Masaaki Shirakawa: Money, government securities and a central bank
Keynote address by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the
2011 Spring Meeting of The Japan Society of Monetary Economics, Tokyo, 28 May 2011.
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I. Introduction
I am honored to be invited today to the Japan Society of Monetary Economics. It is of great
significance to have discussions among academics, practitioners and policymakers in any
academic field, and it is certainly true in the field of monetary economics. As I have worked at
a central bank for a long time, and also placed myself in a university for a while, I sincerely
hope to deepen intellectual interaction among academics, practitioners and policymakers.
Today, from a viewpoint of a policymaker and a practitioner, I will offer my thoughts with the
title of "Money, Government Securities and A Central Bank."
Since the 2000s, the global credit bubble and the ensuing financial crisis have marked the
most striking events in the global finance. The course of the events during the bubble and the
ensuing crisis periods shed new light on the interdependency of the confidence in the
government, the financial system and the central bank. During the bubble period preceding
the crisis, implicit government guarantee by the Government-Sponsored Enterprises (GSEs)
such as Fannie Mae and Freddie Mac was one of the causes of the residential bubble in the
United States. During the crisis period after the failure of Lehman Brothers, decisive actions
backed by the confidence in the government were required in order to end the crisis. The
U.S. and European governments were forced to make large-scale capital injections and
guarantees to financial institutions to restore confidence in private financial institutions and
the stability of the financial system. The governments also employed aggressive fiscal
policies as decisive macroeconomic measures to escape from sharp and deep economic
contractions.
Even after the crisis, confidence in the government has remained an important issue. Since
the mid-2009, the world economy has gradually recovered, thus preventing a deep
depression, through a different path from the 1930s. However, confidence in sovereign debts
has been eroded due to the deterioration in fiscal balance. At present, Greece and other
European peripheral countries were hit most severely by the deterioration in fiscal balances
and resulting sovereign debt problems. Those countries faced an adverse feedback loop
among the sovereign risks, the financial system and the real economy. Although Japan has
not confronted such a rise in yields on government securities, the deterioration in fiscal
balance is also severe.
The issue of confidence in a government has been relevant to a central bank. After the
failure of Lehman Brothers, central banks in advanced countries, including Japan, took
unconventional policy measures. Those measures were not pure monetary policies defined
as liquidity provisioning. They included, more or less, quasi-fiscal policy elements. Debates
are still going on regarding to what extent a central bank should pursue such monetary
policy, namely, the relationship between a central bank and the government, or the
relationship between monetary and fiscal policy.
Looking back on those series of events, I hope you understand why I choose the topic of
money, government securities and a central bank.
II. Interdependency of Confidence
Money and government securities
I will start by talking about two financial assets, money and government securities (Slide 1).
Money plays an important role as a means of payment, a unit of account and a store of
value. The primary form of money is central bank money which consists of banknotes issued
by a central bank and deposits in central bank current accounts. In Japan, the balance of
central bank money is 122 trillion yen in March 2011. In addition, bank deposits, which are
easily convertible to central bank money, also function as money. The outstanding balance of
bank deposits is 1,024 trillion yen.
The outstanding balance of Japanese government securities is 865 trillion yen. A
government uses the securities as a means of funding; a central bank uses them as the
instrument of monetary control; and investors including private financial institutions use them
as one of the primary financial assets for investment. Since government securities are, in
many cases, regarded as risk-free assets whose credit risks are negligible, yields on
government securities are often used as benchmark rates for pricing various financial
instruments.
Both of money and government securities are merely pieces of paper which represent the
liability of issuers, i.e., a central bank, private banks and a government. The debtor of central
bank money is a central bank, the debtors of bank deposits are private banks, and the debtor
of government securities is a government. Although those financial assets do not have
intrinsic value as materials in themselves, they are regarded as valuable assets and fulfill
their functions. That is ultimately because holders of money or government securities have
confidence in the issuers of those debts.
The importance of confidence is not a new topic; most textbooks on monetary economics
emphasize its importance. Governments, central banks and private banks make their best
efforts to maintain the confidence. Governments make their efforts to maintain the medium-
to long-term fiscal balances. Central banks maintain the stability in prices and the financial
systems through the conduct of monetary policy, through actions as the lender of last resort,
through financial supervision, and others. Private banks maintain their capital base, manage
various risks, and provide credit intermediation and payment services.
My point here today is the interdependency of confidence. Confidence in each issuer is
supported not only by the issuer's own efforts but also by the fact that confidence in other
issuers is maintained and that members in society understand the importance of confidence
in each other. Now, I will elaborate on the interdependency of confidence.
Determination by the government to underpin confidence in private financial
institutions
First, confidence in bank deposits of private banks, or in debts of financial institutions, is
significantly affected by confidence in governments as well. The global financial crisis after
the failure of Lehman Brothers demonstrated that. After the failure, financial institutions lost
confidence in each other's creditworthiness, and the interbank money markets almost
stopped working. Under the circumstances, central banks acted as the lender of last resort
and aggressively provided funds in order to deal with the liquidity shortage of financial
institutions. Although the provision of liquidity by central banks was extremely important
during the crisis after the failure of Lehman Brothers, it alone was not enough to restore the
stability of the financial system. That was because the adverse feedback loop between the
financial system and the real economy eroded capital positions of financial institutions and
thereby confidence in their solvency significantly. As the central issue shifted from the
liquidity shortage problem to the capital shortage problem, governments were required to
inject public capital and to guarantee senior debts of the financial institutions in order to
restore confidence in private financial institutions. The amount of public capital injected by
the governments of the United States, United Kingdom, Germany and France during the
recent global financial crisis reached an equivalent of 84 trillion yen.1 The experience above
suggests that the stability of money and the financial system also depends on confidence in
governments.
Support by the public to underpin confidence in a government
Second, having talked about the importance of confidence in a government, I would like to
emphasize that confidence in a government is, in the end, underpinned by support by the
public. After the global financial crisis, fiscal conditions in many countries deteriorated
seriously as a result of decreases in fiscal revenues associated with the downturns in
economic conditions, aggressive fiscal policy and capital injections to financial institutions.
The International Monetary Fund (IMF) reported that fiscal deficits of advanced economies in
G20 countries were 1.7 percent of GDP in 2007. The deficit rose to 9.4 percent in 2009 and
are projected to be as high as 8.0 percent in 2011 (Slide 2). The report notes that about an
half of the increase in outstanding public debts in G20 advanced economies is due to the
decrease in fiscal revenues, while nearly 20 percent of the increase is due to fiscal stimulus
measures and the authorities' support to financial institutions.2
When fiscal conditions deteriorate, confidence in a government's ability to repay its debts
declines. As I mentioned earlier, confidence in private financial institutions is affected by
confidence in a government as well. Therefore, when confidence in a government is
undermined, confidence in private financial institutions is affected through various channels.
The channels include a decline in the value of government securities they hold, erosion of
their ability of funding due to the depreciation of values of collateral among others. Real
economic activity suffers from rises in funding rates and difficulties in obtaining liquidity. As a
result, tax revenue declines and confidence in a government's ability to repay their debts is
weakened. In other words, an adverse feedback loop emerges among sovereign risk, the
financial system and real economic activities. Although the cause of sovereign debt problems
in European peripheral countries varies from country to country, the common nature of the
problem is such adverse feedback loop.
When private financial institutions faced the financial crisis, governments succeeded in
stabilizing the economy and the financial system by injecting public capital and conducting
countercyclical fiscal policy. A prerequisite for such success is that a government is
perceived to secure future revenue to cover the current expenditure. If a government is
perceived as lacking sufficient future revenue to cover increased expenditure due to public
capital injection or expansionary fiscal policy, the effect of the policy measures may lessen,
or even worse, could be adverse. The key to success of various aggressive policy measures
in an emergency is confidence in the government's ability to maintain the sustainability of
medium- to long-term fiscal balance. Various aggressive policies by a government in a crisis
become effective only when a government has a "stock" of confidence in it. And the
substance of the stock is, in the end, support by the public to maintain the sustainability of
fiscal balance. A government is not able to pursue fiscal policy at will regardless of support
by the public in such a way as to wave a magic wand.
Determination by the government and support by the public to underpin confidence in
a central bank
Third, I would like to emphasize that confidence in a central bank is not maintained solely by
the efforts of a central bank. Support and understanding by the government and the public
about the importance of confidence in a central bank are also essential. Since the recent
global financial crisis, central banks around the world have conducted unconventional
monetary policies on a large scale.3 There is no universally-accepted definition of
"unconventional monetary policy," as "convention" varies from country to country. In the case
of the Bank of England, unconventional monetary policy means a large-scale purchase of
long-term government bonds under the Asset Purchase Programme. By contrast, the Bank
of Japan has been conducting the purchase of long-term government bonds for nearly fifty
years. In that respect, purchasing long-term government bonds is one of the "conventional
monetary policy" measures. An unconventional monetary policy measure for the Bank of
Japan after the Lehman shock is the purchase of corporate bonds, commercial papers
(CPs), exchange-traded funds (ETFs), real estate investment trusts (REITs), etc. In the case
of the Fed, the typical unconventional monetary policy measure is the purchase of CPs and
mortgage-backed securities.
As I mentioned above, central banks acted decisively to maintain the stability of the financial
system in the wake of the recent financial crisis. In such a situation, confidence in a central
bank is a prerequisite for a central bank to take those decisive actions. I will explain this point
by taking the expansion of a central bank's balance sheet as an example. When financial
systems become unstable, demand for liquidity increases. Opportunity costs of holding
central bank money could be negligible because of extremely low short-term interest rates.
Under such condition, an increase in central bank money does not necessarily lead to a price
hike. As a matter of fact, even though balances in central bank current accounts and the
monetary base increased markedly in Japan and the United States in recent years, inflation
rates in both countries did not rise (Slide 3). However, it is crucial for a central bank to have
the capacity to take necessary action promptly when an increase in interest rates is required
due to changes in economic conditions. If market participants and the public perceive that
the central bank is unable to take prompt action "for some reasons" when needed, rampant
inflation may follow because the amount of money is extremely large.
"Some reasons" include these. One would oppose an increase in interest rates on the
grounds of concern about capital losses of government securities held by private financial
institutions or concern about an increase in interest payments on government securities.
Although those arguments do exist at any time, the arguments tend to be heated more when
the outstanding balance of government securities is larger and the period of low interest
rates continues longer.
Confidence in a central bank is formed in a complicated manner, and each country designs
institutional arrangements deliberately and each central bank acts carefully when conducting
their policies in order to maintain the confidence. I will come back to this point in more detail
later.
III. Issues related to fiscal balance
Having talked about the interdependency of confidence, let me discuss the importance of
confidence in light of Japan's current fiscal condition.
Japan's current fiscal condition is very severe (Slide 4). The outstanding amount of gross
financial liabilities of the government is as high as 198 percent of GDP. As the Japanese
government, unlike other major countries' governments, has a large amount of financial
assets, some observers argue that net liabilities rather than gross liabilities may be a more
adequate indicator for true indebtedness of the Japanese government. In terms of net
financial liabilities of the government, Japan is still ranked as the worst among developed
countries with its ratio of 114 percent, higher than that of Italy, which is 103 percent. In any
event, so far Japan has experienced no currency crisis or financial crises triggered by the
deterioration in fiscal balances that occurred in some other countries.
Though the necessity of the sustainability of fiscal balance is generally well recognized in
Japan, arguments which raise the alarm on risks associated with the deterioration in fiscal
balance are sometimes regarded as crying wolf. That is because Japanese government
securities have been issued smoothly for years and yields on long-term Japanese
Government Bonds (JGBs) have been stable at low levels in spite of the deteriorated fiscal
balance.
No country can perpetuate fiscal deficit. Confidence in a government's ability to repay its
debts can change in a non-linear fashion. The European sovereign debt problem that started
in Greece is a case in point. In the fall of 2009, widening spreads of government securities of
the European peripheral countries against Germany became evident (Slide 5). In October
2009, spreads were below 2 percent, but suddenly widened dramatically and now remains at
high levels currently such as 13.4 percent for Greece, 8.0 percent for Ireland and 6.6 percent
for Portugal. Though macroeconomic conditions have not changed drastically since the fall of
2009 in those countries, market participants' perception has changed substantially.
Yields on JGBs have been stable at a low level of 1.15 percent on average in fiscal 2010
(Slide 6). One of the most frequent questions I have got at international meetings is why
yields on JGBs have been stable at low levels despite the very severe fiscal condition.
According to the economic theory, a quick answer is the expectations for a low growth rate
and a low inflation rate. If we compare the past 10-years' average nominal growth rates,
which are the sum of Japan's real GDP growth and inflation rate, with 10-year JGB yields, we
will witness both have followed similar paths generally albeit with a small deviation (Slide 6).
The low and stable JGB yields are explicable if many investors expect what prevailed in the
past 10 years will continue into the next 10 years. However, the low growth and inflation
rates are not sufficient to explain low yields on JGBs. Long-term interest rates are
determined not only by the expected growth rate and the expected inflation rate, but also by
the risk premium that compensates for their uncertainties. Thus, to fully explain the low yields
on JGBs, we have to discuss why the risk premium is low. In that regard, I have to point to
the following two.
First, market participants believe that Japan ultimately has a will and an ability to work on
fiscal consolidation despite a severe fiscal condition. Second, confidence is maintained in the
Bank of Japan's conduct of monetary policy focused on achieving sustainable economic
growth with price stability. To put it differently, if confidence in those two points were to be
undermined, the rise in risk premium would raise the yield on JGBs. That clearly underscores
the responsibilities of the government and the parliament that formulate fiscal policy and
those of the central bank that conducts monetary policy. As I mentioned earlier that
confidence in one entity is underpinned by confidence in other entities, it is crucial for all the
entities to recognize the importance of confidence in other entities. Ultimately, confidence in
money and government securities is underpinned by the determination of people who
recognize the importance of confidence. And, such support by the public is able to exist only
with a comprehensive account by the government and the central bank, and with people's
understanding of the situation based on the account.
The future is always full of uncertainties, and I see that there are two tendencies on how
market participants and the public form expectations for a long-term future. First, they may
tend to think that what has continued over a long period will stay as it is. In the context of the
current Japanese economy, they may think that yields on long-term government bonds will
continue to be stable at a low level in the future as the yields were for a long time. Second,
once a change begins to occur with a trigger, this change reminds them of big events in the
past and they may think that drastic changes will occur. Market participants and the public
may drastically change their expectations triggered by an increase in fiscal deficit or an event
which make market participants and the public think that the independence of the Bank of
Japan is not respected. Then, they may expect that rampant inflation will occur in the end.
Having mentioned those two contradictory tendencies, I have to add that it is quite difficult to
predict when the former tendency will be replaced by the latter. What is certain is that
expectations change in a non-linear fashion. That is why the principles of the authorities'
behavior have to be clear.
It is vital for the fiscal authorities to work on the sustainability of fiscal balance in the midium-
to long-run. The deterioration in fiscal balance lowers the increase in the expected future
income by households, especially for the working-age population, and thus reduces current
household expenditure. To make things worse, if confidence in fiscal sustainability is eroded,
an adverse feedback loop among fiscal balance, the financial system and the real economy
may exert a negative impact on economic activity, as shown in the sovereign debt problem in
the European peripheral countries.
IV. Role of a central bank and government securities
Use of government securities in the money market operations
Principles of a central bank's behavior must be clear as well as those of the fiscal authorities.
Let me now discuss the principles of a central bank's behavior in association with
government securities.
First, let me show you some facts on the relationship between the Bank of Japan and the
JGB market. The Bank of Japan uses JGBs to conduct money market operations (Slide 7).
During a one-year period up to April this year, central bank money increased by 20.7 trillion
yen on the liability side of the Bank of Japan's balance sheet. Correspondingly, JGBs
increased by 8.2 trillion yen on the asset side as a result of the outright purchases of JGBs.
To deal with short-term fluctuations in financial institutions' demand for reserves, the Bank
conducts funds-supplying operations against pooled collateral. The operations are that the
Bank extends loans to financial institutions against pooled collateral which they submitted
beforehand. During a one-year period up to April this year, those loans increased by 20.1
trillion yen and JGBs account for 80 percent of the collateral. It is an example of how JGBs
play an important role in the Bank's money market operations.4 Apparently, the Bank is the
most proactive among the central banks of major countries in using government securities in
the money market operations.
This way, the Bank of Japan uses JGBs on a large scale in conducting money market
operations. In that context, I would like to stress that the goal of the central bank's outright
purchases of JGBs is to satisfy demand for secular growth in currency and to conduct
monetary policy, but not to finance government debt or to stabilize yields of long-term
government bonds. If market participants were to regard the central bank's outright
purchases of JGBs as a means of government financing or of stabilization of long-term JGB
yields, the resultant hike in risk premium would raise yields on long-term government bonds.
If the rise in the yields on long-term government bonds reflects improvements in economic
conditions, the rise in the yields is natural and desirable. However, if the rise in the yields on
long-term government bonds reflects the rise in risk premium, it exerts a negative impact on
the real economy and the financial strength of financial institutions.
The Bank has made the principle on the outright purchases of JGBs very clear. This
principle, called "banknote principle," has been working to prevent uncertainties of the Bank's
actions from raising a risk premium and thus from exerting a negative impact on the
economy and finance. More specifically, the Bank keeps the total amount of its holding of
government bonds below the outstanding amount of banknotes in circulation.
Some criticize the Bank for establishing such a principle. However, if a central bank that
holds such a large amount of government bonds were to purchase government bonds
without making its fundamental principle of the purchases clear, increased uncertainties
would create a risk premium and lead to a rise in yields on long-term government bonds. In
addition to the ceiling of the total holding of government bonds, the Bank also makes public
the amount of purchases in specific maturity segments as well as the frequency of the
purchases in advance (Slide 8).
In 2009, the Bank increased the amount of Bank's outright purchases of JGBs to
1.8 trillion yen per month, that is, 21.6 trillion yen per year. Since then, the Bank has been
keeping the ceiling. The average duration of the JGBs purchased by the Bank was about
4 years in 2010. If the Bank purchases JGBs at the current pace, it will lead the Bank to
hold 82 trillion yen of JGBs, the amount calculated by multiplying the amount purchased
per year by an average duration. The current outstanding amount of banknotes is around
81 trillion yen. At present, the outstanding amount of JGBs held by the Bank is
60 trillion yen and less than that of banknotes. However, if the Bank continues to purchase
JGBs at this pace, the outstanding amount of JGBs will reach that of banknotes. The
outstanding amount of banknotes in the future cannot be predicted with certainty because it
depends on the income, the interest rate and the degree of stability of the financial system
in the future. The Bank thinks it desirable for economic and financial stability that the Bank
continues to purchase JGBs at a stable pace, based upon the best possible forecast of
those economic developments.
Underwriting of government securities by the Bank of Japan
Now, I will talk about the idea of the underwriting of government securities by the Bank,
which is occasionally advocated as a way for funding new government spending.
In many countries, laws do not allow the central bank to directly underwrite government
securities. In Europe, the underwriting is prohibited by law explicitly. In many other countries
around the world, including emerging economies, it is not allowed, either. In Japan, Article 5
of Public Finance Act prohibits the Bank from underwriting government securities.
The principle on prohibiting the central bank from underwriting government securities has
been derived from historical lessons. History shows that once the underwriting by the central
bank was introduced, it often led to an excess issuance of money and hence rampant
inflation, even if it seemed to be under control at an initial phase. The excess issuance of
money and resultant inflation destroy people's lives and the national economy.
Based upon this conventional wisdom, the introduction of the Bank's underwriting of
government securities would damage confidence in money. The damage would lead to
higher long-term interest rates and instability in the financial market. Then, the government
might not be able to issue its debts in the primary market.
The current condition in the auction of Japanese government securities remains stable even
after the recent Great East Japan Earthquake. Still, taking account of the deteriorated fiscal
condition in Japan, it is of utmost importance to maintain the current stable condition in the
primary government securities market.
Confidence in money and the well-developed government securities markets are parts of the
social infrastructure for the Japanese economy. Now, it is even more important to maintain
confidence in money and government securities on both international and domestic grounds,
given the severe fiscal condition and damage of the recent earthquake on the Japanese
economy.
Let me add a few words about the Bank's bitter experience in oft-quoted underwriting of
government bonds in the early 1930s when the veteran Finance Minister Korekiyo Takahashi
initiated it. Though some commentators refer to this episode at times in their favor, they do
not necessarily recognize a big difference between financial and economic conditions at that
time and those at present (Slide 9).
First, conditions in the financial market were tight on the eve of the Bank's underwriting of
government bonds in the early 1930s. The overnight call rate was 6.6 percent in December
1931, compared with the current level of 0.07 percent. The long-term interest rate was
5.9 percent in December 1931, compared with the current level of 1.14 percent.
Second, fiscal conditions were much better in the early 1930s than in 2011. The outstanding
amount of government securities was 47.6 percent of GNP at the end of December 1931,
compared with 181.9 percent of GDP at the end of March 2011.
Third, the Bank's underwriting of government bonds in the early 1930s was associated with
tighter capital controls in the early 1930s. By contrast, the financial market and other
economic activities are much more globalized now. Under those circumstances, the
misconduct of monetary and fiscal policy, which leads to a deterioration in confidence in
money, would affect long-term interest rates immediately.
Fourth, the relative size of a domestic financial market was smaller in the early 1930s than
today, and the government securities markets were less developed. In the 1920s and in the
early 1930s, the government issued its securities mainly through a syndicate of private
financial institutions or through the Deposit Bureau of the Ministry of Finance. A large part of
the fund of the Deposit Bureau came from postal savings. Under such condition, the
government lacked effective measures to issue a large amount of its securities promptly and
smoothly.
During the first several years of Mr. Takahashi in office, the Bank was able to sell most of the
underwritten government bonds in the secondary market promptly. The amount of the Bank's
holding of government securities did not grow significantly, hence the monetary base did not,
either.
By contrast, we now have well-developed primary government securities markets. Even after
the recent earthquake, the government is able to issue its securities in the market smoothly,
and the bid-to-cover ratios in the primary markets remain unchanged.
Although some commentators mention a sharp depreciation of the Japanese exchange rate
in the early 1930s, the exchange rate regime at that time was quite different. After the
departure from the gold standard at the end of 1931, the yen depreciated from an overvalued
level under the gold standard. By contrast, Japan is on the flexible exchange rate system
today.
As many of you know, Mr. Takahashi was assassinated in 1936 by militarists when he was
trying to stop ever-growing demand for military spending, and the course of events led to the
eventual rampant inflation. I would argue that the introduction of the scheme of the Bank's
underwriting of government securities itself paved the way for eventual ballooning of fiscal
spending, precisely because the scheme lacked the checking process through the market
mechanism.
We often use the words of "entrance" and "exit" to discuss the conduct of monetary policy
nowadays. In that terminology, we should interpret that the "entrance" of the introduction of
the Bank's underwriting of government bonds in the early 1930s led to the "exit" of the failure
in containing growing demand for fiscal expenditure.
In retrospect, we should note that the Bank's underwriting of government bonds started as a
"temporary measure."5 Though Mr. Takahashi stated that he issued government bonds by a
means of the Bank's underwriting just temporarily in his address at a Diet session,6 history
told us that it was not temporary.
Today, central banks are not allowed to underwrite government securities in emerging
economies as well as developed countries. Underwriting government securities by central
banks may eventually lead to an excess issuance of money and rampant inflation,
devastating people's lives and economic activity, even though it may appear no problem at
the beginning. Humans are prone to temptations, but at the same time, humans are aware of
that and take a preventive measure by prohibiting central banks' underwriting of government
securities.
We are not able to improve fiscal balance simply by creating inflation (Slide 10). Inflation may
cause an increase in tax revenue, but as the data for the last twenty years in Japan shows,
changes in fiscal revenue show no significant correlation with inflation. Rather, fiscal revenue
increased as the economy grew in real terms. Expenditures such as social security and
public works increase with inflation. Interest payments on the government debts also
increase with inflation, since long-term interest rates also go up, reflecting inflation.
In the interest of time, I do not get into more detail on fiscal issues. What is clear is that we
need to review the overall structure of revenues and expenditures in order to improve fiscal
balance. Also, higher economic growth is needed to improve fiscal balance. Here, we have to
bear in mind that it is growth in real terms rather than