustainable economic growth with price stability, examines risk factors that have a low
probability of materializing but that could have a large impact on economic activity and prices
if they do materialize. In my view, what the monetary policy frameworks of the ECB and the
Bank of Japan have in common is that they both deliberately incorporate the practice of
examining financial imbalances using various types of information.
Regardless of what framework central banks adopt in their monetary policy, preparing for
so-called tail risks will be increasingly important. As shown by Japan's experience and the
recent gl