richard werner intro
reface
In January 2001, the ambassador to Japan of a European country told me about his recent New Year's Eve party at his residence in Tokyo. Among the guests was a highranking official from Japan's Ministry of Finance (MoP). Most guests were in a joyful mood. They looked forward to the dawn of the twenty-ftrst century. Champagne was flowing and the party was in full swing. But not everyone was happy: "I noticed," the ambassador told me, "as the clock approached midnight, this gentleman seemed to be getting sadder and sadder. He was from the Ministry of Finance, and he looked really down. I wondered what the problem was. It was most unusual, I thought. Finally, as the clock struck midnight, he came up to me and told me, in a very sad voice: '''Now ... it's all over .... ' '''What do you mean?' I asked him. '''We lost our name,' he replied. 'It's over .... From January 2001, Okurasho [the Japanese name for Ministry of Finance] is gone.' "I tried to console him by saying, 'Well, but it's just the name. You shouldn't worry too much about a name. The ministry is still there. You still have power and influence.' "But he said: 'If they at least had left us the name ... They had already taken away our power. It's gone .... But that they would also take away our name ... ' He shook his head despondently." Not noticed by many English-speakers, to whom the old OkurashO was simply known as the Ministry of Finance, a long and illustrious history ended abruptly in January 2001. For much of the past century, at least according to the letter of the law, the Okurasho had been the most powerful institution in Japan. Its grand old name is more correctly translated as "Great Storehouse Ministry" or "Great Treasury Ministry" and its history goes back to the time when taxes were paid in kind and the ministry literally was the storehouse of the rice that would arrive from all over the country.
Structural Change
The general public has not shed any tears over the demise of OkurashO. MoF, the Finance Ministry, is generally held responsible for the most flagrant economic mismanagement in modern peacetime Japanese history: the creation of the bubble of the 1980s and the long recession that followed in the 1990s.
ix
x PREFACE
The recession had produced the general conviction that Japan's old economic system, headed by its leading bureaucracies, did not work anymore and thus had to be reformed drastically. Most commentators now claim that structural changes are "badly needed." Prime Minister Junichiro Koizumi 's most repeated slogan is "No recovery without structural reform." Senior members of the Japanese central bank have been calling for far-reaching structural reform on an almost daily basis. These voices claim that liberalization, deregulation, and privatization, in other words, the introduction of U.S.-style capitalism, is necessary for Japan's economy to recover. But is it really necessary to abandon Japanese-style capitalism? One would think so, when considering the dismal performance of the economy during the 1990s. But it is strange that Japan's economic system was far more closed, cartelized, and controlled in the 1980s, and yet nobody complained that its economy was growing too slowly then. The same applies to the 1950s or 1960s, when an almost completely cartelized economy delivered double-digit growth. Moreover, the U.S. economy itself still suffers from business cycles and downturns. It seems, then, that the same economic structure can deliver high or low growth, and growth performance depends on other factors as well. This book shows that the Japanese recession was indeed due to the main force driving the business cycle-money. It is not by coincidence that the main proponents of structural change are precisely those who are in control of Japan's money.
The Defiant Bank of Japan
The central bank has consistently defied calls by the government, finance minister, and prime minister to create more money to stimulate the economy and end the long recession. At crucial junctures, such as in 1992, 1993, early 1995, and much of 1999, the Bank of Japan (BoJ) even actively reduced the amount of money circulating in the economy. This shrank purchasing power, reduced domestic demand, rendered the government's currency intervention ineffective, and strengthened the yen, thus aborting emerging recoveries. Lacking sufficiently supportive monetary policies, the government had to rely on fiscal policies. Those were not effective, and instead produced the largest national debt mountain of any industrialized country. The big puzzle of the 1990s is just why, despite record unemployment and deflation, the Bank of Japan failed to expand the amount of money further and thus create a recovery, reduce deflation, and stabilize employment. Sometimes fear of inflation is given as the answer. But Japan has witnessed sharp falls in inflation during the first half of the 1990s and outright deflation in the second. When prices rise and there is inflation, we know that monetary policy is too loose and too much money is being created. Then the central bank needs to tighten. When prices fall and there is deflation, the central bank has a duty to create more purchasing power. In general, it is the job of the central bank to create sufficient
PREFACE xi
amounts of money to keep the actual growth rate close to potential and hence avoid both inflation and deflation. Given the obvious deflation problem, the Bank of Japan admitted a while ago that fear of inflation is not the reason for its cautious stance. To the contrary, for many years now the Bank of Japan has been saying that it is trying hard to stimulate the economy, noting that it has lowered interest rates to zero. But, it claims, the problem has been a lack of demand for money. Yet it is clear that the largest demand for money in the world is located precisely in Japan. First, the government sector demands record amounts of money to fund its fiscal spending. Second, the many small and medium-sized firms that are Japan's main employers would like to borrow money. But the banks, burdened with bad debts, have only been willing to lend to larger, lower-risk borrowers. That is why the central bank needs to step in and substitute for their lending. Sometimes the Bank of Japan claims that it is already injecting plenty of money into the economy. But it has mostly poured its money into the very narrow money market to which only banks have access. At other times, worries about deflation are countered by its spokesmen with the assertion that deflation is due to desirable structural changes and hence good. But if those structural changes have indeed made Japan's economy more productive, this would raise Japan's potential growth rate, leaving an even larger gap with actual growth. In that case, the central bank would have to create even more money to reduce the deflationary gap. The most recent argument by central bankers, apparently also backed by the prime minister and his minister of economic and fiscal policy, is that there is too much "excess capacity" in Japan. This is true, and another way of putting it would be to say that aggregate supply is larger than aggregate demand. But instead of drawing the logical conclusion that demand should be stimulated-which the central bank could easily do-the advice is given to restrict the supply by closing down firms. Reminiscent of the ill-fated policies of certain depression-era politicians in Japan, Germany and the United States, this "excess capacity" is said to result in "excess competition," which must be dealt with through bankruptcies. Ironically, this argument is proposed by the very same commentators who also argue that Japan needs more deregulation, because it suffers from a "lack of competition." The pattern is clear: While the Bank of Japan's arguments vary-and are quickly changed, when countered-they always come to the same conclusion, namely that the central bank's monetary policy has been appropriate and that the blame lies with Japan's economic structure.
The Bank of Japan Could Have Helped, But It Didn't
Money is normally created by banks. It is precisely because banks did not lend that the central bank needed to inject more money directly into the economy. It would thus act as the banker to the nation-as other central banks have done before, and as, indeed, the Bank of Japan did after 1945, when banks' balance sheets
xii PREFACE
looked far worse than in the 1990s. This worked so well in the years after 1945 that credit growth quickly recovered and the economy boomed. But throughout much of the 1990s, the Bank of Japan failed to take these tested and tried policies and failed to create enough money for a sustained economic recovery. Moreover, it has refused to lend to those who needed money most, the government and the small firms. The Bank of Japan also has had it in its power to delete the entire mountain of bad debts in the banking system without any costs to itself, the tax payer, or society at large. Yet it chose not to act. Why? It is natural to start with the incompetence hypothesis. Incompetence may indeed explain the actions of some of the actors in this drama. The Ministry of Finance, for instance, and the political leaders during the 1990s could have created a recovery simply by changing the way they funded their fiscal expenditure. Instead of borrowing from the public by issuing bonds-thus draining the money from the economy-they could have funded the public sector borrowing requirement by direct loan contracts from banks. When banks lend, they create money out of nothing, without withdrawing it from other parts of the economy. This way, fiscal policy would not have crowded out private-sector activity yen by yen, as actually happened. Had they fully understood this, I am sure they would have used this method to create a recovery. However, this mechanism is little known among economists, whether in Japan, Europe, or the United States.! The more obvious and better-known mechanism is the one prescribed even by introductory economics textbooks: The central bank can inject money directly into the economy, even when banks are bankrupt, by increasing its purchases of assets, including government bonds.2 Yet the central bank has denied the truth of this fact for years--out of incompetence? The deeper I researched into the issues and their history, the clearer it became that the leaders at the Bank of Japan have personally been very familiar with Japan's predicament and how to end it. In several previous recessions that were due to a credit crunch (such as the 1960s slump), the central bank increased lending to the corporate sector and the government. Also today, the central bank has many options available to achieve this. To name a few, it could purchase debt paper issued by firms, lend to the government, buy more bonds, buy real estate and turn it into public parks, or just print money and hand some to each citizen. In all cases, purchasing power would increase and demand would be stimulated. Printing money might also weaken the yen, which would help exports.3 This would not produce inflation, since the very problem and cause of the recession is lack of money and hence deflation. An economic recovery could have been engineered at any time during the 1990s by increased central bank credit creation. Japan could have had high growth throughout the 1990s if the Bank of Japan had wished it to happen. All this is not rocket science. Moreover, today central bankers can look back on the rich history and experience of the Bank of Japan or other central banks that have dealt with the same issues, such as the German central bank or the U.S. Federal Reserve. So the puzzle remains: Why did the Bank of Japan not create more money?
PREFACE xiii
Concerning the motives of the players, there is little doubt that over the 1990s, the Ministry of Finance, just as the many governments that came and went, had every incentive to create an economic recovery. The ministry, in the firing line of fierce criticism, was painfully aware that a long recession endangered its legal predominance and that of the postwar economic structure. Upon closer examination, the motives of the central bank seem less clear. By 1992, when I was a visiting researcher at the Bank of Japan, I had discovered the importance of credit creation and its allocation. I realized that Japan's recession was going to get worse and unemployment was going to soar if the central bank did not implement the right policies. Interest rate reductions and fiscal policy were not sufficient. What was needed was more central bank money creation. But at the time the central bank was doing the opposite, actively withdrawing money from the economy. I could not understand why and kept asking different members of the Bank of Japan to give me an answer. Finally, one particular central banker explained to me: "If we printed more money, we would get a recovery. But then nothing would change. Japan's structural problems would not be solved." At the time I could not believe his words. Would the Japanese central bank intentionally prolong the recession in order to change the economic structure? Would it be the job of the central bank to implement such economic and social change-especially change of such scale, at such economic and human cost, and in this opaque fashion? By 1998 suicides had reached a postwar high, many induced by the recession.4 The Bank of Japan's official statements about its policy have been highly contradictory. On one hand, the central bank has insisted that the recession was due not to its policies but to the economic structure. That's why structural changes, not monetary stimulation, were necessary-as its officers never tire of repeating. Yet its staff (including its governor) have also said that they did not want to stimulate the economy (thus admitting that they could), because this would put off "badly needed" structural changes.s Central bank staff even argue that significant monetary easing "could cause harm" by inducing "a further delay in the progress of structural adjustment.,,6 Adam Posen, an economist at Washington's Institute for International Economics, has therefore concluded: "Between a process of elimination, and careful reading of the statements of BoJ policy board members, I am led to the conclusion that a desire to promote structural change in the Japanese economy is a primary motivation for the Bank's passive-aggressive acceptance of deflation."7 If the reader is as skeptical as I was in the early 1990s, then this is a conclusion that is hard to accept.
The Rise and Rise of the Bank of Japan
If a recovery would prevent structural changes, then this means that structural changes are not necessary for a recovery. So why are structural changes needed? While the Japanese system has had many problems and there is room for improve
xiv PREFACE
ment--especially when it comes to increasing the quality of life, the size of houses, leisure time available, the number of parks, and so on-it is not clear that a U.S.style economic system will significantly improve living standards. A U.S.-style economic system also has disadvantages. The Japanese economic system had many positive aspects that could have been preserved if a public debate had occurred about the structural change agenda. The fact is that the recession of the 1990s has indeed triggered a structural transformation that many experts refer to as "remarkable."8 The structural and administrative reforms of the 1990s did not just create losers. While former Okurasho bureaucrats may have been close to tears on New Year's Eve 2000, the champagne corks were perhaps popping elsewhere. When the Okurasho was scrapped, its tasks had already been either abolished or reassigned to other agencies. In 1998 monetary policy was put into the hands of the newly independent Bank of Japan and regulation of the financial sector was put into the hands of the independent Financial Services Agency (FSA). Since many of the influential FSA staff hailed from the central bank, a clear winner had emerged from the administrative reshuffling.9 That was none other than the Bank of Japan, MoF's long-standing rival. It had finally triumphed and was now more powerful than ever before. Despite the ministry's dominant legal status, the central bank had the better cards: It was in charge of a little-known and extralegal credit control mechanism. Hiding behind the smoke screen of traditional interest rate policies, its decision makers remained entirely unaccountable. All this was possible because of a lack of transparency and a lack of meaningful accountability by the central bank for its monetary policy.
Central Bank Independence
The new Bank of Japan Law was proposed in 1997 as part of Prime Minister Hashimoto's administrative reform program. At the time, the financial press argued that the new law merely meant a "slight increase in autonomy" for the Bank of J apan.lO The deputy governor of the Bank of Japan at the time, Toshihiko Fukui, lobbied press and politicians and argued that the new Bank of Japan Law "would allow the bank to make monetary decisions faster and more flexibly, and help it gain more credibility from the financial markets."ll This is not what happened-just as I had feared in 1997, when the new law was being debated. By that time I had done enough research to become convinced that the new BoJ Law was against the interests of the Japanese people, and by example also a threat to democracies in other countries. So I did my best to stop its passage. I faxed a letter to as many parliamentarians as I could. I also tried to arrange meetings with the members of the relevant parliamentary committees. Many ignored my faxes and phone calls. But a substantial number did take the time to see me and hear what I had to tell them. But it was an uphill
PREFACE xv
battle. Just as I had thought myself before my years of research on the Bank of Japan, most experts also felt that central bank independence was a good thing. We will see later in this book that the arguments in favor of central bank independence, whether in Europe or Asia, have serious flaws. This includes the argument that the German Bundesbank's great success was based on its independence. The truth, as we shall see, was quite the opposite. The new Bank of Japan Law was passed. And that is why today the government has no more control over monetary policy. After the stock market falls of 200 1 and 2002, many politicians called for the resignation of the BoJ governor. Mr. Hayami responded to such criticism by demanding that Japanese people give up lifetime employment and face less job security. His own job security was assured. There was nothing the government could do to sack him. Under the new Bank of Japan Law he was not doing anything wrong, because it does not clearly state that it is the job of the central bank to achieve healthy economic growth. There is no mechanism for politicians to exert their will, except changing the central bank law again. It is not the government but the BoJ that decides whether we will have a boom or a recession.
Just Who Are the Central Bankers?
While the central bankers are good at keeping a low profile, their career paths tend to be more predictable than those of ordinary citizens or politicians. Few people would venture to guess who the next finance minister is going to be or how long the current prime minister will last. During the postwar era there has been no such uncertainty about the top job at the Bank of Japan. Japan has had twenty-six prime ministers in the fifty-eight years since the war. However, a much smaller number of people have been in control of Japan's money and hence the heart of its economy. Known as "princes" by their colleagues, they were the men behind the Bank of Japan. Like the puppeteers of Japanese bunraku, dressed in black and moving in the background, these little-known central bankers shaped key events in Japan's postwar history. Politicians, governments, and bureaucrats--even the mighty Ministry of Finance-became unwitting puppets in their money game. Yet until now very little has been known about them and their policy tools. I hope this book will shed some light on their activities and make the reader more aware of the power wielded by unelected central bankers. Even today, a large number of journalists and commentators seem quite sure about who is going to be the next Bank of Japan governor. In May 2001, in the same week this book was published in Japanese, Toshihiko Fukui, head of the Fujitsu Research Institute, staged an attempt to take over from Governor Hayami as the new governor. The media had been touting Fukui as an "impressive" candidate, the leading contender "in the running for the BoJ governorship;' and "in line for the top job.,,12 The Nikkei, Japan's leading financial newspaper, prematurely introduced him on its cover page, with a photo, as the n~w governor. In
xvi PREFACE
the event, Governor Hayami refused to resign. However, his five-year term ends in March 2003. Until December last year, despite other plausible candidates, the media agreed on the likeliest successor: Toshihiko Fukui, called the "compromise candidate at the top of the list" by the Financial Times. Why? He is an "effective leader, capable of steering the BoJ through the murky waters that lie ahead."13 In actual fact, in postwar history there has been little compromise in the selection of the true heads of the Bank of Japan. The same unanimous case was made by the media and well-informed observers before Yasushi Mieno became governor in 1989, and ten years before that, when Haruo Maekawa became governor. Again, ten years earlier, the insiders knew that Tadashi Sasaki would become governor. We find in this book that Fukui, Mieno, Maekawa, and Sasaki have many things in common. The least of those is that they were at the helm of the central bank for ten years each, and they all played a leading role in the Japan Association of Corporate Executives (Keizai Doyukai), which has argued since the 1970s that Japan should radically change its economic structure. More ominously, all of them had been known as "princes" since their youthful early years at the central bankthe anointed future heads of the Bank of Japan. It was an epithet that was not awarded lightly: only one central banker per decade could become a prince. In its earlier Japanese version this book contributed to an increasing awareness by the Japanese public about these princes, their goals and their way of implementing their policies-including Fukui's pivotal role in the events that led to the creation of the financial bubble of the 1980s and the decade-long period of underperformance in the 1990s. Moreover, more politicians appear to understand that the Bank of Japan has been the main culprit behind the Japanese malaise and that a more supportive policy by the central bank is a necessary condition for an economic recovery. Perhaps as a result, Prime Minister Koizumi stated in late December 2002 that he would appoint as governor of the Bank of Japan only someone who is "aggressive in fighting deflation." 14 This should effectively have ruled out "prince" Fukui as contender: not only his past actions but also his recent statements seemed to indicate that he is unwilling to fight deflation.15 To the contrary, he demanded that more companies should be bankrupted and that Japan's unemployment rate should rise further to at least 8 percent.16 But what is said is not always what is done. If an outsider had been appointed as new Bank of Japan governor, in place of Fukui, the old guard at the Bank of Japan would likely have resorted to a welltried method of staying in charge in such cases: we will see in this book that whenever a former Finance Ministry official or an outsider from the private sector became Bank of Japan governor, he would be kept in the dark about the-allegedly "technical"-details of the actual monetary policy implementation, namely the quantity of the central bank's credit creation. These were decided by the deputy governor, one of the princes, who would after five years become official governor. During the first five years, the official governor would have control over the
PREFACE xvii
minor policy tools of interest rates and banks' reserves with the central bank, while the old guard would remain in charge through their control over the quantity of credit. In the event, Toshihiko Fukui once again made the race, just as had been planned thirty-five years ago. Back in 2000, when I was finishing the Japanese version of this book, I predicted that he woud become the next governor of the Bank of Japan. The fact that he was duly appointed, despite contrary statements by the prime minister and by an administration famous for surprise appointments, merely serves to demonstrate the extent of the power wielded by the princes.
Public Debate Is Needed
Nobody knows better than prince Fukui that the introduction of an inflation target, now thought to be favored by the prime minister, is also not itself a solution. He knows that what is needed are policies to expand credit creation. Instead, just like the Reichsbank during the Weimar Republic, the Bank of Japan has been implementing inappropriate credit policies that go significantly beyond the call of duty without the necessary accountability. There is a danger that the European Central Bank and the U.S. Federal Reserve are following in the footsteps of these central banks. Even central bankers are human. As such, they are as prone to errors and acts of selfishness as anyone else. What they need is the right incentive structure to limit these tendencies, namely, democratic checks and balances. Implementing such checks does not mean that money should be debauched and inflation allowed. To the contrary, history teaches that the only guarantor of stable money is accountability of a central bank that has been given the right policy goals. A broader debate about the correct role of central banks in democracies is necessary. Any such debate must be based on knowledge of the facts and the history of central banking. This includes the realization that central banks often may use interest rates as a smoke screen to distract others from their true policies, which usually can be judged better when measuring the quantity of credit. I am happy to report that my book has made a modest contribution to this effort. The Japanese version was published with a print run of 150,000 copies, becoming a number one best-seller. Many members of parliament read it. Several LDP members took it to heart and established the LDP Central Bank Reform Research Group. I hope the English edition will contribute to the stimulation of such debate also in other countries.
Tokyo, 28 February 2003 Richard A. Werner
In January 2001, the ambassador to Japan of a European country told me about his recent New Year's Eve party at his residence in Tokyo. Among the guests was a highranking official from Japan's Ministry of Finance (MoP). Most guests were in a joyful mood. They looked forward to the dawn of the twenty-ftrst century. Champagne was flowing and the party was in full swing. But not everyone was happy: "I noticed," the ambassador told me, "as the clock approached midnight, this gentleman seemed to be getting sadder and sadder. He was from the Ministry of Finance, and he looked really down. I wondered what the problem was. It was most unusual, I thought. Finally, as the clock struck midnight, he came up to me and told me, in a very sad voice: '''Now ... it's all over .... ' '''What do you mean?' I asked him. '''We lost our name,' he replied. 'It's over .... From January 2001, Okurasho [the Japanese name for Ministry of Finance] is gone.' "I tried to console him by saying, 'Well, but it's just the name. You shouldn't worry too much about a name. The ministry is still there. You still have power and influence.' "But he said: 'If they at least had left us the name ... They had already taken away our power. It's gone .... But that they would also take away our name ... ' He shook his head despondently." Not noticed by many English-speakers, to whom the old OkurashO was simply known as the Ministry of Finance, a long and illustrious history ended abruptly in January 2001. For much of the past century, at least according to the letter of the law, the Okurasho had been the most powerful institution in Japan. Its grand old name is more correctly translated as "Great Storehouse Ministry" or "Great Treasury Ministry" and its history goes back to the time when taxes were paid in kind and the ministry literally was the storehouse of the rice that would arrive from all over the country.
Structural Change
The general public has not shed any tears over the demise of OkurashO. MoF, the Finance Ministry, is generally held responsible for the most flagrant economic mismanagement in modern peacetime Japanese history: the creation of the bubble of the 1980s and the long recession that followed in the 1990s.
ix
x PREFACE
The recession had produced the general conviction that Japan's old economic system, headed by its leading bureaucracies, did not work anymore and thus had to be reformed drastically. Most commentators now claim that structural changes are "badly needed." Prime Minister Junichiro Koizumi 's most repeated slogan is "No recovery without structural reform." Senior members of the Japanese central bank have been calling for far-reaching structural reform on an almost daily basis. These voices claim that liberalization, deregulation, and privatization, in other words, the introduction of U.S.-style capitalism, is necessary for Japan's economy to recover. But is it really necessary to abandon Japanese-style capitalism? One would think so, when considering the dismal performance of the economy during the 1990s. But it is strange that Japan's economic system was far more closed, cartelized, and controlled in the 1980s, and yet nobody complained that its economy was growing too slowly then. The same applies to the 1950s or 1960s, when an almost completely cartelized economy delivered double-digit growth. Moreover, the U.S. economy itself still suffers from business cycles and downturns. It seems, then, that the same economic structure can deliver high or low growth, and growth performance depends on other factors as well. This book shows that the Japanese recession was indeed due to the main force driving the business cycle-money. It is not by coincidence that the main proponents of structural change are precisely those who are in control of Japan's money.
The Defiant Bank of Japan
The central bank has consistently defied calls by the government, finance minister, and prime minister to create more money to stimulate the economy and end the long recession. At crucial junctures, such as in 1992, 1993, early 1995, and much of 1999, the Bank of Japan (BoJ) even actively reduced the amount of money circulating in the economy. This shrank purchasing power, reduced domestic demand, rendered the government's currency intervention ineffective, and strengthened the yen, thus aborting emerging recoveries. Lacking sufficiently supportive monetary policies, the government had to rely on fiscal policies. Those were not effective, and instead produced the largest national debt mountain of any industrialized country. The big puzzle of the 1990s is just why, despite record unemployment and deflation, the Bank of Japan failed to expand the amount of money further and thus create a recovery, reduce deflation, and stabilize employment. Sometimes fear of inflation is given as the answer. But Japan has witnessed sharp falls in inflation during the first half of the 1990s and outright deflation in the second. When prices rise and there is inflation, we know that monetary policy is too loose and too much money is being created. Then the central bank needs to tighten. When prices fall and there is deflation, the central bank has a duty to create more purchasing power. In general, it is the job of the central bank to create sufficient
PREFACE xi
amounts of money to keep the actual growth rate close to potential and hence avoid both inflation and deflation. Given the obvious deflation problem, the Bank of Japan admitted a while ago that fear of inflation is not the reason for its cautious stance. To the contrary, for many years now the Bank of Japan has been saying that it is trying hard to stimulate the economy, noting that it has lowered interest rates to zero. But, it claims, the problem has been a lack of demand for money. Yet it is clear that the largest demand for money in the world is located precisely in Japan. First, the government sector demands record amounts of money to fund its fiscal spending. Second, the many small and medium-sized firms that are Japan's main employers would like to borrow money. But the banks, burdened with bad debts, have only been willing to lend to larger, lower-risk borrowers. That is why the central bank needs to step in and substitute for their lending. Sometimes the Bank of Japan claims that it is already injecting plenty of money into the economy. But it has mostly poured its money into the very narrow money market to which only banks have access. At other times, worries about deflation are countered by its spokesmen with the assertion that deflation is due to desirable structural changes and hence good. But if those structural changes have indeed made Japan's economy more productive, this would raise Japan's potential growth rate, leaving an even larger gap with actual growth. In that case, the central bank would have to create even more money to reduce the deflationary gap. The most recent argument by central bankers, apparently also backed by the prime minister and his minister of economic and fiscal policy, is that there is too much "excess capacity" in Japan. This is true, and another way of putting it would be to say that aggregate supply is larger than aggregate demand. But instead of drawing the logical conclusion that demand should be stimulated-which the central bank could easily do-the advice is given to restrict the supply by closing down firms. Reminiscent of the ill-fated policies of certain depression-era politicians in Japan, Germany and the United States, this "excess capacity" is said to result in "excess competition," which must be dealt with through bankruptcies. Ironically, this argument is proposed by the very same commentators who also argue that Japan needs more deregulation, because it suffers from a "lack of competition." The pattern is clear: While the Bank of Japan's arguments vary-and are quickly changed, when countered-they always come to the same conclusion, namely that the central bank's monetary policy has been appropriate and that the blame lies with Japan's economic structure.
The Bank of Japan Could Have Helped, But It Didn't
Money is normally created by banks. It is precisely because banks did not lend that the central bank needed to inject more money directly into the economy. It would thus act as the banker to the nation-as other central banks have done before, and as, indeed, the Bank of Japan did after 1945, when banks' balance sheets
xii PREFACE
looked far worse than in the 1990s. This worked so well in the years after 1945 that credit growth quickly recovered and the economy boomed. But throughout much of the 1990s, the Bank of Japan failed to take these tested and tried policies and failed to create enough money for a sustained economic recovery. Moreover, it has refused to lend to those who needed money most, the government and the small firms. The Bank of Japan also has had it in its power to delete the entire mountain of bad debts in the banking system without any costs to itself, the tax payer, or society at large. Yet it chose not to act. Why? It is natural to start with the incompetence hypothesis. Incompetence may indeed explain the actions of some of the actors in this drama. The Ministry of Finance, for instance, and the political leaders during the 1990s could have created a recovery simply by changing the way they funded their fiscal expenditure. Instead of borrowing from the public by issuing bonds-thus draining the money from the economy-they could have funded the public sector borrowing requirement by direct loan contracts from banks. When banks lend, they create money out of nothing, without withdrawing it from other parts of the economy. This way, fiscal policy would not have crowded out private-sector activity yen by yen, as actually happened. Had they fully understood this, I am sure they would have used this method to create a recovery. However, this mechanism is little known among economists, whether in Japan, Europe, or the United States.! The more obvious and better-known mechanism is the one prescribed even by introductory economics textbooks: The central bank can inject money directly into the economy, even when banks are bankrupt, by increasing its purchases of assets, including government bonds.2 Yet the central bank has denied the truth of this fact for years--out of incompetence? The deeper I researched into the issues and their history, the clearer it became that the leaders at the Bank of Japan have personally been very familiar with Japan's predicament and how to end it. In several previous recessions that were due to a credit crunch (such as the 1960s slump), the central bank increased lending to the corporate sector and the government. Also today, the central bank has many options available to achieve this. To name a few, it could purchase debt paper issued by firms, lend to the government, buy more bonds, buy real estate and turn it into public parks, or just print money and hand some to each citizen. In all cases, purchasing power would increase and demand would be stimulated. Printing money might also weaken the yen, which would help exports.3 This would not produce inflation, since the very problem and cause of the recession is lack of money and hence deflation. An economic recovery could have been engineered at any time during the 1990s by increased central bank credit creation. Japan could have had high growth throughout the 1990s if the Bank of Japan had wished it to happen. All this is not rocket science. Moreover, today central bankers can look back on the rich history and experience of the Bank of Japan or other central banks that have dealt with the same issues, such as the German central bank or the U.S. Federal Reserve. So the puzzle remains: Why did the Bank of Japan not create more money?
PREFACE xiii
Concerning the motives of the players, there is little doubt that over the 1990s, the Ministry of Finance, just as the many governments that came and went, had every incentive to create an economic recovery. The ministry, in the firing line of fierce criticism, was painfully aware that a long recession endangered its legal predominance and that of the postwar economic structure. Upon closer examination, the motives of the central bank seem less clear. By 1992, when I was a visiting researcher at the Bank of Japan, I had discovered the importance of credit creation and its allocation. I realized that Japan's recession was going to get worse and unemployment was going to soar if the central bank did not implement the right policies. Interest rate reductions and fiscal policy were not sufficient. What was needed was more central bank money creation. But at the time the central bank was doing the opposite, actively withdrawing money from the economy. I could not understand why and kept asking different members of the Bank of Japan to give me an answer. Finally, one particular central banker explained to me: "If we printed more money, we would get a recovery. But then nothing would change. Japan's structural problems would not be solved." At the time I could not believe his words. Would the Japanese central bank intentionally prolong the recession in order to change the economic structure? Would it be the job of the central bank to implement such economic and social change-especially change of such scale, at such economic and human cost, and in this opaque fashion? By 1998 suicides had reached a postwar high, many induced by the recession.4 The Bank of Japan's official statements about its policy have been highly contradictory. On one hand, the central bank has insisted that the recession was due not to its policies but to the economic structure. That's why structural changes, not monetary stimulation, were necessary-as its officers never tire of repeating. Yet its staff (including its governor) have also said that they did not want to stimulate the economy (thus admitting that they could), because this would put off "badly needed" structural changes.s Central bank staff even argue that significant monetary easing "could cause harm" by inducing "a further delay in the progress of structural adjustment.,,6 Adam Posen, an economist at Washington's Institute for International Economics, has therefore concluded: "Between a process of elimination, and careful reading of the statements of BoJ policy board members, I am led to the conclusion that a desire to promote structural change in the Japanese economy is a primary motivation for the Bank's passive-aggressive acceptance of deflation."7 If the reader is as skeptical as I was in the early 1990s, then this is a conclusion that is hard to accept.
The Rise and Rise of the Bank of Japan
If a recovery would prevent structural changes, then this means that structural changes are not necessary for a recovery. So why are structural changes needed? While the Japanese system has had many problems and there is room for improve
xiv PREFACE
ment--especially when it comes to increasing the quality of life, the size of houses, leisure time available, the number of parks, and so on-it is not clear that a U.S.style economic system will significantly improve living standards. A U.S.-style economic system also has disadvantages. The Japanese economic system had many positive aspects that could have been preserved if a public debate had occurred about the structural change agenda. The fact is that the recession of the 1990s has indeed triggered a structural transformation that many experts refer to as "remarkable."8 The structural and administrative reforms of the 1990s did not just create losers. While former Okurasho bureaucrats may have been close to tears on New Year's Eve 2000, the champagne corks were perhaps popping elsewhere. When the Okurasho was scrapped, its tasks had already been either abolished or reassigned to other agencies. In 1998 monetary policy was put into the hands of the newly independent Bank of Japan and regulation of the financial sector was put into the hands of the independent Financial Services Agency (FSA). Since many of the influential FSA staff hailed from the central bank, a clear winner had emerged from the administrative reshuffling.9 That was none other than the Bank of Japan, MoF's long-standing rival. It had finally triumphed and was now more powerful than ever before. Despite the ministry's dominant legal status, the central bank had the better cards: It was in charge of a little-known and extralegal credit control mechanism. Hiding behind the smoke screen of traditional interest rate policies, its decision makers remained entirely unaccountable. All this was possible because of a lack of transparency and a lack of meaningful accountability by the central bank for its monetary policy.
Central Bank Independence
The new Bank of Japan Law was proposed in 1997 as part of Prime Minister Hashimoto's administrative reform program. At the time, the financial press argued that the new law merely meant a "slight increase in autonomy" for the Bank of J apan.lO The deputy governor of the Bank of Japan at the time, Toshihiko Fukui, lobbied press and politicians and argued that the new Bank of Japan Law "would allow the bank to make monetary decisions faster and more flexibly, and help it gain more credibility from the financial markets."ll This is not what happened-just as I had feared in 1997, when the new law was being debated. By that time I had done enough research to become convinced that the new BoJ Law was against the interests of the Japanese people, and by example also a threat to democracies in other countries. So I did my best to stop its passage. I faxed a letter to as many parliamentarians as I could. I also tried to arrange meetings with the members of the relevant parliamentary committees. Many ignored my faxes and phone calls. But a substantial number did take the time to see me and hear what I had to tell them. But it was an uphill
PREFACE xv
battle. Just as I had thought myself before my years of research on the Bank of Japan, most experts also felt that central bank independence was a good thing. We will see later in this book that the arguments in favor of central bank independence, whether in Europe or Asia, have serious flaws. This includes the argument that the German Bundesbank's great success was based on its independence. The truth, as we shall see, was quite the opposite. The new Bank of Japan Law was passed. And that is why today the government has no more control over monetary policy. After the stock market falls of 200 1 and 2002, many politicians called for the resignation of the BoJ governor. Mr. Hayami responded to such criticism by demanding that Japanese people give up lifetime employment and face less job security. His own job security was assured. There was nothing the government could do to sack him. Under the new Bank of Japan Law he was not doing anything wrong, because it does not clearly state that it is the job of the central bank to achieve healthy economic growth. There is no mechanism for politicians to exert their will, except changing the central bank law again. It is not the government but the BoJ that decides whether we will have a boom or a recession.
Just Who Are the Central Bankers?
While the central bankers are good at keeping a low profile, their career paths tend to be more predictable than those of ordinary citizens or politicians. Few people would venture to guess who the next finance minister is going to be or how long the current prime minister will last. During the postwar era there has been no such uncertainty about the top job at the Bank of Japan. Japan has had twenty-six prime ministers in the fifty-eight years since the war. However, a much smaller number of people have been in control of Japan's money and hence the heart of its economy. Known as "princes" by their colleagues, they were the men behind the Bank of Japan. Like the puppeteers of Japanese bunraku, dressed in black and moving in the background, these little-known central bankers shaped key events in Japan's postwar history. Politicians, governments, and bureaucrats--even the mighty Ministry of Finance-became unwitting puppets in their money game. Yet until now very little has been known about them and their policy tools. I hope this book will shed some light on their activities and make the reader more aware of the power wielded by unelected central bankers. Even today, a large number of journalists and commentators seem quite sure about who is going to be the next Bank of Japan governor. In May 2001, in the same week this book was published in Japanese, Toshihiko Fukui, head of the Fujitsu Research Institute, staged an attempt to take over from Governor Hayami as the new governor. The media had been touting Fukui as an "impressive" candidate, the leading contender "in the running for the BoJ governorship;' and "in line for the top job.,,12 The Nikkei, Japan's leading financial newspaper, prematurely introduced him on its cover page, with a photo, as the n~w governor. In
xvi PREFACE
the event, Governor Hayami refused to resign. However, his five-year term ends in March 2003. Until December last year, despite other plausible candidates, the media agreed on the likeliest successor: Toshihiko Fukui, called the "compromise candidate at the top of the list" by the Financial Times. Why? He is an "effective leader, capable of steering the BoJ through the murky waters that lie ahead."13 In actual fact, in postwar history there has been little compromise in the selection of the true heads of the Bank of Japan. The same unanimous case was made by the media and well-informed observers before Yasushi Mieno became governor in 1989, and ten years before that, when Haruo Maekawa became governor. Again, ten years earlier, the insiders knew that Tadashi Sasaki would become governor. We find in this book that Fukui, Mieno, Maekawa, and Sasaki have many things in common. The least of those is that they were at the helm of the central bank for ten years each, and they all played a leading role in the Japan Association of Corporate Executives (Keizai Doyukai), which has argued since the 1970s that Japan should radically change its economic structure. More ominously, all of them had been known as "princes" since their youthful early years at the central bankthe anointed future heads of the Bank of Japan. It was an epithet that was not awarded lightly: only one central banker per decade could become a prince. In its earlier Japanese version this book contributed to an increasing awareness by the Japanese public about these princes, their goals and their way of implementing their policies-including Fukui's pivotal role in the events that led to the creation of the financial bubble of the 1980s and the decade-long period of underperformance in the 1990s. Moreover, more politicians appear to understand that the Bank of Japan has been the main culprit behind the Japanese malaise and that a more supportive policy by the central bank is a necessary condition for an economic recovery. Perhaps as a result, Prime Minister Koizumi stated in late December 2002 that he would appoint as governor of the Bank of Japan only someone who is "aggressive in fighting deflation." 14 This should effectively have ruled out "prince" Fukui as contender: not only his past actions but also his recent statements seemed to indicate that he is unwilling to fight deflation.15 To the contrary, he demanded that more companies should be bankrupted and that Japan's unemployment rate should rise further to at least 8 percent.16 But what is said is not always what is done. If an outsider had been appointed as new Bank of Japan governor, in place of Fukui, the old guard at the Bank of Japan would likely have resorted to a welltried method of staying in charge in such cases: we will see in this book that whenever a former Finance Ministry official or an outsider from the private sector became Bank of Japan governor, he would be kept in the dark about the-allegedly "technical"-details of the actual monetary policy implementation, namely the quantity of the central bank's credit creation. These were decided by the deputy governor, one of the princes, who would after five years become official governor. During the first five years, the official governor would have control over the
PREFACE xvii
minor policy tools of interest rates and banks' reserves with the central bank, while the old guard would remain in charge through their control over the quantity of credit. In the event, Toshihiko Fukui once again made the race, just as had been planned thirty-five years ago. Back in 2000, when I was finishing the Japanese version of this book, I predicted that he woud become the next governor of the Bank of Japan. The fact that he was duly appointed, despite contrary statements by the prime minister and by an administration famous for surprise appointments, merely serves to demonstrate the extent of the power wielded by the princes.
Public Debate Is Needed
Nobody knows better than prince Fukui that the introduction of an inflation target, now thought to be favored by the prime minister, is also not itself a solution. He knows that what is needed are policies to expand credit creation. Instead, just like the Reichsbank during the Weimar Republic, the Bank of Japan has been implementing inappropriate credit policies that go significantly beyond the call of duty without the necessary accountability. There is a danger that the European Central Bank and the U.S. Federal Reserve are following in the footsteps of these central banks. Even central bankers are human. As such, they are as prone to errors and acts of selfishness as anyone else. What they need is the right incentive structure to limit these tendencies, namely, democratic checks and balances. Implementing such checks does not mean that money should be debauched and inflation allowed. To the contrary, history teaches that the only guarantor of stable money is accountability of a central bank that has been given the right policy goals. A broader debate about the correct role of central banks in democracies is necessary. Any such debate must be based on knowledge of the facts and the history of central banking. This includes the realization that central banks often may use interest rates as a smoke screen to distract others from their true policies, which usually can be judged better when measuring the quantity of credit. I am happy to report that my book has made a modest contribution to this effort. The Japanese version was published with a print run of 150,000 copies, becoming a number one best-seller. Many members of parliament read it. Several LDP members took it to heart and established the LDP Central Bank Reform Research Group. I hope the English edition will contribute to the stimulation of such debate also in other countries.
Tokyo, 28 February 2003 Richard A. Werner
Comments
Post a Comment