toshihiko fukui : incentive mechanisms for economic policy makers opening speech by mr toshihiko fukui, governor of the bank of japan, at the 12th international conference hosted by the institute for monetary and economic studies, bank of japan, 30 may 2005. * * * introduction good morning, ladies and gentlemen. i am very pleased to address the 12th international conference hosted by the institute for monetary and economic studies. on behalf of my colleagues at the bank of japan, i welcome participants from all over the world. over the last twenty - four years, we were fortunate to have the best minds from the academia and central banks come together at previous conferences to discuss current issues in central banking. i would like to thank everyone who has been involved, because the positive reviews we received are reflections of all the commitments in time and efforts of the people attending the conferences. from this year, the institute will hold the conference every year, not every other year. this should enable us to cover a wider range of monetary and economic issues in a more timely manner. the new annual conference format should offer more opportunities for candid exchanges of views between central bankers and scholars. i hope that you would extend to us your continued support for our future conferences. theme of this year's conference this year, we discuss how to design incentive mechanisms for economic policy makers. institutions and the incentive mechanisms they engender collectively influence economic performance. some institutions create incentives to induce efficient behavior, and others do not. take two of the broadest of institutions, a market economy and a centrally planned economy. in a market economy, the market price signals any excess demand or supply, and creates incentives for producers. when the market price is higher than the equilibrium price, a producer has an incentive to increase his or her production and increase sales. on the other hand, a producer also has an incentive to cut back on his or her production when the market price is lower than the equilibrium price. meanwhile, increased supply will let the market price fall and vice versa, until the market is cleared at the equilibrium price. such an incentive mechanism achieves efficient resource allocation in a market economy. in a centrally planned economy, the track record of central planning agencies is dismal. they generally failed to structure incentives for a producer to autonomously respond to excess demand and excess supply. at the same time, central planning agencies themselves lacked proper incentives to identify changes in demand, and consequently, often failed to instruct producers to produce according

to changes in demand. efficient resource allocation was not achieved. it is no wonder then that centrally planned economies collapsed around the world by the 1990's. institutions and their incentive mechanisms play a key role in determining economic performance. failure of incentive mechanisms in a market economy the market price is not the only source of incentives in a market economy. some incentive mechanisms, however, fail to induce efficient behavior. for example, incentives influenced the course taken by japanese banks in dealing with the problem of non - performing loans. until the late 1990's, the japanese regulatory and institutional environment did not motivate banks to take prompt actions that would have prevented their balance sheets from deteriorating further. for example, the latitude banks had in the disclosure of non - performing assets enabled banks to withhold information, perfectly legally, on the full extent of their problems. as a result, market discipline could only play a limited role. at the same time, measures available to regulators and supervisors were rather limited. a bigger stick would surely have helped the authorities to persuade banks to take more decisive actions. finally, in the late 1990's and early 2000's, various policy measures were introduced to better align the incentives of banks. they included the introduction of more precise standards for disclosure and prompt corrective actions by the fsa. the functions of the deposit insurance corporation were strengthened as well. the bank of japan encouraged japanese banks to make an appropriate evaluation of their loans by using discounted cash flow method. these measures finally generated proper incentives for japanese banks to put their houses in order. the recent removal of the blanket guarantee of deposits was a symbolic event in this regard. this example suggests that incentive mechanisms could affect the stability of the financial system. the central bank has a vested interest in the design of such incentive mechanisms. incentive mechanisms for a central bank central banks are not free from incentives created by their institutional settings. for example, in the past, governments in the industrialized economies tended to regard that there was a trade - off between high growth and moderate inflation. this created an environment where central banks would acquiesce inflation resulting from above - potential economic growth. the stagflation in the 1970's could be regarded as a consequence of such misguided institutional incentives. fortunately, we have learned from history. from the late 1980's onwards, there seems to be a growing recognition among governments in the industrialized economies that central banks should aim for price stability, which is a precondition for