Masaaki Shirakawa: Society, economy and the central bank
Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Foreign Policy
Association, New York, 18 April 2012.
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Introduction
Even as the world is practically getting smaller, with the remarkable advances in
transportation and communications technologies, and with all the resulting increases in
interaction among peoples and economies, foreign policy is, unfortunately, something that is
all too often put on the back burner by people busy with their daily lives. This is why the
activities of the Foreign Policy Association are so invaluable. Since its foundation in 1918, for
nearly a century, the Association has served as a catalyst for developing awareness,
understanding of, and providing informed opinions on global issues. I am honored, therefore,
this evening, to receive the FPA Medal, whose past recipients include many people I respect
very much.
Today, I will offer my views on the recent Global Financial Crisis, which, from the viewpoint of
central banks, was the most important international development of the past few years. In
doing so, I will not comment on the Crisis itself, on which a lot of ink has been spilt already,
but on the issues that the Crisis has raised concerning the role of central banks in relation to
the well-being of the society at large. As the Crisis is bound to leave indelible marks on the
global economy, it would probably affect how central banks would conduct their business in
the future.
In this Crisis, as I will later explain, central banks have succeeded in deflecting the
destructive forces in the acute phase, by injecting unprecedented amounts of liquidity into the
financial system and by rolling out massive monetary easing. Now, the Crisis has moved into
the chronic phase, characterized by low growth and persistent unemployment. In this regard,
many more challenges certainly lie ahead, before we can even take back the lost ground and
make further advances from there.
One reminder that prosperity is quite fragile can be found in The Economic Consequences of
the Peace, by John Maynard Keynes.1 I believe it is rather fitting to quote his writing today,
considering that FPA was founded to promote the "Just Peace," advocated by President
Wilson, who led the U.S. delegation to Versailles, and that the collective failure of the
international community to achieve that goal at Versailles prompted Lord Keynes to write the
book. Lord Keynes describes the world before the First World War as "economic Eldorado"
or "economic Utopia," where a middle-class Londoner could easily "order by telephone...the
various product of the whole earth," "adventure his wealth...in any quarter of the world," and
"secure...cheap and comfortable means of transit to any country." Furthermore, this state of
affairs was regarded "as normal, certain and permanent, except in the direction of further
improvement." Whenever I read this passage, I am always struck by the power of
globalization in bringing about economic prosperity, the ephemeral quality of such
achievement in the light of the two World Wars, and the parallel with our experiences leading
to the Great Financial Crisis.
I. The changing economy and central banking
In our current discourse on economic policy, or more broadly the whole economy, no one
would doubt the critical stabilizing role played by central banks. Nevertheless, economic
history after the Second World War reveals that such a view is quite a recent product. The
enhanced role of central banks came into being on the back of three important changes.
Firstly, there is now a clear division of labor between monetary and fiscal policies. To our
eyes, such an arrangement seems too obvious, but during the War, in many countries
including the United States and Japan, monetary policy was subordinated to fiscal policy.
Central banks were doing all they could to finance the war effort, and there was no room for
independent monetary policy. In fact, monetary policy continued to be constrained for some
time after the War. For example, in the United States, the Fed was freed, in 1951, from the
obligation to maintain long-term interest rates below a level set by the Treasury, after arriving
at the so-called "Accord" between the Treasury and the Fed.2
Secondly, there is no longer any doubt about the role of monetary policy. It is widely
accepted that monetary policy should be an important stabilizing force for the
macroeconomy. During the 1960s and as late as the first half of 1970s, an influential school of
thought, now more or less discredited, held that a slightly higher inflation was a necessary
evil for achieving stronger growth and fuller employment. As monetary conditions were
relaxed and tightened discretionarily with such a bias over a number of business cycles,
inflation, both actual and expected, began to creep up quite noticeably. It became evident
that higher inflation was not contributing to higher growth or employment. Furthermore, the
distortions in the savings and investment decisions of economic agents and in resource
allocation resulting from higher inflation became a drag on growth. This was how stagflation
of the late 1970s came into being. This unpleasant experience taught us that economic
growth could only be sustained with price stability, and price stability should be the goal of
monetary policy.
Finally, against the backdrop of the first two changes, central banks are nowadays granted
formal independence. If central banks are to pursue price stability, they should be able to
conduct monetary policy from a medium to long-term perspective, away from short-term
concerns. This is legally secured by recognizing the independence of central banks in
national laws. Looking back, there were not many central banks that had statutory
independence in the 1980s. The situation changed markedly during the 1990s, when many
countries, including Japan, revised their central bank laws. The new laws clearly stipulated
the independence of the central banks in conducting monetary policy.
These changes were the basis of the new institutional framework for the conduct of monetary
policy, which emerged from the second half of 1980s and into 1990s. At the core of the new
framework was the linkage between independence and the mandate to ensure price stability.
In other words, central banks are held strongly accountable for achieving price stability, in
return for being granted independence. The increasing adoption of inflation targeting from the
second half of 1980s and into 1990s symbolizes this development. In the context of this
transformation, there was also a slight shift in the traditional mandate granted to central
banks regarding the regulation and supervision of financial institutions. Under the view that
price stability and financial stability are two distinct objectives, and in order to avoid
concentrating too much power in one institution, at some central banks, for example at the
Bank of England, regulatory and supervisory functions were carved out and transferred to
another organization, thereby letting central banks to focus solely on monetary policy.
As this new framework of monetary policy was being accepted over the 1990s, many
developed economies experienced a prolonged period of both relatively high growth and
stable prices. The age of Great Moderation had come. The phrase, which seemed to have
appeared shortly after the turn of the century, quickly gained popularity, capturing the
optimistic mood of the times, and central banks were praised for their substantial role in
bringing about prosperity. In a sense, the 1990s and 2000s, up until the Crisis, were, in fact,
the heyday of central banking.
One exception, however, was Japan, which experienced a prolonged period of sub-par
growth and modest but persistent deflation. Actually, Japan was experiencing profound
changes in the economy ahead of other developed economies. While Japan had suffered
severe stagflation at the time of the first Oil Crisis of the 1970s, its subsequent economic
performance was superior compared with other developed economies, reflecting the restraint
in wage increases and appropriate monetary policy. The bubble years of the second half of
1980s were, in this vein, the culmination of all that was good about the Japanese economy.
The bubble burst in the 1990s, and Japan has since been suffering from its lingering effects.
It is quite remarkable that economies in North America and Europe are now experiencing the
same changes that Japan has experienced from the 1990s onwards. Since 2006, the United
States has experienced a drawn-out period of declining house prices. This was only the
beginning. Financial strains quickly spread around the world engulfing many venerable
names both in the United States and Europe, and leading to, but not ending with the demise
of Lehman Brothers. As governments and central banks intervened aggressively, the global
financial system and the economy subsequently gained a respite, but it was short-lived.
Beginning from the spring of 2010, cascading problems within the euro area weighed on
global economic activity and heightened uncertainties. Consequently, output in the
developed economies is only 4 percent above the pre-crisis peak, and average growth since
2007 is a paltry 0.8 percent.
What went wrong? What can central banks do to prevent the development of another
disruptive bubble? Policy makers are certainly in the midst of soul-searching, regarding the
conduct of monetary policy and the regulation and supervision of financial institutions in the
years leading to and during the crisis. Today, I will just stress one point, considering that I
have already explained my thinking on another occasion.3 The key issue is that price stability
and financial stability are intricately intertwined. In an environment of price stability, economic
agents may come to expect ever more strongly that a prolonged period of low interest rates
would be sustained. This could exacerbate financial imbalances, such as increasing asset
prices or leverage. Taken too far, such imbalances would destabilize the financial system,
which would then lead to unacceptably large fluctuations of real economic activity and
ultimately prices. In this vein, monetary policy must take account not only of inflation but also
of financial imbalances, and it must attempt to look beyond the conventionally accepted time
horizon. At the same time, it has also become clear that it is not appropriate to purge
nonmonetary policy functions from central banks, and that central banks must maintain at least
some regulatory and supervisory functions over financial institutions.
Apart from these somewhat abstract challenges of tomorrow, today, central banks are still
confronted with numerous challenges, resulting from the recent global economic and
financial turmoil. What can central banks do in this difficult environment? The answers are
inevitably unique to each central bank, but let me identify some common emerging themes.
II. Central banking today
Currently, many central banks are implementing measures that were unthinkable only a few
years ago. As interest rates are cut to almost zero, there is no longer any room for
conducting monetary policy in the traditional sense. Consequently, central banks are now
conducting so-called unconventional monetary policy. This fact is reflected in the most
significant increases in the size of central bank balance sheets. The composition of balance
sheets has also changed considerably. In the case of the Bank of Japan, over the last ten
years, it has purchased commercial paper (CPs), corporate bonds, equities,
exchangetraded funds (ETFs), and real estate investment trusts (REITs). Looking at the Fed, it has
purchased various risk assets, such as mortgage-backed securities. Meanwhile, at the end of
last year and in February this year, the European Central Bank (ECB) supplied an unlimited
amount of three-year loans to banks. Furthermore, on interest rate developments, the Bank
of Japan has made clear its commitment and the Fed has announced its guidance.
Unfortunately, notwithstanding these efforts, growth in the developed economies remains
anemic, as I noted a few minutes ago.
When conducting monetary policy in such an environment, central banks must be aware of
three socioeconomic trends.
Firstly, in many developed economies, there are heightened expectations on what central
banks could deliver.4 In this regard, one of the most symbolic discussions touched upon the
measures that could be unleashed by the ECB in the context of the euro-area financial crisis.
As an analogy to the lender of the last resort function to banks, which is an important and
established function of central banks, some have forcefully argued for increasing the Bank's
supply of liquidity through a novel and untested function - a lender of last resort to
governments.
There are probably several reasons for the elevated expectations. Probably, the most
important one is the prolonged period of low growth and high unemployment. Another factor
is the increasing constraints on the conduct of fiscal policy, reflecting the dire straits of
government finances in most developed economies. In fact, the outstanding amount of
government debt relative to the size of the economy in G7 countries is fast approaching
levels not seen since the end of the Second World War.5 Furthermore, one could also point
out that central banks can act quickly - they can put up a huge wall of money almost
instantaneously. This could be most relevant given the differences in the speed demanded
by markets for results and the amount of time that is necessary for the democratic process to
agree on and implement fiscal and structural policies.
However one interprets what is happening now, there is a potentially toxic mix of heightened
expectations regarding central banks on the one hand and what central banks could actually
deliver on the other. If central banks cannot deliver, public confidence in the institution will be
eroded. This, to which I will come back later, will impact the efficacy of central bank policies.
Turning to the second issue, I would like to draw your attention to the blurring of the line
between monetary and fiscal policies. As I have just explained, unconventional monetary
policy of central banks involves the purchases of substantial amounts of long-term
government bonds and/or risk assets. The value of these assets, in the long run, may fall,
and when that happens, losses incurred by the central bank will have to be passed on to
taxpayers in the form of reduced profit distribution from the central bank to the government.
Additionally, these purchases will inevitably influence micro-level resource allocation. In
these respects, unconventional monetary policy is getting closer to fiscal policy. Considering
that, in a democracy, the delegation of the power to issue unlimited amounts of legal tender
to an independent central bank can only be justified by the tacit understanding that it will not
overstep into the realm of fiscal policy, the adoption of measures bordering on fiscal policy
could ultimately undermine the legitimacy of central bank independence and public trust in
the institution.
The third and final issue is a corollary to the first two issues. Reflecting the fact that central
banks are introducing heretofore untested measures, public opinion is beginning to diverge
widely on the desirable course of action by central banks. One example is the policy proposal
for ECB that I have noted a few minutes ago. In the United States, monetary easing by the
Fed is criticized by those who fear the consequence of inflation, while there are many
economists who believe additional easing is warranted in view of the slightly falling but still
stubbornly high unemployment. Also in Japan, there is a heated discussion on monetary
policy and fiscal consolidation.
III. The capacity and limits of central banking
Up till now, I have explained the significant economic and social changes evident in the
operating environment for central banks. The role of central banks, whether it should or
should not change, needs to be carefully deliberated in the context of these changes. If I may
jump to the conclusions first, it is dangerous to both over- and underestimate what central
banks could achieve. Central banks must act correctly.
What central banks can do
One thing that central banks can always do is to stamp out inflation. No matter how severe
inflation is, conceptually, it can be contained by monetary tightening. In the history of
mankind, severe inflation has never been defeated without tightening. Nevertheless, it should
also be noted that conceptual possibility and practicality is not the same. Statutory
independence is not sufficient. Timely and appropriate policy requires something more.
Central banks should not waver in the face of unpopularity and the society at large must be
ready to acquiesce.
Another important thing that central banks can achieve is to prevent the meltdown of the
financial system through its lender of the last resort function to banks. This is the most
important role in view of preventing the economy from falling into a severe deflation.
Reflecting on the Japan's financial crisis of the late 1990s and the recent Financial Crisis,
missteps in policy could have resulted in a much worse outcome, perhaps akin to the Great
Depression of 1930s. The most important difference was that central banks acted as the
lenders of the last resort. Shocks could be dampened through central bank actions that
mitigated the loss of trust among private economic agents, which hindered the use and
acceptance of privately created money. The central bank could stand between two private
counterparties and provide its money, which would be unconditionally accepted. The central
bank is the only institution that could play this important role in a financial crisis. Furthermore,
in a crisis environment, it also becomes imperative to maintain the efficient and uninterrupted
functioning of the systems and arrangements through which money and other financial
instruments flow. The working of what one might call the plumbing of the financial system
requires constant attention, and central banks have, over the last two decades, made various
efforts to improve its resilience, for example, promoting real-time gross settlement (RTGS),
ensuring delivery versus payment of securities (DVP), and introducing simultaneous
settlement of foreign exchange claims. Such exercises are not glamorous but central bank
veterans are pleased to reflect on their achievements, which probably contributed
considerably in preventing chaos after the recent collapse of Lehman Brothers.
What central banks cannot deliver
While central banks can achieve a lot, we should not have the illusion that there are no limits
to the power of central banks. Central banks cannot reasonably deliver solutions to structural
issues.
Let me take the current problems in the euro area as an example. The situation in the euro
area, whose troubles became evident around the end of 2009, significantly deteriorated since
the summer of last year. The fire sales in the government bond markets of the so-called
periphery countries led to a vicious cycle of worsening fiscal balance, increasing tensions in
the domestic banking system, and dampening of real economic activity. With a view to
arresting and hopefully reversing this destructive momentum, ECB has conducted two
operations, once at the end of last year and another at the end of this February, supplying an
unlimited amount of three-year funds. The subsequent return of relative calm to global
financial markets demonstrates that central bank liquidity can play an important role. At the
same time, it must also be impressed that liquidity provision has only bought time. One must
not lose sight of the fundamental issues, one of which is the current account imbalances
within the euro area. When the euro was introduced in 1999, interest rates for all member
economies converged on one low level. This led to credit expansion in the periphery, which,
at the same time, lost competitiveness because of increases in wages and prices. Now,
policies must be put in place to address the root causes of the problem. Structural reforms
must be implemented within the breathing space provided by the provision of central bank
liquidity. If complacency sets in because of the improvements in market sentiment, we could
be headed for a worse outcome. Time bought can equally be usefully spent or wasted.
Structural issues are everywhere in the developed economies. Japan is no exception. The
Japanese economy has stagnated and the rate of growth is sub-par among the major
economies. Given that the ten-year average per capita GDP growth is comparable to other
developed economies and per worker growth is the highest among its peers, the challenges
facing Japan is not demography per se, but adapting to the rapidly changing demography,
which no other country has so far experienced. The low aggregate growth and the huge
fiscal hole are both largely the symptoms of the failure to adapt to the demographic reality.
The modest deflation is, in turn, largely attributable to the lower growth outlook impacting
expected future income and hence current spending.
Monetary policy influences economic activity and hence prices in two stages. Firstly, the
central bank influences the financial conditions, and secondly, the resulting financial
conditions influence the spending decisions of firms and households. Considering that the
Japanese financial conditions are probably the most expansionary among developed
economies, the failure of Japan to shake off modest deflation can mostly be explained by its
deteriorating growth potential. In this sense, if the Japanese economy is to extricate itself
from deflation and return to a path of sustainable growth under price stability, it requires both
policies aimed at enhancing growth potential and supporting monetary stimuli. This is why
the Bank of Japan is fully committed to continuing powerful monetary easing through various
measures, including maintaining the policy interest rate at practically zero and purchasing
financial assets, until the current goal of year on year CPI inflation at 1 percent is deemed to
be achievable.
IV. Realizing the full potential of central banking
The ultimate objective for central banks is to realize stable and sustainable growth.
Operationally, this is going to be achieved through the stability of prices and the financial
system. Having said that, it must also be stressed that this goal is not pursued in a vacuum.
Such growth can only materialize through the intricate interaction among various economic
agents - households, firms, financial institutions and the government - each dynamically
pursuing their own goals. While the central bank is probably the actor most responsible for
ensuing price stability in a steadily expanding economy, some conditions must be met before
the central bank could make the most of its potential. Those conditions have not always been
appreciated, but our experiences after the recent global financial turmoil have brought them
back in focus.
The first condition is ensuring the sustainability of public finances.6 When doubts arise over
fiscal sustainability, serious efforts are required to regain confidence. If this is unsuccessful,
the only plausibly available options are either inflation or outright default. The operational
objectives of the central bank, price stability in the first instance and financial stability in the
second will be compromised, with dire consequences for economic activity and the welfare of
the people. In this sense, the sustainability of public finances is an essential condition for the
central bank to realize its ultimate objective.
The second condition is maintaining the credibility of the central bank among the general
public. Economic agents can be savers or borrowers, exporters or importers, and while some
may benefit from the actions of the central bank, others may lose out. The pain in the short
term could be considerable. As a result, it is most important that the general public truly
believes that the central bank is acting to maximize the medium- to long-term potential of the
whole economy. To begin with, if the central bank is not credible, it may even end up not
being able to implement measures that it deems necessary. Furthermore, the effectiveness
of the measures heavily depends on expectations formed against the background of
credibility. The time-honored reluctance of central banks to enter into quasi-fiscal measures
is based on the deference of neutrality, i.e., the need to be seen as not meddling with the
allocation of scarce resources, which is crucial for maintaining independence. In this context,
the unconventional policies currently implemented by central banks of the major developed
economies will truly be tested when central banks deem that the policies are no longer
necessary. The appropriateness of the policies will inevitably be judged by how quickly and
smoothly such policies could be unwound. The tricky issue is that expectations and credibility
are not necessarily malleable or may not behave predictably. While central banks must be
bold in times of crisis, they need to be most vigilant at the same time.
The third condition is upholding the public support for the market economy. While this goes
beyond central bank policies, it is most relevant because all the policies adopted by the
central bank presuppose the existence of a competitive market economy. Such support can
easily be eroded when the public at large comes to believe that the decks are stacked
against them. The increase in unemployment following the recent financial crisis, the
widening of the wage gap between skilled and unskilled workers due to deepening
globalization, and the antipathy against banks and bankers rescued by taxpayer money,
could all result in the weakening of support for a competitive market economy. In the long
run, this could pave the way for the adoption of policies that are detrimental to the efficient
functioning of the economy. One of the lessons learned from the interwar years in the first
half of the twentieth century was that crisis response begets the next crisis, then epitomized
by the spread of protectionism and beggar-thy-neighbor competitive devaluation. Policy
makers, including central bankers must not forget such lessons of history.
V. Concluding remarks
In his recent book, the influential author Robert Shiller notes that "Central banks are an
invention that served its purpose at a certain time in history, in a certain kind of environment,"
and goes on to say that their time may have passed.7 Central banks could not prevent the
bubble and the following Crisis. Nevertheless, as I have explained today, the role of central
banks has evolved over the years and that process is continuing or has even accelerated
after the Great Financial Crisis.
Our economic system, while bringing us unprecedented prosperity, is an inherently unstable
creature because of its dynamism. If the peoples of the world are to maintain, let alone
further improve, their current lifestyles, policy makers, including central banks, must not let
the various currents unleashed by the Crisis threaten the foundations of an affluent society.
In an ideal world, if we could understand and model why you decided to have latte instead of
espresso this morning, it could be possible to design an automatic stabilizing mechanism for
the economy, and central banks would become only a chapter in economic history books.
Nevertheless, being a complex system that involves people and their emotions, managing
the economy will probably remain an art rather than a science, where human actors, who can
learn from the past and adapt accordingly, have to play a leading role. Automatic stabilizers
and mechanical rules would not work. Continuing this process of learning and adapting, I
believe, is at the core of the challenges facing central banks at this juncture, and if central
banks can meet those challenges, central banks will still be able to fully serve the good
society.
Thank you very much.