Masaaki Shirakawa: The importance of fiscal sustainability - preconditions
for stability in the financial system and in prices
Remarks by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Bank of France
Financial Stability Review launch event, Washington DC, 21 April 2012.
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Relationship between fiscal sustainability and central banks
The mission of a central bank is to contribute to sustained growth of the economy by
maintaining public confidence in money, and price stability and financial system stability are
two facets of this mission. Fiscal sustainability is an important element that has a
fundamental impact on both. According to conventional wisdom, when the government loses
its credibility with respect to the sustainability of government debt and does not make enough
effort to regain it, this ultimately leads to either inflation or a default on the debt. To put this
differently, it is often said that a central bank comes to face a tradeoff between price stability
and financial system stability. However, since both are essential preconditions for sustained
economic growth, it is not at all meaningful to consider which of the two we should choose.
What is crucially important is to prevent the economy from getting into such a tradeoff in the
first place; for that reason, fiscal sustainability itself is an essential precondition for the proper
functioning of a central bank. Let me now elaborate on this point.
In normal times, government bonds are traded in large volumes in financial markets and
used as collateral, reflecting their characteristics as safe assets. They are also held by
financial institutions as liquidity buffers and investment assets. As such, a heightened risk for
government debt default is likely to lead to instability in the financial system, through an
increase in the liquidity risk and the capital loss of financial institutions. In such a situation, a
central bank may be called into action as a "lender of last resort" by providing liquidity in
order to maintain the stability in financial markets and the financial system, and such
operations are expected to be effective at least in the short term. Taking an example from
Europe, the ECB's Long-Term Refinancing Operations (LTROs) have helped to restore calm
in financial markets. We are fully aware of the importance of such operations, but one has to
also keep in mind that they can only be used to "buy time."
A central bank's operations to "buy time" may help the government to garner time to build a
public consensus on the need for fiscal consolidation and gain the credibility of market
participants for a consolidation plan. However, the side effects of such operations become
significant when the government's commitment to fiscal reforms is weak and the plan for
fiscal consolidation is less effective. Specifically, a temporary lull in financial markets due to a
decline in government bond yields is likely to dilute the sense of urgency among the
government and the public, and thus weaken the momentum for progress toward fiscal
reforms. If the government continues to run fiscal deficits, a possibility arises in which the
central bank is forced to supply an unlimited amount of liquidity - in the form of either liquidity
provision against government bonds as collateral or an outright purchase of government
bonds - in order to get around a re-emergence of financial system instability. Historically, the
consequence of such a large-scale supply of money is uncontrollable inflation. If market
participants and the public, which have the knowledge of this history, were to anticipate a
regime shift at some point, the credibility with respect to government bonds and money
would be lost abruptly, and a process leading to uncontrollable inflation would begin.
After all, without solid progress toward fiscal consolidation, we cannot avoid significantly
adverse impacts on economic activity and the standard of living.
The case of Japan
Now I would like to take up the case of Japan, which attracts frequent questions. As is well
known, the ratio of gross government debt to GDP in Japan is the highest among developed
countries. In spite of such unfavorable fiscal conditions, the government bond yields remain
low and stable, and policy discussions are focused on mild deflation instead of concerns
regarding inflation, as evidenced by the fact that the consumer price index has fallen by
3.4 percent in cumulative terms since 1998, which can be translated to 0.2 percent annually.
The low level of the government bond yields is consistent with the growth rate of the
economy and the inflation rate, and at issue is the interpretation of the premium that could
arise from worsening fiscal situations.
It seems difficult to explain the case of Japan in light of the conventional wisdom. One
frequently offered explanation is that the ample domestic savings in Japan have absorbed
the issuances of Japanese Government Bonds (JGBs) and the share of JGBs held by foreign
investors is very small. But a more fundamental explanation is that the stability in the
government bond yields reflects market participants' expectations that fiscal soundness will
be restored through structural reforms in both the economic and fiscal areas. At the moment,
such expectations are not firmly backed by concrete reform plans; the public therefore
restrains spending on concerns over future fiscal developments, and this constitutes one
factor behind sluggish economic growth and mild deflation. If this is indeed the case, the
experience of Japan indicates a possibility that a cumulative increase in government debt,
combined with weak growth expectations, might generate deflationary pressures as long as
the government retains its credibility with respect to eventual fiscal consolidation. In other
words, this is the situation before the loss of fiscal sustainability leads to either inflation or a
default on the debt.
Behind the decline in growth expectations and the cumulative increase in government debt
are the aging of the population and the failure of the Japanese economy to adjust to it in a
flexible manner. There is a limitation, at least in the short run, to changing the demographic
trend itself. Therefore, given that the rapid aging of the population is likely to continue,
strengthening the growth potential through productivity improvements and making the fiscal
structure sustainable in the situation of an aging population are the most important
challenges for Japan in terms of maintaining macroeconomic stability over the medium to
long term.