17 18 asian fin crisis 97

The Asian Crisis and the Central Bankers

The Asian Crisis

Japan was not the only high-performance economy in Asia that in the 1990s found itself in the deepest recession since the Great Depression. In 1997, the currencies of the key Southeast Asian countries could not maintain their fixed exchange rates with the U.S. dollar. They collapsed by between 60 and 80 percent within the year. This boosted the value of their large foreign liabilities. Unable to pay their debt and facing the possibility of national default, Thailand, Korea, and Indonesia asked the IMF for emergency funding. The IMF stepped in, but only in exchange for a set of stringent policies. Instead of improving, the economies of Thailand, Korea, and Indonesia deteriorated throughout 1998. The banking sectors verged on total default. Economic growth contracted. In Thailand, the country where the crisis started, manufacturing production fell by the largest amount in more than forty years. Stock markets collapsed.
Crisis Due to Economic Structure?

What had happened? Alan Greenspan, the chairman of the U.S. central bank, as well as Robert Rubin, then U.S. Treasury secretary, led a chorus of commentators who asserted that the Asian crisis was the result of the Asian economic system, which was based on closed markets and government interference.1 Although commentators from Europe and the United States had in preceding years praised the virtues of Asian-style capitalism, they were now virtually unanimous in their belief that the Asian crisis was due to the informal links between governments and big business (now called “cronyism”), the large reliance on bank lending instead of stock market finance (now referred to as “bloated banking systems” and “debt mountains”), and the many forms of government intervention in the markets (now called “government meddling”).
It was not surprising that observers trained in the tenets of a particular branch of neoclassical economics should come to this conclusion. As we have seen, this approach to economics axiomatically assumes that only free market economies can be successful. Asia, just like Japan and Germany, had achieved high growth under conditions where the influence of individual shareholders was restricted, managers were given a freer hand, credit allocation policies guided the financial sector, and government intervention was pervasive. As in Japan, the roots of the Asian system could be found in the dark days of the Second World War, when governments reorganized their economies for maximum resource mobilization following the German blueprint. Highly successful, the Asian miracle had been the biggest thorn in the flesh for mainstream economists. No wonder, then, that proponents of mainstream economics were relieved to find that such a system was, finally, underperforming. Since the IMF also subscribes to the neoclassical approach, its officials were quick to claim that the crisis was the result of the Asian system. Based on this assertion, the IMF then made any provision of loans to Thailand, Indonesia, and Korea conditional upon a historic transformation of their economic structures.2
But the crisis years, even though they were prolonged over a decade in Japan, were still the exception. There can be no doubt that the Japanese-style mobilized economy not only worked extremely well for Japan, but in various modified forms also contributed to the “miracle economies” all over Asia. Until 1997, the macro-economic performance of Thailand, Korea, Indonesia, Malaysia, Singapore, and Taiwan was widely praised by commentators, academics, and policymakers alike. Economic growth of the first three countries averaged in the double digits for most of the 1970s, the 1980s, and the first half of the 1990s. Per capita income grew 5.5 percent on average from 1960 to 1990.3
While there were periods when other developing countries also grew fast, no others have managed to sustain such high growth rates as these for three decades. But the achievements of these economies did not end with such impressive growth rates. They also attained remarkably low levels of income inequality and have been unusually successful in reducing poverty. Moreover, life expectancy improved by more than in any other region.4
It is therefore relevant to find out whether the Asian crisis really was the result of the Asian system. A thorough study of its causes reveals that, quite to the contrary, it was the policies “recommended” by the U.S. Treasury, the IMF, and the local Asian central banks that resulted in the Asian crisis.5 While the Asian central banks previously had had no independence and few legal powers, after the Asian crisis almost all of them had become independent and unaccountable for their actions.
Cause of the Asian Crisis

In Thailand, the country where the Asian crisis erupted first, the causes go as far back as 1993. In that year, Thailand implemented a policy of aggressive deregulation of the capital account and the establishment of the Bangkok International Banking Facility (BIBF). This banking facility enabled the corporate and banking sector to borrow liberally from abroad—the first time in the postwar era that Thai borrowers could do so. In the words of an expert observer: “This plan [implementation of the BIBF] was initiated in 1990 by the Bank of Thailand [Thailand’s central bank], which, in view of the successful financial liberalization carried out so far, felt that Thailand was ready and the timing and opportunity were right.”6 Korea and Indonesia adopted similar policies around the same time— again, postwar firsts.
There is no doubt that, as with Japan’s liberalization of capital flows in December 1980, this marked a major departure from the old economic structure. What is less clear is just why such liberalization of capital flows was adopted. There was no need for Thailand to borrow money from abroad: It boasted a high savings rate, had sufficient foreign exchange reserves, and possessed a large and vibrant banking sector and a central bank. All the money necessary for domestic investments could be created at home.
Indeed, the pressure to liberalize capital flows came from outside Thailand. Since the early 1990s, the IMF, GATT (predecessor of the WTO), and U.S. Treasury had been lobbying Thailand, as well as other Southeast Asian nations, to allow domestic firms to borrow from abroad. Such liberalization of capital flows had been the key U.S. demand in almost all APEC summits since 1993.7 The U.S. argument in favor of liberalization was that borrowing from abroad would enable Thailand, Korea, Indonesia, and their neighbors to run balance-of-payments deficits, which could be funded by capital inflows. Moreover, the IMF and the U.S. Treasury argued that neoclassical economics had proven that free capital markets and free capital movement increased economic growth.
These arguments, emerging from Washington, were not convincing to some developing countries that had for decades studied the options available to them. India, most notably, had consistently refused to deregulate the capital account and again in the 1990s resisted U.S. pressures.8 The Indians had good reasons: The experience of the 1970s and 1980s in almost all Latin American countries had proved that the liberalization of capital flows might result in an excessive buildup of foreign debt. That was not only expensive, as the foreign debt had to be serviced and hence valuable domestic resources would constantly flow out of the country as interest payments, but also dangerous. The Old Testament advises that the borrower is servant to the lender. By becoming indebted, developing countries became more dependent on the lender countries. And the lenders could quickly withdraw their funds at any time if they so wished. If the loans could not be paid, the collateral could be called in, such as equity in indigenous industries. This was the experience of many Latin American countries that implemented the liberalization and deregulation policies that the IMF and the U.S. Treasury had recommended to them before their crises of the 1970s and 1980s.9
Most of all, it did not make much economic sense for a country to borrow significant amounts from abroad in order to fund investments at home. History shows that successful economic powers, such as Germany or Japan, developed their economies with little foreign borrowing. As long as a country has an indigenous banking system, it can create all the necessary money through its banks or central bank, without the need to become dependent on the whims of foreign interests.
Central Bank Policies

There was also a domestic force in favor of capital account liberalization: the central banks of Thailand, Korea, and Indonesia, and the economists of their research departments. They argued that such liberalization would improve resource allocation. This line of argument was picked up by neoclassical economists at home and abroad, who already knew this to be true. While India resisted the pressures from the U.S. Treasury and Wall Street, on one hand, and central banks and neoclassical economists, on the other, the leaders of Thailand, Korea, and Indonesia eventually gave in. By 1993, they had all deregulated their international capital flows.
By doing so, they had committed the first of a series of crucial policy mistakes that would throw their countries into the biggest disaster in the postwar era. The next policy step toward financial meltdown was again taken by the central banks. They set about creating irresistible incentives for domestic firms to borrow from abroad. The impact of the BIBF was foreseeable, with one expert writing as early as 1995, “Large corporations will seek to obtain more funds through the BIBF,” hence from abroad.10
The central banks in Thailand, Korea, and Indonesia emphasized in all their public statements that they would, at all costs, maintain fixed exchange rates with the U.S. dollar. On the other hand, they raised domestic interest rates above U.S. dollar interest rates. Since the capital account had been deregulated, this meant that rational domestic investors were now given maximum incentive to borrow from abroad. Who would want to take out more expensive domestic loans if foreign loans were cheaper and the central bank guaranteed that there was no exchange rate risk? Hence billions of dollars were borrowed on a short-term basis from abroad by these countries in the years between 1993 and 1997. Net private capital inflows into Asia surged from U.S. $54.3 billion in 1993 (sharply up from U.S. $20.9 billion in 1992) to U.S. $98.3 billion in 1996.11
The pattern of consistent policy “mistakes” by the central banks continued. For decades, the central banks of Thailand, Korea, and Indonesia had been using their own version of window guidance credit controls (in Korea, they were known by the same name; in Thailand they were called the “credit planning scheme”). From 1993 onward, these central banks then implemented policies not dissimilar to those of the Bank of Japan in the 1980s—they raised the loan growth quotas that they were allocating to the commercial banks. Banks were ordered to increase lending. They were faced with less loan demand from the productive sectors of the economy, because these firms had been given incentives to borrow from abroad instead. But the banks had to meet their increased lending quotas. They therefore had to resort to increasing their lending for speculative purposes. Lending to the real estate sector and nonbank financial institutions soared. The rest is history. This excess credit creation did not primarily lead to more consumer price inflation. Since the money was used for transactions to purchase assets, it had to result in asset inflation. Land and stock prices soared.
Policy Mix to Create a Crisis

If the aim of the central banks had been to create a financial crisis, complete with currency collapse and economic recession, the combination of their policies could not have been more suitable. The economic outcome was predictable, inevitable, and should not have surprised anyone, least of all the central banks. Since the domestic economy boomed due to the credit bubble, imports were bloated. Moreover, the fixed exchange rate with the U.S. dollar was maintained at greatly overvalued levels, especially since the 80 percent weakening of the yen between 1995 and 1997. As a result, the exports of the Asian countries dropped sharply. With exports falling and imports rising, the trade balance plunged into a large deficit. But thanks to the substantial foreign borrowing of the corporate sector, capital inflows were so large that they plugged the hole in the trade balance. This ensured that the otherwise unsustainable economic boom and trade deficit could continue for several years.
The danger was that the capital inflows were of a short-term nature and could be withdrawn at short notice. What happened next was the inevitable result of the explosive policy mix adopted by the East Asian central banks. Foreign investors began to worry that this unsustainable situation was about to give way to a crisis. The question had become not whether the Asian currencies would collapse, but when. Investors who could forecast the timing of the collapse of the dollar pegs would make fortunes. The hedge funds, quite familiar with the games played by central banks and the IMF from decades of experience in Latin America, watched the ratio of foreign exchange reserves to short-term foreign-currency-denominated loans. Once the loans from overseas had reached a multiple of the foreign exchange reserves, one had to bet on a devaluation of the respective currency. To defend their currency pegs, the central banks had to use up precious foreign exchange reserves. As other investors became worried and pulled out their short-term foreign lending, more foreign exchange reserves would leave the country. Eventually, the outflow would turn into a flight of capital. The stampede for the door by foreign lenders would quickly exhaust all foreign exchange reserves, if central banks continued to insist on maintaing the dollar pegs. And once the foreign reserves had disappeared, the currencies would have to be devalued anyway. That was the bet of the speculators, who could then make hundreds of millions of dollars in profits.
More Central Bank Mistakes

When speculators began to sell the Thai baht, the Korean won, and the Indonesian rupiah, the respective central bank in each country failed to implement the right policy response. That would have been to immediately abandon the overvalued exchange rate and devalue. Any attempt to defend the peg would merely waste valuable foreign exchange reserves and thus make matters worse. The central banks knew that if the countries ran out of foreign exchange reserves, they would have to call in the IMF to avoid default. And once the IMF came in, the central banks knew what this Washington-based institution would demand—for its demands in such cases have been the same for the previous three decades.12 In each case, one of the biggest winners in the domestic economy would be the central bank, which would be made independent.
Instead of devaluing, the Bank of Thailand, the Bank of Korea, and the Bank of Indonesia responded with futile attempts to maintain the peg until they had squandered virtually all of their foreign exchange reserves. Especially in the case of Thailand and Korea, these had been substantial when the crisis broke. But with all the foreign exchange reserves lost, these countries did not have enough short-term funds to cover their balance-of-payments deficit. Moreover, the delay of the devaluation gave the foreign lenders ample opportunity to withdraw their money at the overvalued exchange rate. Faced with default, the central banks of the three crisis-stricken countries advised their governments to ask the IMF for help.
The Quick Solution to the Crisis

What type of policies should the IMF have advocated in order to end the crises quickly and maintain stable growth? The most important domestic aspect of the crisis was identical to the Japanese recession. In their attempts to defend their currencies, central banks raised their interest rates sharply. This pricked the credit bubbles, and it was clear that a credit crunch would follow if the right policies were not taken. So the policy prescription that the IMF should have recommended was a reduction in interest rates and, more importantly, an expansion of credit creation by the central bank and the banks. In order to stabilize the foreign exchange rate, controls on short-term capital movements should have been reintroduced. Finally, the central bank could have purchased all bad debts at face value. With these simple policies implemented swiftly, the crisis could have been ended within about six months and a credit crunch recession avoided. Indeed, it is similar such policies that Malaysia—which refused to hand over control to the IMF— pursued.
Thailand’s leaders initially also had comparable ideas, it seems. Soon after the baht crisis broke in Bangkok in May 1997, the Thai finance minister and the prime minister felt that they should simply borrow some more money to bridge the temporary balance-of-payments crisis and implement a bailout program. Who would lend to them without too much ado? The biggest foreign investor in Thailand was Japan. And Japanese companies, Japanese banks, and even the Japanese government had a vital interest in quickly ending the crisis and preventing it from widening. Hence on July 16, the Thai finance minister, Thanong Bidaya, took a plane to Tokyo. He met the most senior government and Finance Ministry figures and held urgent discussions. All Thailand needed was around U.S. $20 billion. Japan at the time had U.S. $213 billion in foreign exchange reserves—more than the total resources of the IMF.13 Clearly, Asia did not need the IMF. Japan could just as easily have done the job. And Japan was willing. Politically, Japan had found it hard to play a more active role in Asia in the postwar era, and now that its Asian neighbors were in deep trouble Japan had a chance to prove that it was a reliable neighbor willing to help out.
Washington Stopped Japan

In response to Thailand’s request, the Japanese government began to talk of an Asian crisis fund. The vice minister of finance at the time, Eisuke Sakakibara, went as far as proposing that an Asian Monetary Fund should be established, so that there would be no need to get the IMF involved. In theory, Washington should have been delighted, as for years it had criticized Japan heavily for not playing a political role commensurate with its large economic weight. Now Japan was even offering to bail out Asia single-handedly, thus saving the IMF and its main contributor and shareholder, the United States, a lot of money. Moreover, there could have been little doubt that Tokyo would have adopted appropriate policies to quickly end the emerging crisis. Japan has long experience with capital controls and has used them successfully and fruitfully when they were necessary. Japan would have allowed the Asian economies to reflate and bail out their banking systems without closing them down. That would have prevented a full-blown credit crunch and likely avoided any recession.
But Washington stopped Japan’s initiative. It unambiguously let Tokyo know that it was not allowed to rescue its Asian neighbors. Any solution to the emerging Asian crisis had to come from Washington via the IMF. Japan thought it could convince Washington otherwise, but failed. It was forced to withdraw its proposals. The same fate awaited Taiwan, which was also not permitted by the United States to help out its Asian neighbors through loans.
The Screws Tighten

As a result, the leaders of Thailand (and later Korea and Indonesia) felt that they had no choice but to follow the advice of their central banks and invite the IMF. The “help” of the IMF was indeed swift. But it took quite a different form from what was necessary for a recovery, and also from what a Tokyo initiative would have offered. In exchange for supplying enough short-term funds to avoid insolvency, the IMF demanded a string of policies, including sharp rises in interest rates, curbs on central bank and bank credit creation, and deep structural reforms encompassing major legal changes. These policies were “performance criteria” that were nonnegotiable.14
The structural reforms increased deflationary pressure. The forced reduction in credit creation reduced demand further. The excess credit creation of the previous years thus turned into nonperforming loans. Burdened with large amounts of bad debts, the banking systems of Thailand, Korea, and Indonesia were virtually bankrupt. As credit creation fell, domestic demand shrank. Even otherwise healthy firms started to suffer from the widening credit crunch. As this forced firms to reduce capital expenditures, lay off staff, or close down altogether, unemployment rose, disposable incomes shrank, and the propensity to consume fell. The slump in domestic demand hurt the corporate sector further and raised the number of bankruptcies and loan defaults. As bad debts rose, the banks would lend even less. In this situation, attempts to stimulate the economy via interest rate reductions had to fail. Despite a declining price of borrowing, the quantity of credit creation dropped. Industrial production and output collapsed. Corporate bankruptcies soared. Unemployment rose to the highest levels recorded in the Asian countries since the 1930s.
What Were the Aims of the IMF?

The story seems familiar. Since the IMF’s own internal macroeconomic model uses credit creation as the key variable, there can be no doubt that the IMF knew well what the consequences of its policies would be.15 In the Korean case, the IMF even had detailed but undisclosed studies prepared that had calculated just how many Korean companies would go bankrupt if interest rates were to rise by five percentage points. The number was substantial. Yet the IMF’s first agreement with Korea demanded a rise of exactly five percentage points in interest rates.16
It almost seemed that the main interest of the IMF was not in the creation of quick recoveries. The two key demands that the IMF was adamant to push through involved legal revisions that were to change the nature of the Asian democracies. Arguing that the crisis had been due to the economic structure, not the wrong combination of monetary policies, the IMF demanded that in Thailand, Korea, and Indonesia the laws should be changed so that foreign investors would be allowed to purchase land and to take over banks and key industries. The governments had to obligate themselves not to rescue bust banks but to close them down and sell them off cheaply as distressed assets, often to large U.S. investment banks. In most cases, the IMF-dictated letters of intent explicitly stated that the banks had to be sold to foreign investors, although, economically speaking, there is no rationale why this should be necessary.
The other key demand in the IMF list of conditions was that legal changes were required to make the central banks independent—and de facto unaccountable. Yet there was one place the central banks were closely coordinating their policies with: the IMF itself. Immediately after arrival in the crisis-stricken countries, the IMF teams set up offices inside the central banks of Thailand, Korea, and Indonesia, from where they dictated what amounted to terms of surrender, practically ruling the economy as an unelected government.
Instead of analyzing the real causes of the Asian crisis and learning the lessons—namely, to make central banks more accountable and less independent in their key policy tool, the quantity of credit creation—the IMF ensured that the central banks would be rewarded for their actions.
Studying the personnel policies, it can be found that, exactly as in the case of Japan, key individuals at the central banks who had decided to increase bank credit creation before the crisis, and who had favored the liberalization of capital accounts, the maintenance of the dollar peg, and higher domestic interest rates, were promoted after the crisis and continued to control the central banks.17 Today, the central banks of Thailand, Korea, and Indonesia are all legally independent. They have not been held accountable in a meaningful sense for their disastrous policies.
Further research is clearly needed on the true motivations of IMF policies and whether there is any causation in the correlation observed by former World Bank chief economist Joseph E. Stiglitz between the policies advanced by the IMF’s deputy managing director during the Asian crisis and his subsequent employment at the largest U.S. bank. Stiglitz concluded: “Looking at the IMF as if it were pursuing the interest of the [U.S.] financial community provides a way of making sense of what might otherwise seem to be contradictory and intellectually incoherent behaviors.”18
It is noteworthy that international organizations appear aware of just what provides the main opportunity for increasing foreign ownership in other countries and implementing deep changes in their economic structure. For instance, World Bank staff argue that a “crisis can be a window for structural reform,” and it can “be an opportunity to reform the ownership structure in the country.”19 The view that a crisis is “an opportunity” or a “window” suggests that it is, in some respects, to be welcomed.
Calling Off the Crisis

The policies of the Asian central banks closely resembled those taken by Hjalmar Schacht in the 1920s, which made the German banking system dependent on short-term capital inflows from the United States—whose sudden withdrawal was then allowed to bankrupt the banking system and much of the corporate sector, creating mass unemployment. Until early 1998, therefore, it seemed that things went well for the structural reformers. Asia was getting ever more deeply engulfed in the crisis. Then, however, two events occurred that changed the picture. As a result, the recession policies were abandoned, and an expansionary monetary policy was adopted, sanctioned by the IMF.
The first event was the increasing awareness among Asian leaders of what game was being played, and hence an increasingly hostile attitude toward the IMF and the U.S. Treasury. The Malaysian leader, Mohammad Mahathir, early on blamed international capital and foreign interests for the creation of the Asian crisis. He became increasingly critical of the IMF and the policies in Asia, which his government had initially also begun to introduce in Malaysia. But in September 1998, Mahathir imposed controls on short-term capital movements and hence stabilized the exchange rate. Simultaneously, his central bank stepped up credit creation and the government implemented a program to clean up the balance sheets of banks. None of the IMF-style structural or legal changes were implemented. This posed a problem for the IMF: The way the Malaysian economy was managed, there was going to be a significant recovery, while the IMF client countries Thailand, Korea, and Indonesia would continue to be mired in deep and steadily worsening recessions. If that happened, it would become obvious to onlookers that IMF policies were the cause of the Asian recessions and that sensibly administered capital controls would enhance social welfare.
Mahathir’s policies could not fail to boost the economy. The exchange rate stabilized, foreign exchange reserves shot up by 33 percent in the first half year after the introduction of capital controls, and exports grew by double digits in early 1998, exceeding those of Malaysia’s Asian neighbors. Most of all, since there was no IMF demanding the closure of banks and the sell-off of their assets, far fewer companies went bankrupt and unemployment stayed at lower levels.20 As a result of the better economic performance, ironically, foreign investment had actually increased.
Since continued attacks in the world media on his policy decision to curtail capital flows failed to dissuade Mahathir, the IMF had no choice but also to give the signal to end the Asian crisis in Thailand, Korea, and Indonesia. Suddenly, the IMF allowed the central banks in those countries to create credit rapidly. As a result, economies bottomed in late 1998 and began to recover in 1999. Since Korea had most faithfully implemented all IMF demands, it would look best for the IMF if the Korean recovery was also the strongest. Credit creation by the Bank of Korea in mid-1998 shot up by the biggest amount in twenty-five years—quite parallel to the BoJ’s reflation. As a result, Korean economic growth expanded sharply in the first quarter of 1999. Industrial production rose by double digits in mid-1999, and GDP growth followed. This policy U-turn was probably possible from the IMF’s viewpoint because some changes had already been achieved: the crisis had changed governments in all countries concerned; legal changes had allowed foreign interests to take over many key banks, corporations, and real estate; and the central banks had all received full legal independence.
Cronyism in Wall Street

Later in 1998, another problem developed that further accelerated the reflation policies now pursued by the IMF in Asia: What started as a regional Asian crisis quickly began to engulf the entire world. Investors who had lost money started to pull their investments not just out of Asia, but also out of other emerging markets. On August 17, 1998, Russia defaulted on domestic debt. Next, Brazil teetered on the verge of collapse. By September 1998, several major hedge funds had lost billions of dollars; most notable among them the Connecticut-based long-term capital management (LTCM). This hedge fund accepted as clients only high-net-worth individual investors and institutions. It had accumulated an estimated U.S. $5 billion from them. However, the fund used this money as collateral to borrow even more money from banks. The banks thus created new credit and gave the hedge funds such as LTCM new purchasing power over resources. LTCM leveraged its capital by more than twenty-five times in the year before its collapse, thus borrowing more than U.S. $100 billion from the worlds’ banks. However, similar to the Japanese bubble of the 1980s, this purchasing power was not used to invest in the creation of new goods and services. It was invested purely speculatively. When the Asian crisis had affected world financial markets, LTCM’s losses threatened to undermine the banks that had lent to the fund, with the possibility of a systemic banking crisis that would endanger the U.S. financial system and economy.
The reaction of the U.S. Treasury and the U.S. Federal Reserve was indicative of their true attitude toward Asia, where they had consistently insisted that hundreds of banks had to be closed, employees laid off, and the assets sold off cheaply.21 In Asia, government-organized bailouts to keep ailing financial institutions alive were not allowed. But when a similar crisis happened back home in New York, the very same institutions reacted differently: At the end of September, William McDonough, the chairman of the New York Fed, summoned some of the most powerful men of world finance to the boardroom on the tenth floor of the New York Federal Reserve. The assemblage included the chairmen of J. P. Morgan, Travelers, Merrill Lynch, Goldman Sachs, and Morgan Stanley, together with heads of the top European banks and board members of LTCM. Instead of closing down the hedge fund, the Fed organized a cartel-like bailout for the ailing LTCM by leaning on Wall Street and international banks to contribute funds so that it could roll over its liabilities. A full-blown default was therefore averted. But as a result, the banks’ exposure had actually increased.
To the Asians this made it obvious that two different standards had been applied. The Asians had been told by Washington that precisely this type of rolling over of liabilities of ailing financial institutions must not happen, that the institutions must be closed down. Moreover, the criticism of Asian countries as being infested with “cronyism” was seen for the bigotry it was, as LTCM was said to have personnel links to the Fed. The 2001 Enron bankruptcy, followed by other high-profile accounting and fraud scandals, further blurred the distinction between Asian-style and U.S.-style cronyism.22
Japan and Asia

Feeling betrayed by America, many Asian leaders thought it was time the Asians got closer together. Indeed, Europe had united already. America is forming a free trade zone reaching from Alaska to Chile. But Asia still may seem to be out in the cold. Until recently it had not been viable as a trade bloc. From Japan to China, Korea to Indonesia, virtually all Asian economies were heavily dependent for their economic growth on exports. Unlike the European Union, the majority of Asian exports are not directed to countries within the region. Asia is heavily dependent on countries outside its regions as export destinations. This dependence on export markets outside Asia has been an important economic, if not political, reason why the formation of an Asian trade area has been slow to develop. For Asia to be able to form an autarkic bloc and hence reduce the potential risk from inward-looking regions in Europe and America, Asia needed a market able to act as final export destination for its consumer products. That market must be as highly developed and as large as Europe or America. In the Asian region there is only one country that could hope to foot this bill—and that is Japan.
Japan has been intimately involved in the integration and development of Asian economies since the 1930s. However, as other Asian economies have been developing rapidly in the 1980s, the Asian trade area has begun to run into a problem that prevents it from becoming a trade bloc similar to the European Union. That problem was the closed Japanese market. An Asian currency bloc will work only if Japan opens itself more widely to Asian imports—and not only those manufactured by Japanese plants abroad. Only then would an Asian bloc become less dependent on exports to Europe and America.
The third shift of Japanese factories into Asia, and hence the final phase of the creation of an Asian economic zone, has started with the Asian currency devaluations and economic downturns that began in 1997. As Asian currencies fell up to 80 percent against the U.S. dollar, the production bases of Japanese manufacturers in Asia were suddenly far more competitive than could have been hoped. Though factories that produced output for domestic consumption would be affected by the prolonged Asian slump, more than half of Japanese factories abroad have been serving as offshore production bases from which to reexport to other parts of the world, including Japan.
Already, more than half of all automobiles made by Japanese companies, half of all machinery, and a quarter of all manufactured output are produced outside Japan.23 This almost means the creation of a second Japan beyond the borders of its archipelago, mainly in Asia.
Japan will directly benefit from the fast-paced development of the Chinese economy, exporting not only manufacturing plants but also technology and know-how. Moreover, as China develops, it will offer a prodigious market for anyone ready to capture it—and Japan will be ready to supply both products and services. Japanese systems have the unique opportunity to evolve into the standard for the entire Asian region. The increasing expansion of Japanese industry abroad will be another factor necessitating fundamental changes in the domestic structure, for as manufacturing jobs are exported to Asia and the rest of the world, service and nonmanufacturing jobs will have to be found for the workforce at home.
On the Road to Asian Currency Union

Once central banks had achieved independence from their national governments and parliaments, power to control the entire Asian economic region could now be further consolidated by making formal and public what had been going on behind the scenes: Central banks had quietly established ties and cooperation, and increasingly talk was heard about the need for currency unification.
The goalposts had moved closer. The immediate outcome of the Asian crisis in 1997 was that the Asian countries abandoned their link to the U.S. dollar. Not only did the dollar link (instead of the overvaluation) receive much of the blame for the crisis, but without any U.S. dollar reserves left, a dollar-based fixed exchange rate was hardly possible. By the time the foreign exchange reserves of most crisis-affected countries had recovered in 1998, the opinion of policymakers had already shifted against a dollar link. Instead, the Asian countries were loosely targeting a trade-weighted basket of international currencies. Since trade with Japan had become more important by the early 1990s than trade with Europe or the United States, this naturally gave a big weight to the Japanese yen. In other words, since 1998, Southeast Asia had de facto already adopted the first stage of a yen-centered currency system.
After the dust of the Asian crisis began to settle in 1999, many meetings and conferences of Asian leaders discussed how Asia should organize its financial markets in the future. Mahathir, keen to counterbalance Washington’s influence, had been the first to demand more formal links between Asian countries—a form of Asian economic union. From the Japanese side, the Asian Monetary Fund idea was warmed up again in 1999. The head of the Hong Kong Monetary Authority argued in May 1999 that Asia should move toward currency union. This was endorsed in June 1999 by the president of the Philippines. Meanwhile, think tanks in Tokyo (such as the Asian Development Bank Institute and the Institute for International Monetary Affairs) and Manila (the Asian Development Bank) began to draw up plans for a phased introduction of monetary union, modeled on the process that led to currency union in Europe: first introducing target zones between exchange rates, then gradually moving on to semifixed and finally fixed exchange rates, so that the public could slowly acclimatize to the ultimate goal.
Since 1999, the United States’s attitude toward greater Japanese involvement in Asian monetary affairs appears to have changed again, as talk of an Asian monetary fund is no longer criticized. Japan has been actively encouraged to increase the use of the yen abroad. This U-turn in U.S. policy may be because Washington and New York never rejected the idea of Asian currency union. Tokyo was probably only rebuffed with its proposal of an Asian Monetary Fund because it had excluded the United States.
Future historians may well see in the Asian crisis the trigger for the first step toward the creation of an Asian currency union and the introduction of an independent single Asian central bank. Behind the scenes, the princes from Tokyo had not been idle bystanders concerning the developments in Asia. Already in 1991, the eleven central banks of the East Asia and Pacific region formed an exclusive club, called the Executives’ Meeting of East Asia-Pacific Central Banks, or EMEAP. Little known to the public and maintaining a low profile, the central bank deputy governors of the entire region have been meeting twice a year. Since a landmark meeting of all the governors hosted by the Bank of Japan in Tokyo on July 19, 1996, cooperation has been tightened further. It now includes annual governor-level meetings, as well as more frequent meetings of several working groups and study groups per year. The Bank of Japan has been functioning as the temporary secretariat of the exclusive club. No minutes of the frequent meetings and discussions are published.
It is surprising that EMEAP could not prevent the Asian crisis despite the fact that the club had forged an agreement concerning cooperation in case of currency crises just a few months before it broke up in 1997. And yet the policies taken by the Asian central banks before, during, and after the crisis were very similar to each other—and indeed similar to the disastrous policies of the Bank of Japan during the 1980s and 1990s.

More Power to the Princes

Crowning the Princes as Uncontested Rulers

On May 21, 1997, the Lower House of the Japanese Diet passed the first revision of the new Bank of Japan Law in half a century. It was passed by the Upper House in June and became effective on April 1, 1998. The old law had given the democratically elected government ways and means to influence the central bank, and it had named “support of national policy” as the main policy objective. The new law made the Bank of Japan legally independent, with only minimal reporting requirements to the government and the Ministry of Finance.
The new law says that “the Bank of Japan’s independence in formulating and implementing monetary policy shall be respected.” Two paragraphs down it says again: “In implementing this law, the Bank’s independence in carrying out its operations shall receive sufficient consideration.”1 There are no more government representatives among the members of the new Policy Board. The ultimate threat of dismissal of the governor is gone. As the official report on the change of the BoJ law recommended, “The Officers shall not be dismissed for holding opinions different from that of the government.” Article 25 states, “Executives of the BoJ shall not be dismissed against their will during their term of office.” Even if Bank of Japan staff are found guilty of misconduct, all the government can do is ask the Bank of Japan itself to “take necessary measures to correct such misconduct.” In the new law, “the power of the minister to conduct on-site inspections shall be abolished.”2 Most of all, “the broad authority of the minister of finance to issue directions to the Bank of Japan and appoint its Comptroller shall be abolished.”
After half a century of behind-the-scenes battles with the Ministry of Finance and the politicians, the princes had reached their goal: The extensive powers that they had quietly enjoyed throughout the postwar era had now become official and perfectly legal. They had moved up from being backstage manipulators to being the crowned rulers of Japan’s economy.
Waking up to Reality

Not long after this momentous law change the politicians woke up to the reality of what they had done. From early 1999 onward, more and more politicians realized that throughout the 1990s, the economy could have been stimulated quite easily by an expansion in central bank credit creation. Throughout 1999, members of the government and the LDP called on the Bank of Japan to increase the credit supply by buying government bonds. Their voices became even louder in early 2001, when the LDP called for “quantitative easing” by the BoJ.
They were too late. Having just been made independent the previous year, the Bank of Japan saw this as the first challenge to its new powers, and vigorously rebuffed the politicians. Governor Hayami and his deputy, Yutaka Yamaguchi, denied that any such “quantitative easing” was possible or would be effective. Throughout 1999, the BoJ failed to increase bond or commercial paper (CP) purchases. Many politicians, not used to a publicly recalcitrant central bank, were infuriated by the cold refusal of the Bank of Japan to budge. But it was too late. The politicians had decided to cut off their right hand by voluntarily giving up control over monetary policy.
The politicians were not the only ones to realize just how powerless they had become. Throughout 1999, and against the expectations of the majority of currency forecasters, the yen strengthened. Worried about the economy and about the employment situation of its citizens, the Ministry of Finance ordered drastic foreign exchange intervention. But, as we saw, in a repeat performance of the events of early 1995, the Bank of Japan sterilized all foreign exchange interventions by selling its bonds to the domestic economy. Just as in 1995, it oversterilized. Instead of creating credit, the central bank was tightening it at the fastest rate yet seen in the postwar era. This strengthened the yen back to ¥100/$ by the end of 1999.
Those Ministry of Finance officials and politicians who went back to study the new Bank of Japan Law could find nothing to fault the central bank on, for the only explicit policy goal that the law prescribed was “price stability.” Since there was no inflation, the central bank and its decision makers argued, they were fulfilling their duty.
The lobbying by leading Bank of Japan staff of Diet politicians in 1996 and 1997 had paid off. At the time, BoJ insiders such as Yutaka Yamaguchi (later deputy governor) and Toshihiko Fukui had spearheaded the campaign that blamed all of Japan’s economic ills on the Ministry of Finance. The grounds for this argument had already been laid by Mieno, who had devoted much of his public life after his 1994 retirement to lobbying in numerous speeches and meetings for a change in the Bank of Japan Law. Given his reputation as the Robin Hood who had pricked the bubble to help poor people, many listened to what this selfless man had to say.
Sovereignty for the Princes

There was another reason why the politicians felt the case for an independent central bank was sound. To implement changes in Japan, it is always helpful to be able to refer to the experience of other countries that had already made the change. Then it could be argued that Japan had to follow the international trend. Japanese politicians had been trained in the postwar era to pay attention to the trends set by the “international community.” So Bank of Japan officials helpfully pointed out that parliaments in many of the advanced industrialized countries had already made their central banks independent.
The most forceful case in favor of central bank independence was made in the Maastricht Treaty of 1992, which laid the foundations for monetary union in Europe. The treaty described the role and function of the European Central Bank (ECB), which started operations as scheduled, on January 1, 1999, and which is legally the most independent central bank in the world. According to the treaty, the ECB was going to be totally independent from and unaccountable to any government and any democratically elected assembly.
The Maastricht Treaty quickly became the new goal to aspire to among central bankers all over the world. Bank of Japan staff specifically referred to it as the prime example of a “modern” central bank law that enshrined central bank independence from democratic control and only set the task of ensuring price stability.3 Proponents of the Maastricht Treaty based their case on the experience of the German central bank, the Bundesbank. Since that treaty was new, and most central banks in other countries had only recently become independent, proponents of Bank of Japan independence ultimately also referred to the case of Germany, where central bank independence had the longest history. Based on frequent reference to the experience of the Bundesbank, Bank of Japan staff created the impression that the proposed new Bank of Japan Law was within internationally accepted best practice, and Japan merely had to follow the “global standard.”
The German Experience

The experience of the Bundesbank remains such a focal point of discussions about central bank independence that it deserves much closer scrutiny (which is the purpose of the next chapter). It is well known that the German central bank, then called the Reichsbank, created too much money in 1922 and 1923, and hence caused hyperinflation. It is normally thought that this is why the postwar German constitution made the Bundesbank largely (though not completely) independent from the government. And indeed, the Bundesbank’s track record is very good. It is this experience that probably convinced most parliamentarians in Japan, as well as other countries, that it was the right thing to make the central bank independent.
Yet the German case may not be representative. The chain of logic that led to an independent Bundesbank was as follows: The authors of the German constitution looked back at German monetary policy and determined the biggest policy mistakes. No doubt that was the hyperinflation of the early 1920s. They then set out to ascertain its cause, concluding it was the legal status of the central bank that was the problem. Hence the Bundesbank’s status was determined.
Mieno and his fellow officers at the Bank of Japan boiled this down to the formula that the Bundesbank’s success was due to its very strong legal independence. They then urged politicians to adopt these conclusions without proper reflection on the true status of the Bundesbank and the chain of thinking that had led the Germans to their conclusions. It was akin to copying steep roofs for houses from Germany and introducing them in Tokyo without realizing that the steep roofs were made for areas with heavy snowfall. If Japan was to truly learn from the German experience, it would, like Germany, have to look back at past monetary policy, determine the biggest policy mistake, find its cause, and then implement a law that prevents any recurrence of that problem.
Doing this for Germany, we get quite a different story from the above. As we will see in the next chapter, it turns out that the monetary policy mistakes of the 1920s and early 1930s were made by a Reichsbank that was totally independent and unaccountable to the German government or parliament. This is why, contrary to popular belief, the Bundesbank was made less independent and more accountable than the Reichsbank.
If It Ain’t Broke, Don’t Fix It: Japan’s Inflation Record

Furthermore, by referring to the German experience, Bank of Japan staff insinuate that inflation is the biggest problem of monetary policy. While this may have been the case in Germany, in Japan inflation has not been the problem. Compared to virtually any other country, postwar Japan has enjoyed one of the lowest inflation rates. In the twenty years from 1976 to 1996, consumer prices rose by an average of just 2.9 percent per year. In the decade from 1986 to 1996, they rose only 1.2 percent. This is significantly lower than the inflation in the United States, which averaged 5.3 percent in the twenty-year period and 3.5 percent in the ten-year period. Many people are surprised to find that Japan’s inflation has been lower even than Germany’s, the reputed model for low inflation. German inflation averaged 3.1 percent over the twenty years from 1976 to 1996 and 2.4 percent over the decade from 1986 to 1996. The latter figure is exactly twice as high as the Japanese inflation rate over that decade.4
Japan’s inflation record is impeccable. It would make the Bundesbank jealous. Since nobody criticized the Bundesbank’s inflation record or suggested that it needed another legal change to make it even more powerful, why did the Japanese parliament change the Bank of Japan Law?
Japan’s Problem: Dramatic Boom-Bust Cycles

While inflation has not been Japan’s biggest monetary policy problem, this is not to say that monetary policy has been without serious flaws. We have seen that the biggest problem of Japanese monetary policy has been the creation of boom-and- bust economic cycles. This started with the stop-and-go growth pattern and the asset deflation crisis of the 1960s. Then there was a huge speculative boom in the early 1970s, which ended in a deep recession in 1974 and the following years. Growth then accelerated in the late 1970s, only to slump again in the early 1980s. In the second half of the 1980s, the biggest economic bubble on record was created in Japan. This was followed by a decade of recession and record high unemployment. Parallel with these momentous swings in economic growth, the economy has also suffered from extreme gyrations of the exchange rate, such as the swing of the yen to ¥79.75/$ in April 1995, after which it collapsed by 80 percent to hit ¥147/$ in mid-1998.
In this book we have seen that the rate of economic growth, asset price movements, and exchange rates have been largely determined by the Bank of Japan.5 Using its extralegal window guidance credit controls, in the 1980s the central bank forced the banks to lend excessively to real estate speculators. In the 1990s it restricted credit and burst the bubble. It then failed to increase credit creation and actively disrupted government policies to stimulate the economy. In addition to prolonging the recession, the Bank of Japan at key junctures manipulated the exchange rate to strengthen the yen. The considerable national debt resulting from these blows to the economy has also been the responsibility of the Bank of Japan.
The Cause: Too Much Independence

Did the Bank of Japan undertake these disastrous policies because it lacked independence from the government or the Ministry of Finance? There is no disagreement about the consensus view that the Bank of Japan was not fully in charge of interest rate policies. However, we have found that it was not interest rates that were responsible for these costly gyrations in economic activity. Instead, they were driven by the quantity of credit creation. There has been no evidence that the Ministry of Finance, the government, or other agencies had any influence over the Bank of Japan’s quantity of credit policies. To the contrary, we found that a small number of insiders at the Bank of Japan independently determined these policies without being held accountable for their actions. Instead of being demoted for their policies, the creators of the bubble, Mieno and Fukui, were promoted to governor and deputy governor, respectively. Fukui was still vying for the top job in 2002 (though his chances have been damaged by increasing public awareness of his role in the creation of the bubble). Thus the Bank of Japan’s biggest problem has been not lack of independence, but rather excessive independence and lack of accountability in terms of the key monetary policy tool, the quantity of credit.
The Power of the Princes

The lesson from German and Japanese history is that instead of increasing its independence, the power and independence of the Bank of Japan should have been reduced. As politicians have found out, there is little they can now do to influence the central bank. All the Bank of Japan is required to do in exchange for its far-reaching powers is to “establish relevant procedures to prepare a report every six months, stating the Policy Board’s monetary policy decisions and the status of its implementation.” Moreover, “the Bank shall endeavor to publicly disclose the contents of its decisions, and decision-making process, regarding monetary policies.” In other words, the central bank merely needs to report on a few topics of its choice. Neither the Diet, the government, nor the Ministry of Finance, not to mention ordinary citizens, can do anything to change its monetary policy. The only policy objective in the new law is “price stability.” In the name of trying to achieve “price stability,” the central bank can do what it wants, and nobody can interfere, short of scrapping the new law.
The increased “disclosure” of its decision-making process remains a farce. Short summaries of the Policy Board meetings are now published on the Internet after a time lag. But from studying these, it is clear that the crucial decisions are not even discussed by the Policy Board. Every month, the Bank of Japan decides how much credit it will create. This decision affects economic growth, asset prices, and (quite immediately) the exchange rate. Yet in the years since publication of Policy Board minutes, this decision has never been discussed explicitly by the Policy Board, which is preoccupied with discussions about interest rate policy, the BoJ’s longstanding smoke screen, or banks’ reserves, the more recent decoy.6 From this it follows that the board, staffed with Bank of Japan insiders and largely malleable outsiders, is still not the location of real decision-making power—as it has never been in the postwar history of the Bank of Japan.
Information Management

Without outside checks on their actions, central banks are unlikely to divulge much about their actual policies to the public. To the contrary, their emphasis on interest rates in public discussions has served as disinformation. In Japan, an important tool for the propagation of misleading descriptions of the Bank of Japan’s policy is the central bank’s Institute for Monetary and Economic Studies. This institute is not involved in briefing actual decision makers at the Bank of Japan about economic conditions. Instead, it produces academic studies and invites foreign and domestic academics on well-paid research projects and conferences. Milton Friedman, for many years one of the academics invited by central banks, concluded that in the case of the U.S. Federal Reserve, there was no sincere interest in scholarly activity of the type that searches for the truth and attempts to draw suitable lessons from it. Instead, he found that economic research and exchanges with academic scholars were mere “window dressing,” employed to support or cover up the central bank’s actual policies.7
Another respected researcher of central bank policies, Oxford University’s James Forder, concluded upon close scrutiny of the activities of the European Central Bank’s publications that they are merely self-serving.8 Already in the early 1970s, researchers had argued that central banks could be expected to argue that “monetary policy could achieve rather little, and always to offer explanations of events that would diminish their own responsibility for policy failures, while taking credit for successes. Secondly, they could be expected to try to maximize their policy leeway and minimize accountability by “presenting different explanations of the same phenomenon at different times—presumably with the implication that only they knew which explanation was applicable at which time. Then, depending on the explanation offered, different policies could be chosen. A useful component of policy presentation would always be the announcement of a variety of different policy targets or indicators. While giving the appearance of transparency, the central bank’s discretion would then be increased by being able to refer to different indicators at different times so as to justify the desired policy.”9 Forder concluded from its publications that “all these things can be seen in the behaviour of the ECB today.”
These findings are very much consistent with the activities of the Bank of Japan’s Institute for Monetary and Economic Studies. A glance at its research output reveals that it focuses on propagating economic analyses that are hardly relevant for the decision makers. Any issues of real importance, such as the role of the quantity of credit or the decision-making process concerning the quantity of credit, remain out of bounds. The institute never published a serious analysis of the role of window guidance in the creation and propagation of the bubble. Instead, the economists employed by the Bank of Japan produce writings that give the impression that monetary policy is made and can be fully understood by focusing on interest rates. The Bank of Japan’s hired economists have even been producing research that suggests that central banks have practically no power. In his publications throughout the 1990s, Kunio Okina, currently the head of the institute, claims that the Bank of Japan cannot control the quantity of money or credit in the economy. According to Okina, money is always determined by the demand for it, and the problem has been that during the 1990s there has not been enough “demand for money.” Instead, lowering interest rates has been a sufficient response of the Bank of Japan during the 1990s.
Okina failed to point out that the world’s largest demand for money was indeed located in Japan, where the government desperately demanded money and where the majority of small firms have remained cash-strapped for almost a decade. Yet the Bank of Japan refused to extend any money to them. As Friedman and others have explained in detail, such arguments serve central banks to fend off any criticism of their policies and thus allow them to pursue their own agendas without serious accountability.10
It can probably be said that most of the staff at the institute are not even aware that they are being used as a smoke screen by the princes. Many are hired economists who have been shielded from actual experience of the implementation of monetary policy. Instead, they have been sent to the United States to gain Ph.D.s in the type of theoretical economics that sees little role for the existence of money and thus provides an ideal diversion from the important facts of reality.
The production of misleading and one-sided propaganda is not the only way in which central banks attempt to reduce their accountability. Indeed, the scope for the “management” of information by central banks is substantial. Anyone who wants to monitor the policies of a central bank needs to have accurate information. But the data needed to assess the economy and central bank policies are produced by none other than the central bank itself. This creates a conflict of interest. It is exacerbated by the view, sometimes expressed by economists and central bankers, that a central bank should be vague about the economy and its policy intentions. The Bank of Japan has been excelling on this count. In April 1998, when it gained legal independence, the Bank of Japan stopped publishing the monthly data for sectoral bank loans, which it has been compiling and using as the basis for its credit allocation since 1942. This series has been at the core of the window guidance credit allocation process. No wonder the Bank of Japan is trying to keep these data under wraps. They are a reminder of the key tool of the princes. Stopping the publication of such data series will make it harder for economists to analyze the economy and to assess BoJ policies.
Ironically, the Bank of Japan’s Okina has admitted in his publications that statistics on credit are important and, indeed, have greater information value than other data series (such as M2+CD). However, he regrets that the data series are hardly useful to economists for forecasting, because they are announced too late— by the Bank of Japan.11 The central bank of course has the data available in real time, yet it has not speeded up their publication. The time lag between the end of an observation period and the publication of credit statistics remains the two to three months that were needed thirty or forty years ago, despite the fact that information technology has increased efficiency of data processing to the extent that real-time publication has become possible.
Power in the Hands of a Few

A governor of the Bank of Japan once reminded us that “a large part of the daily transactions of households, firms and investors are settled by means of funds transfers and remittances between banks. In turn, banks’ balances are settled across their accounts held with the Bank of Japan. In other words, the majority of transactions conducted throughout the country are eventually concentrated and settled at the Bank. As a result, the amount settled across the current accounts at the Bank totals more than ¥300 trillion per day. This means that an amount equivalent to approximately 70 percent of Japan’s annual GDP is transferred each day through the accounts at the Bank.”12
With the end of the Cold War, traditional politicians have lost out to central bankers as the driving force in the world. Central bank decisions can open the floodgates for capital flows to pour into one market and out of another, redenominating prices, quantities, and currencies. As the movement to strengthen the independence of central banks has gained momentum, the discreet individuals in dark suits, who are not known for verbosity, have become the de facto rulers over economies, countries, and regions. They create booms, busts, and crises; they reflate and deflate, appreciate and devalue, affecting the daily lives of millions of people.
Most observers have assumed that the Bank of Japan had wanted to create a recovery in the 1990s. The truth is, it didn’t. This finding sheds new light on events that happened in other countries. We normally assume that the U.S. Federal Reserve had wanted to end the Great Depression of the 1930s—a tragedy that led to starvation in the United States and other countries. However, the Fed failed to take the policies that were necessary to create a recovery for almost a decade. Instead of intervening and implementing the policies for which it was created, namely, printing sufficient amounts of money and supporting the banks, the Fed watched as tens of thousands of banks went bankrupt, taking the savings and livelihoods of many ordinary citizens with them. Moreover, as in the 1990s in Japan, the reason for the banking crisis of the 1930s lay in the preceding decade, when the Fed allowed bank credit to rise significantly, especially credit creation used for speculative purposes. Whether we consider the quantitative policies taken by the Swedish central bank in the 1980s and 1990s or the policies of the central banks in the United States, Asian countries, or Japan, the historic fact is that central banks have been at the center of the boom-and-bust cycles that have plagued the world economy. With such a performance record, has it really been wise to further increase the power of central banks and decrease their accountability?
Accountability and Transparency

To make central banks accountable, clear policy objectives are necessary that go beyond the narrow goal of producing low inflation.13 Central banks should be required to avoid business cycles and achieve near-full employment. The macro-economic variable that matters to the constituency of central banks is nominal GDP growth, since it determines overall sales, profits, wages and salaries and, together with its gap to potential growth, prices.14 It therefore does not make sense to require central banks to target anything else. If other variables are chosen as so-called intermediary targets, then there is immediately room for divergencies between this intermediary target and the ultimate goal that matters for most. Central bank bureaucracies could be expected to exploit these in order to reduce accountability and work towards their own interests.
In Japan’s case, the Bank of Japan could be given a nominal GDP growth target of 4 percent. If this goal is not met within an error margin of, for instance, 0.3 percentage points, serious and credible sanctions need to be imposed on the actual decision makers (not just the figureheads). The sanctions could include dismissal of its entire senior staff. To make this sanction credible, a “shadow” BoJ could simultaneously be appointed consisting of experts ready to take over. There can be little doubt that under such an incentive structure the central bank would deliver high growth with low inflation. Should the central bankers argue that they cannot meet such targets, then allow the free competition that they so admire find suitable personnel in the labor market that can. Not surprisingly, leading macroeconomists argue for nominal GDP targets for central banks.15
It would be better still if the Bank of Japan Law was changed again to make the central bank directly accountable to democratically elected institutions. This is politically not easy, however, since the law was only changed in 1998. But mistakes must be acknowledged and corrected as early as possible.
A public that is aware of the facts is likely to agree that monetary policy should be put back into the hands of democratically elected institutions. This includes ending the monopoly over information that many central banks currently enjoy. The power over collection and dissemination of data relating to banks and credit should be transferred to independent auditing institutions, which are themselves changed at intervals.
In Japan, an independent parliamentary commission should be appointed that closely scrutinizes the past twenty-five years of quantitative policies by the Bank of Japan and brings the responsible individuals to account. It is odd that dozens of bankers and bureaucrats have been arrested in the aftermath of the collapsing bubble, while those who have been truly responsible for both recession and bubble, and hence the bad debt problems of the banks, have never been called to account. The recession has produced unemployment, social dislocation, and suicides. The princes may not realize, or may not care, but they have been playing with the lives of millions of people. It is time for them to take responsibility.
Japan’s economy can easily be set on course for a second economic miracle, thanks to credit creation. But as long as the actions of the princes are outside any democratic checks and balances, the princes can, if they so please, create yet another downturn, as they did in 1997 and 2001.