Hiroshi Nakaso: What the lost decades left for the future
Keynote speech by Mr Hiroshi Nakaso, Deputy Governor of the Bank of Japan, at the 2014
International Conference, held by the International Association of Deposit Insurers,
Asia-Pacific Regional Committee, Tokyo, 23 April 2014.
* * *
Accompanying charts can be found at the end of the speech or on the Bank of Japan's website
Introduction
Ladies and gentlemen, it is my pleasure to address the distinguished audience attending the
International Association of Deposit Insurers (IADI) Asia-Pacific Regional Committee (APRC)
International Conference held here in the historic city of Kyoto.
Today, I want to trace history a little bit in an attempt to find out what can be learned from the
so-called Lost Two Decades in Japan.
The ordeal that Japan's economy has undergone since the bursting of the asset bubbles in
the early 1990s was initially dismissed as a uniquely Japanese experience with limited
implication for the rest of the world. But the subsequent global economic and financial
development suggests it was, in fact, in no way unique. The challenges that the Bank of
Japan faced during the Lost Decades in endeavoring to restore financial stability and
overcome deflation have provided significant lessons, some of which have created the
guideposts for the future. Among the insights obtained, I want to pick up on three issues that
I think are of particular relevance in the current context and for the audience in this room.
These are the mission to overcome deflation, the mechanism to contain a financial crisis, and
the role of a central bank as the Lender of Last Resort.
I. Overcoming deflation
Zero lower bound on nominal interest rates and deflationary equilibrium
The first issue is the mission to overcome deflation. Since the financial crisis in the 1990s,
Japan's economy is said to have fallen into deflationary equilibrium, in which prices decline
gradually and persistently. Let me start with a look at this deflationary equilibrium.
Prices continued to decline principally because a large shock brought by the financial crisis
affected Japan's economy and the output gap widened. Nowadays, there is no need to
explain how a financial crisis damages the real economy through erosion of financial
intermediation. However, at the time, this mechanism seems to have been grossly
underestimated. After entering the 2000s, the downward pressure was compounded by a
new shock of a declining labor force, and this has been putting further downward pressure on
the economy.
However, deflation ought not to continue if a central bank is able to sufficiently lower nominal
interest rates in the face of such large shocks. In this regard, the critically important factor is
whether a central bank faces the zero lower bound or not. Chart 1, which I borrowed from a
paper by President Bullard of the Federal Reserve Bank of St. Louis, shows this in a
simplistic manner.1 In the chart, the nominal interest rate and the inflation rate in a steady
state will be determined when the line describing the Fisher relation - which shows the
relation among nominal interest rates, real interest rates, and inflation rates - crosses the
line representing the central bank's policy reaction function. A central bank's policy reaction
function would have a positive slope as the central bank would react to a declining inflation
rate by lowering interest rates. However, as the central bank cannot lower nominal interest
rates below 0 percent, the reaction function becomes horizontal when nominal interest rates
are at 0 percent, as shown in the chart. Then, the two lines cross twice, creating inflationary
equilibrium on the right side of the chart and deflationary equilibrium on the left side. When
strong downward pressure is added to the economy, an inflationary equilibrium might shift
down toward a deflationary equilibrium. If actual figures for Japan, the United States, and
Europe are plotted on the chart, one can see that Japan's economy has been hovering
around deflationary equilibrium (Chart 2).
These topics of the zero lower bound on nominal interest rates and deflationary equilibrium
were initially considered unique to Japan and taken up as the subject of intellectual curiosity
by only a fraction of academics. However, since the Lehman crisis, as central banks in major
advanced economies have come to face similar problems, these issues have prompted the
policymakers to refocus on Japan's experiences, from which they sought to draw practical
lessons.
Escaping from deflationary equilibrium
Another lesson is that, once the economy falls into deflationary equilibrium, it is difficult to
overcome that situation. In order to get out of deflationary equilibrium, a sufficient escape
velocity needs to be provided to the economy. What is extremely important in this regard is to
employ all policy measures in the arsenal. As for monetary policy, the Bank of Japan
introduced a decisive measure of quantitative and qualitative monetary easing in April last
year. At the same time, as for fiscal policy, the government launched an expansionary policy
partly through a supplementary budget while taking due account of long-term fiscal
sustainability. In escaping from deflationary equilibrium, in my view, monetary and fiscal
policies that were independently conducted under inflationary equilibrium need to be pursued
with a different approach. In this regard, the joint statement of the Bank and the government
announced in January last year may have been playing an important role as a coordination
device that enables the collective conduct of monetary and fiscal policies. Thanks to these
measures taken, the latest figures in Chart 2 suggest that Japan's economy has gradually
but steadily been escaping from deflationary equilibrium.
Having said that, we are only halfway to achieving the 2 percent inflationary equilibrium. In
view of this, what warrants attention are effects of the consumption tax hike from this April.
While there are some goods, like automobiles, that seem to face a larger increase in demand
ahead of the tax hike compared with the previous consumption tax increase in 1997, we
would like to wait for an accumulation of data to judge the overall effects on private
consumption (Chart 3). Personally, I believe that Japan's economy as a whole is resilient
enough to absorb the effects of the consumption tax hike. The major reasons for this are
continued improvement in employment and income conditions and the absence of problems
that existed in the previous 1997 tax hike. In particular, the critical difference is that, while the
financial intermediation function that supports economic activity was broken due to the
domestic financial crisis, which was at its peak in 1997, the financial system is in sound,
robust shape this time around. Put differently, the absence of a financial system problem
corresponds to the fact that problems such as debt overhang, excess capacity, and excess
employment that had haunted the economy at that time have been resolved thanks to
subsequent efforts by firms (Chart 4).
The Bank will steadily pursue quantitative and qualitative monetary easing to make sure we
put an end to this deflation. As we have said repeatedly, should the outlook for economic
activity and prices change due to some risk factors, the Bank will make adjustments as
necessary.
While overcoming this deflation is the Bank's manifest mission, for Japan's economy to move
to a sustainable growth path, it is crucial to inspire private economic entities'
entrepreneurship and dynamism in order to reinforce the growth potential of the economy. In
this regard, I strongly expect that the government's growth strategy will be steadily
implemented.
Now let me bring you to the second issue: the mechanism to contain a financial crisis.
II. Mechanism to contain a financial crisis
Financial system stability and the role of a central bank
Smooth financial intermediation under a stable financial system is a prerequisite for
achieving sustainable economic growth with price stability. Stability of the financial system is
also needed to secure the effectiveness of monetary policy. This is because the financial
system is a major policy transmission channel, in that monetary policy is carried out through
measures such as open market operations that have financial institutions as their
counterparts.
In the Bank of Japan Act, contributing to the maintenance of stability of the financial system
is stipulated as the Bank of Japan's purpose, along with achieving price stability. Against
such a backdrop, through its on-site examinations and off-site monitoring, the Bank has been
striving toward accurately gauging the business conditions of financial institutions. In
addition, while utilizing the information of individual financial institutions obtained through
such processes, the Bank seeks to gain a holistic view on the soundness of the entire
financial system. The points to be checked include whether there is a widespread
accumulation of financial imbalances such as an excessive expansion in credit aggregates or
leverage as well as an excessive rise in asset prices, which are assessed from a
macroprudential perspective.2 The examination of financial imbalances has become one of
the important exercises under the current monetary policy framework in Japan.
Lessons learned from Japan's experience
The efforts to secure financial system stability from the micro- and macro-perspectives I have
just mentioned aim at early detection of a source of crisis and preempting its materialization.
Despite such efforts, we cannot eliminate the probability of a crisis. Therefore, it is critical to
establish an effective mechanism that can minimize the spread of damage in case a crisis
occurs. In this regard, Japan's experience of the financial crisis of the 1990s may provide
many lessons, because it was a painful case that allowed seeds of problems to grow into a
full-scale systemic crisis, during which about 180 depositary institutions failed. There were
multiple reasons why this had to be the case. In what follows, I want to point to three basic
causes, acknowledging the fact that wisdom came only after the event. Hopefully, these will
provide those countries that are in the process of designing and establishing a mechanism to
contain a financial crisis with valuable insights.
a. Delay in authorities' recognition of the situation
The first cause was a delay in authorities' recognition of the situation. In 1992, the size of
nonperforming loans announced by the government was 8 trillion yen in total for 21 major
banks. At the time, the effects of nonperforming loans on the financial system were not
considered to be so serious. For example, a 1992 Economic White Paper stated that
nonperforming loans were not a critical problem for banks' management as those were only
a part of banks' total loan amount of 351 trillion yen and accounted for a small portion of their
total assets, and as banks had about 17 trillion yen of unrealized gains on securities. This
statement ultimately diverged significantly from the actual figure of the banking sector's
cumulative losses in the ensuing 10 years, which turned out to be as much as 100 trillion
yen, or about 20 percent of GDP (Chart 5). This example was not limited to Japan.
Concerning losses associated with the U.S. subprime mortgage problem, which triggered the
recent financial crisis, the U.S. authorities initially announced that these totaled about 50 to
100 billion dollars. Ultimately, the amount bloated to several hundred billions. Amid the vortex
of a crisis, authorities tend to yield to wishful thinking. We need to bear in mind again the
need to expect the worst and plan for the best when the financial system faces preliminary
tremors.
A delay in recognition also held true in terms of the gravity of the effects that nonperforming
loan problems had on the economy. After the bursting of the bubble, the authorities were
aware of the possible impact of a decline in real estate prices on management of individual
financial institutions. However, macroeconomic consequences of eroded financial
intermediation and the resultant tighter monetary condition - in recent terminology, a
negative feedback loop between the financial system and the real economy - had been
underestimated, if not disregarded.
b. Lack of recognition of the nature of systemic risk
The second cause was a lack of recognition regarding the nature of systemic risk. Japan's
financial crisis in the 1990s took hold with the resolution of two Tokyo-based credit
cooperatives in December 1994. At the time, a wide range of financial institutions were
perceived to be facing the common problem of mounting nonperforming loans. Therefore,
even though these two credit cooperatives were small in size, there was a risk that the failure
could drive the entire financial system into turmoil, as the problems with the failed institutions
were easily associated with those faced by the surviving ones - for example, people would
ask themselves, "if those credit cooperatives failed, why can't others?" Then came November
1997. In a single month, now remembered as Dark November, as many as four financial
institutions including internationally active ones failed in succession. Sanyo Securities, a
middle-ranking securities firm, was among those that failed. It defaulted on borrowing from
the call market, the core of the interbank market. The amount of the default by this
nondepositary financial institution was only about 8.3 billion yen - a fraction compared with the
market size. But as that was the first-ever default in the call market, it sent a shockwave
through market participants, and every one of them had a gnawing suspicion that those to
whom they lent money might fail anytime. As a result, the call market contracted sharply and
the market intermediation function was lost.
When there is increased vulnerability of the financial system, even the failure of a small
financial institution or non-depositary financial institution can induce a contagious systemic
shock. At the time, there was a general lack of recognition about the mechanism through
which a shock develops into a systemic crisis.
c. Lack of effective safety nets
The third cause was a lack of effective safety nets. It would have been more desirable if an
effective framework had been in place in normal times that could both contain moral hazard
and avoid systemic risk in a balanced manner. However, in reality, the creation of such a
framework lagged behind the unfolding crisis. This delayed the resolution of problem
financial institutions and resulted in an escalation of the crisis.
In Japan's financial crisis of the 1990s, policy responses were based on the principle that all
depositors, including uninsured ones, should be fully protected in order to preclude a
depositors' run. To cover the cost of the deposit protection, the failed financial institution's
capital would first be used. The residual amount was supposed to be covered by financial
assistance from the Deposit Insurance Corporation of Japan (DICJ). However, under the
primitive legal framework of that time, the amount of available financial assistance in a bank
failure was limited to covering only the insured. Therefore, to collect the cost needed for full
deposit protection including uninsured deposits, the only option left was to rely on voluntary
contributions from financial institutions - a method later called the consortium method.
Although this method worked for a while, it soon reached a limit, as the number of failures
soared and the cost of deposit protection consequently bloated. This led to legislation that
removed the ceiling of financial assistance from the DICJ. But the source of the enhanced
support was deposit insurance premiums collected from the financial industry. This was little
different from the consortium method, in the sense that it was the financial industry that had
to bear the burden anyway. With the financial strength largely exhausted, there was naturally
a limit to what the industry could bear. In other words, the crisis had escalated to the extent
that injection of public funds, the only remaining financial resource, was considered imminent
and necessary. But political difficulties prevented that from taking place in a timely manner.
Indeed, the discussion on public funds injection was not unsealed3 until Japan experienced
the so-called Dark November of 1997, at which point the crisis became visible in the eyes of
everyone. This finally paved the way for the use of public funds.4 However, establishing
safety nets amid escalation of the crisis was a painful process. It was only after May 2003,5
almost six years after Dark November, when we finally felt that the crisis was gradually
waning.
Japan's safety nets that evolved while coping with the crisis
As a member of the policy authorities at the time, I sometimes wonder what could have been
different if public funds had been injected a little earlier. At the same time, however, it should
be appreciated that the safety nets for Japan's financial system have developed into solid
ones as a result of a series of evolving steps taken while coping with the actual crisis.
The current safety nets in Japan are equipped with a framework of investor protection for
each business category. As for depositary financial institutions, a framework is now in place
that allows, if a case is judged to be systemic, for exceptional measures to be taken to
reinforce the capital position of a bank, including an option for temporary nationalization. In
addition, a piece of legislation last year introduced a framework intended to cope with
market-induced-type systemic risk that could be triggered by such non-bank institutions as
securities firms and insurance companies. Thus, I think I can say that Japan's safety nets
have evolved to become comprehensive ones that cover a wide range of financial institutions
and can be considered to represent the culmination of past actual financial crisis
management measures. In that regard, our safety net arrangements have a lot to offer, and
to which countries overseas can make reference. Of course, Japan's system as it stands
does not fit every country exactly. Needless to say, it is desirable to establish frameworks
that suit the financial and legal systems of respective countries while utilizing universal
elements underlying Japan's system.
III. Central bank as the Lender of Last Resort
Scope of the Lender of Last Resort and the safety nets
The third and final issue I will address today is the role of a central bank as the Lender of
Last Resort. In coping with financial crises, a central bank's Lender of Last Resort function
has also played an important role. This is a function in which a central bank provides funds to
a financial institution facing a temporary liquidity shortage in order to prevent systemic risk
from materializing. In carrying out this function - through the so-called special loans - the
Bank of Japan has required, including during the crisis period, that four conditions be fulfilled.
Specifically, first, there must be a strong likelihood that systemic risk will materialize. Second,
there must be no alternative to the provision of central bank funds. Third, all responsible
parties are required to take clear responsibility to avoid moral hazard. And fourth, the
financial soundness of the Bank of Japan should not be impaired.
Of these, the fourth principle entails an inherently difficult problem. As was the case with the
failure of Sanyo Securities and many other cases, a financial crisis typically surfaces in the
form of liquidity shortage with a solvency problem lurking in the background. What is
troubling is that, at an early stage of the crisis, it is quite difficult to differentiate the liquidity
problem from the solvency problem. The traditional wisdom is that the Lender of Last Resort
support should be confined to "illiquid but solvent" institutions, but in practice this is not easy.
This is why a central bank serving as a Lender of Last Resort runs the risk of credit losses. If
the central bank's funds become unrecoverable, its financial soundness will be impaired. If,
as a result, speculation arises that the central bank's policy judgment might be affected,
policy effectiveness could be undermined. Furthermore, losses incurred by the central bank
might ultimately lead to taxpayer burden through reduced transfers to the government.
The problems that I have just mentioned will be even more acute when safety nets are
underdeveloped. A central bank will be forced to make the decision of whether to dare take
risk and exercise its Lender of Last Resort function in order to avoid a crisis despite the
possibility of incurring losses. In Japan, during the 1990s, in the absence of frameworks to
cope with systemic risk triggered by non-bank securities firms and with capital shortage of
depositary institutions, the Bank of Japan intentionally took on the risk and provided special
loans to fulfill its mission to secure stability of the financial system. However, this ended in
the painful result of incurring credit losses of more than 200 billion yen.
Today, as mentioned earlier, comprehensive safety nets are installed, and the DICJ has a
broadened capacity to provide funds including capital injection. Accordingly, the scope of the
Bank of Japan's role has become substantially narrower relative to that in the 1990s, and is
basically confined to back financing toward the DICJ. Going forward, it will become important
to strengthen coordination among related parties under the new framework so that crisis
management measures can be activated promptly in the event of crisis outbreaks.
New dimensions of the Lender of Last Resort
a. Market Maker of Last Resort
The central bank's Lender of Last Resort function seems to have reached a new stage.
During the recent global financial crisis, it has become clear that systemic risk can be
magnified through mutually reinforcing declines in funding and market liquidity in light of
increasingly deepening and interconnected financial markets. After the market turmoil in the
summer of 2007, heightened counterparty concerns among market participants drove the
markets to become dysfunctional. In response, central banks embarked on restoring market
function by providing liquidity to the markets as a whole through open market operations.
Specifically, after the collapse of Lehman Brothers in September 2008, the Federal Reserve
(Fed) provided funds to issuers of CP and holders of asset-backed securities (ABS).
Meanwhile, in Japan, the corporate sector was directly hit by the crisis because the market
liquidity of their funding sources dried up. To address the adverse market condition, the Bank
of Japan took the exceptional steps of making outright purchases of CP, asset-backed
commercial paper, and corporate bonds. More recently, in response to market fragmentation
that became serious in the euro area on the back of the sovereign debt problem, the
European Central Bank (ECB) carried out a large-scale fund provisioning through its
threeyear Longer-term Refinancing Operations (LTROs) on a full allotment basis, aiming at
restoring market function. As these measures substitute for the intermediation function of the
markets, we can probably say that a central bank's Lender of Last Resort function has
evolved to encompass the role of Market Maker of Last Resort.
b. Global Lender of Last Resort
The recent global financial crisis demonstrated that systemic risk can spill over across
national borders and have a global dimension. The deepening of globalization had prompted
financial institutions to broaden their intermediation activities into non-home currencies. This
suggests that home central banks may have to confront the challenges arising from liquidity
crises in non-home currencies. In the first place, provision of liquidity in non-home currencies
is in no way an easy task for the home central bank to implement in a timely manner given
the potential size needed, time difference, and other operational constraints. During the
recent financial crisis, U.S. dollar liquidity shortage became an acute concern, especially
among European banks, which had expanded their dollar intermediation activities. In
response, the ECB and Swiss National Bank each entered into swap arrangements with the
Fed at the end of 2007 to obtain dollars to be fed through to financial institutions operating in
respective markets. Other major banks, including Japanese ones, had also expanded dollar
intermediation. Therefore, the Bank of Japan, the Bank of England, and the Bank of Canada
joined the swap arrangements with the Fed after the collapse of Lehman Brothers. Triggered
by the sovereign debt problem in Europe, this arrangement was reinforced in 2011 to
become a network of bilateral swap arrangements that provides the six participating central
banks with access to the yen and major currencies other than the US dollar,6 should a
liquidity crunch occur in these currencies (Chart 6). The arrangement has now become a
permanent measure. This provision of non-home currencies under central bank cooperation
embodies the role of Global Lender of Last Resort.
As I have described, while the essential nature of a central bank's Lender of Last Resort
function remains unchanged, specific ways of exerting the function have evolved, and new
dimensions have been added to it. More than ever, central banks now face the need to
enhance collective efforts to improve crisis management skills in order to better withstand
future shocks.
Concluding remarks
Ladies and gentlemen, let me now conclude.
The Japanese experience tells us that a negative feedback between the real economy would
come into play once financial stability is undermined, and that, for this reason, we need to
have a good set of crisis prevention and crisis management measures in place. Today, I
have focused on the latter, but let me reiterate that crisis prevention tools such as financial
regulation and macroprudential policies are no less important. In dealing with the financial
crises of the recent past, we also have recognized that a central bank's Lender of Last
Resort function remains an important tool that needs to be constantly refined to meet the
potential challenges arising from globalization.
Two decades may seem a mere instant in history for a city like Kyoto that has survived more
than one thousand years with a myriad of historic events. But the past two decades were so
eventful that I am sure it will long be remembered in the history of economy and finance. We
have learned a lot and may have become a little wiser, but so many things remain to be
explored.
We can never regain the two decades that have elapsed. But we can make full use of the
insights obtained during the period in fulfilling our mission of bringing the economy back on
track toward sustained growth and in contributing to building up effective safety nets to
underpin financial stability in Japan as well as in other countries. Only when these tasks are
done can we probably say, perhaps with a little bit of relief, that the spell the Lost Decades
cast on us is at last broken, and that not everything was lost after all.
Thank you very much for your attention.
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