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The First Bid for Central Bank Independence

Alchemist Ichimada

In 1946, with the approval of the U.S. occupation, a young Bank of Japan official named Hisato Ichimada was appointed BoJ governor. He had previously received an outstanding training in the intricacies of credit creation. Having spent time at the crucial Banking Department, which deals with the banks and supervises the extension of central bank credit, the BoJ sent him to Berlin, where, from 1923 to 1926, he witnessed Hjalmar Schacht’s ascendancy to “credit dictator.” He studied Schacht’s credit control policies in detail and regarded Schacht and his highly independent Reichsbank as a role model for the Bank of Japan.1 Ichimada was in many ways deeply impressed by the experience. “What left the strongest impression on me in Germany was central bank president Schacht,” he informs us in his memoirs.2 Despite his young age, he personally became acquainted with the great credit dictator. The two seemed to get along well. After the war, when Ichimada had become BoJ governor, Schacht even visited his Japanese acquaintance (although Schacht could not stay long, as Ichimada lamented, since he was under investigation by the war crimes tribunal in Germany).3
After Ichimada’s return to Japan he was again posted to the Banking Department. He worked at this key department uninterrupted for a total often years (from 1927 to 1937)—longer than usual. This, together with his posting to Germany, indicated that he had been tapped for higher office. After a short stint as Kyoto branch manager, he spent four years in the Auditing Bureau, quickly rising to become its chief in 1942. As an auditor, he monitored for what purpose loaned money was used—one of the key aspects of Schacht’s qualitative allocation of funds. The main criterion, just as with Schacht’s Reichsbank, was to decide whether loans were used “productively” in the eyes of the central bank.4
The time to make full use of his knowledge and experience came in 1942, when the system of a mobilized war economy was being fully implemented and the National Financial Control Association was established. Initially, simultaneously with his function as Audit Bureau chief, Ichimada became the Control Association’s first secretary-general, placing him right at the heart of Japan’s war effort: The Control Association was the nerve center of the mobilized war economy. It was operated by the Bank of Japan, with the formal top posts of chairman and vice chairman being held by the Bank of Japan governor and vice governor.5 However, Ichimada, “as secretary-general of the association, was in effect responsible for supervision and guidance of its daily affairs.”6 Ichimada was now in charge of doing whatever it took to provide the priority industries with funds, and preventing nonpriority firms from claiming scarce resources. This could include bank mergers and injections of BoJ funds, but its main function was to allocate credit— called yūshi assen (loan coordination) at the time.7
Bad Debts in the Banking System

When the war was over, banks’ loan books had deteriorated. In the last, desperate years of the war, they had been ordered to extend ever-rising amounts of money to war industries. It is one of the principles of banking that lending for unproductive purposes tends to end up as bad debt. War loans of a country just defeated are the worst kind. The other major asset of the banks was war bonds and other wartime government debt paper. Naturally, there was hardly a market for these, and if traded, they would fetch only a fraction of their face value.
While most bank assets were worthless, their liabilities still existed—money deposited by individual savers. Assets being smaller than liabilities, and equity being insufficient to make up for the difference, the entire banking system was practically bankrupt. On top of that, the commercial banks were weakened by the initial moves toward zaibatsu dissolution.8
Challenge by the Control Bureaucrats

The asset problems of the banks were sufficiently large to create a major credit crunch and deflationary downturn of the economy. To counteract that, credit needed to be created. In the early postwar years there were many experts who realized this and—quite unlike the 1990s, as we shall see—acted quickly to achieve a recovery. Thanks to the experience with the control of creation and allocation of credit during the war, there were not only Bank of Japan staff but also Ministry of Finance, Munitions Ministry, and Cabinet Planning Board officials who knew that credit creation needed to be expanded. The wartime planning and credit allocation program operated by them had delegated implementation to the Bank of Japan, but decisions were made by these government institutions. The Cabinet Planning Board was revived in the form of the powerful but short-lived (1946–52) Economic Stabilization Board (ESB or Keizai Antei Honbu), established in August 1946.9 The Board initially used the Reconstruction Finance Department inside the Industrial Bank of Japan (IBJ) to supply the economy with funding.10 In January 1947, it was separated and established as the public Reconstruction Finance Bank (Fukkō Kinyū Kinko), whose job was to provide preferential funding to strategic industries.11 It was in turn funded by government bills that the central bank had to discount. Second, the government planners took the initiative to reestablish the priority production system from the wartime era with the 1947 Regulations on the Provision of Funds by Financial Institutions (Kinyū Kikan Shikin Yūzū Junsoku), announced by the Ministry of Finance.12 All that had to be done was to switch the priority classification from war objectives to peacetime goals. The Ministry of Finance reformulated the wartime loan classification system. Based on a “priority listing for lending industrial funds,” limits were set on the maximum amount of loans each financial institution could extend. A ranking was established of equipment and operating funds for 460 types of business in four categories, A1, A2, B, and C, “in almost exactly the same way as the financing arrangements based on the wartime Emergency Funds Adjustment Law.”13 The latter wartime law was replaced by MoF with the equivalent Emergency Financial Order (Kinyū Kinkyū Sochi Rei).
The Bank of Japan was unhappy about the activities of the Economic Stabilization Board, for it encroached on what the central bank considered its turf: the creation and allocation of credit. The Bank of Japan resented the fact that the priority categories were defined by the ESB and MoF.14 In accordance with the wartime Bank of Japan Law, MoF expected the central bank to act merely as its agent by faithfully enforcing MoF’s instructions. That was not Ichimada’s vision of the central bank’s role.15 Second, the central bank resented the activities of the Reconstruction Finance Bank, an institution that it did not control and which challenged its monopoly on the control of the creation and allocation of credit.16 If the activities of the wartime bureaucrats in determining the creation and allocation of credit continued, the central bank would not regain its pivotal role in the economy. Ichimada lost no time. Virtually simultaneously with the priority production system, he established his own, additional system to direct funds to those priority industries high on the list.17 Meanwhile, the implementation of MoF’s priority lending categories was largely incapacitated. Ichimada achieved this by assigning only a small section of eight to ten staff to this complex task (MoF’s guidelines had become quite detailed, running to twenty pages), a group whose other job was the equally complex task of administering frozen bank accounts from the wartime period.
The Bank of Japan’s control had already been asserted a year earlier, when the director of the Banking Department had issued instructions that “in principle” banks were not allowed to increase their outstanding loan balance beyond the balance of 20 March 1946 without a permit from the Bank of Japan, as well as the government.18 This prevented low-priority industries and consumers from laying claims to scarce resources. Ichimada now adopted a two-pronged reflation policy. First, while the banks were damaged by bad debts, he borrowed another trick from Hjalmar Schacht’s tool kit and turned the Bank of Japan itself into the banker to the nation. Schacht had used active discounting of certain types of bills issued by official organizations (such as Mefo) to selectively direct credit to priority industries or projects.19 Ichimada did the same in the early postwar years with his “stamped bill system,” under which companies in specific sectors were invited to apply for funding directly, or via their banks, to the Bank of Japan’s Banking Department. The Bank of Japan discounted bills of exchange from selected firms in the coal industry, fertilizer manufacturing sector, textile fabrication industry, and certain regional industries and exporters (which competed for export trade bills to purchase necessary raw material imports).20 Retail, agriculture, education, and construction were then considered to be of lower priority. Most domestic-consumption-related industries fell into the low-priority category. Sectors such as real estate, department stores, hotels, restaurants, entertainment, publishing, and alcoholic beverages—not to mention consumers themselves—were without much hope of obtaining funds. Ichimada felt that Japan could ill afford such luxuries.21 All this took place in the Loan Coordination Division (Yūshi Assenbu) of the Bank of Japan’s Banking Department.22
Banks were brought back into the process through help in restoring their balance sheets and through Bank of Japan “guidance” of their discounting of bills. Restoring banks’ balance sheets was easy; it was nothing more than an accounting problem. All Ichimada needed to do was to have the BoJ buy their worthless wartime bonds for good money. In its own currency, a central bank does not have to worry about bad debts. It could just print money and keep the purchased assets on its balance sheet in perpetuity.23 This made the banks dependent on the goodwill of the central bank, and willing to cooperate with its informal guidance.24 If the central bank wished, it could extend unlimited funding to them. The Bank of Japan, like the Reichsbank, knew that as long as newly created money was used productively, it would result in an increase in output, not in prices.25 In the end, Ichimada had reinstated full control over both the quantity of new bank loans and their sectoral allocation in a mechanism that later became known as “window guidance.”26
First Victory Against MoF

The credit provision programs were highly successful. But not all credit was due to the central bank. The ESB’s activities, including the lending by the Reconstruction Finance Bank, had a lot to do with it. Government deficit spending, as well as the Reconstruction Finance Bank, was funded through the issuance of short-term financing bills or bonds that the central bank had to discount.27 Demand picked up as a result of the provision of funding by the central bank and banks on the one hand, and the Reconstruction Finance Bank on the other. There was no deflation. To the contrary, it soon turned out that demand was stimulated beyond the still limited capacity of the economy, which suffered from supply bottlenecks and lingering problems with infrastructure destroyed by the U.S. bombing raids. Hence inflation became a problem.
The inflation was an opportunity to damage the reputation of the ESB, MoF, and the Reconstruction Finance Bank. The Bank of Japan immediately put the blame on the lending by the rival Reconstruction Finance Bank and on the budget deficit, which the central bank was forced to finance. It had little control over these, and thus it argued that these factors were the reason for the inflation.28 Ichimada’s views were heard in Washington, which first instructed SCAP (the Supreme Commander for the Allied Powers) to issue a Nine-Point Economic Stabilization Program in December 1948 that recommended tighter monetary and fiscal policies. This program was published in Japanese jointly by Ichimada and his assistant Toshihiko Yoshino—and even became a best-seller.29 Washington next sent Joseph Dodge, president of Detroit Bank, to Japan with the rank of minister from February to April 1949 as adviser to SCAP. He is known to have been on less than good terms with MacArthur.30 The Dodge plan, passed without alterations by parliament, prescribed an “overbalanced” budget and thus ended deficit spending and the bulk of central bank underwriting of government bills. Second, it decreed the end of the Reconstruction Finance Bank; new loans were suspended immediately, and the institution was gradually wound up.31 This had long-term implications. It established the principle that henceforth government banks, such as the Japan Export Bank (1950) or the Japan Development Bank (1951), would be funded from postal savings. The central bank welcomed this, because it meant that the government banks had no power to create credit or influence the money supply and therefore also could not influence economic growth. The end of the Reconstruction Finance Bank therefore marked the beginning of the decline of influence by the control bureaucrats at the ESB and MoF. The central bank, together with its client banks, achieved a monopoly on the creation and allocation of new money. It was Ichimada’s first major victory against competition to the central bank’s power.32
Pipeline to the Top

Governor Ichimada’s powers were far-reaching. He personally decided whether a project should go ahead or not. As a result, the top leaders of industry, commerce, and finance felt obliged to visit him frequently at the Bank of Japan to obtain his approval of their investment plans. Usually, both meeting rooms of the governor’s office were occupied by captains of industry, and Ichimada dashed from room to room.33
For many top business leaders this was a humbling experience. The credit allocation was extralegal and “informal,” but they had to follow every whim of Ichimada and his lieutenants. There was no committee, not much discussion, and no right to appeal. It was up to the BoJ governor, who did not hesitate to refuse funding. One such occasion leaked to the press, which widely reported how Ichimada had turned down the request by the president of Kawasaki Steel, a top manufacturer, to build another steel plant on a plot of land in Chiba. Ichimada disagreed: “Japan does not need any more steel,” he told Kawasaki’s Nishiyama. “I can show you how to grow shepherd’s purse there.”34
Ichimada quickly became feared. His decisions over the life or death of a business project earned him the nickname “the Pope.” In his 1984 obituary, his successor and close associate, Tadashi Sasaki, explained that, “he was called Pope, because under him the central bank’s power was stronger than that of the government.”35 It was impossible to argue with the Pope’s decisions. Those who tried to unseat him failed. He was rumored to enjoy the “trust” of the higher powers—the U.S. occupation administration and even more influential figures in the United States—and thus was virtually untouchable.36
A big threat to Ichimada and the powers of the Bank of Japan was the plan by the head of SCAP’s Economic Science Division and fellow democrats to create a more democratic structure for the powerful central bank, with proper checks and balances. The Economic Science Division recommended the establishment of a separate Policy Board whose task would be to make monetary policy and supervise the operations of the Bank of Japan staff. Ichimada vigorously opposed this plan, arguing that it would reduce the “efficiency” of monetary policy. He prevailed and SCAP’s democrats relented. It was agreed to place the new Policy Board inside, and thus under control of the central bank. Ichimada thus was the creator of the system of a “sleeping policy board” that makes no important decisions.37
Ichimada’s advice was listened to by the U.S. authorities. This included his recommendation not to go ahead with the dissolution of the zaibatsu banks. While MacArthur favored the abolition of the wartime government loan guarantee program, Ichimada persuaded him otherwise. The system stayed in place, and by socializing credit risk, many new firms, including an unknown electronics start-up called Sony, managed to obtain vital bank funding. No doubt Ichimada had powerful backers, for he remained in the job for eight and a half years, setting a record as BoJ governor. After that, he even moved higher, making the transition to minister of finance—a rare move for a true Bank of Japan man, and not repeated in the postwar era.
Window Guidance

Ichimada’s key Loan Coordination Division (Yūshi Assenbu) reported directly to him and was independent of other sections. This made it highly unpopular with the rest of the central bank and Ichimada’s opponents tried to scrap it. To appease critics, and fend off attempts by the Ministry of Finance to influence its policies, its abolition was announced in 1954.38 But all credit control powers were retained by the larger Banking Department, which remained loyal to him only and continued its extralegal control over bank credit.
By the early 1950s, the economy was growing at double-digit rates and loan applications had become voluminous. It was around this time that the bank credit allocation system implemented by the Banking Department took its final shape. The governor first decided by how much total loans should grow; then he and the head of the Banking Department, his handpicked junior Tadashi Sasaki, allocated this increase to individual banks as loan quotas. The banks were asked to present their detailed lending plans, down to the names of all large borrowers, monthly to the BoJ. Tokyo banks reported to its Nihonbashi headquarters, others to its thirty-three regional branches.39 The BoJ then “adjusted” the lending plans to fit its credit allocation plans.40 Since bank officials came to the BoJ to be told virtually over the counter (the teller window) of the Banking Department how large their loan quota was going to be, the procedure came to be known as “window guidance” (madoguchi shidō).41
As with Japan’s corporations, banks were also run by managers who were unfettered by shareholders and interested in market-share expansion. Had these managers been left to their own devices, fierce market-share competition among the banks would have resulted in excessive dumping of their product: bank loans. Window guidance was the solution, as it constituted a classic industry cartel that limited competition. It also enabled convenient top-down control of the sector. The growth orientation of the banks ensured that they would always use up the maximum of their quota, to maintain their ranking. Indeed, under the procedure, bank rankings never changed during the postwar era, except after mergers.
The BoJ decided the loan quotas of the large city banks first. A proportion of that was then allocated to the other banks. Since the banks in turn allocated their quota among their hundreds of branches all over the country, where they were further divided and allocated to thousands of individual loan officers, window guidance was the pinnacle of a comprehensive quota allocation pyramid that pervaded the entire economy.42
The system worked well in avoiding unproductive credit creation and channeling newly created money to productive activities.43 Unlike war production, exports now earned foreign currency. Thanks to the continued foreign exchange controls, foreign currency could then be allocated for obtaining necessary imports—raw materials and other inputs. First textiles, then shipbuilding and steel, and later automobiles and electronics were the beneficiaries of allocated purchasing power. Window guidance was the control center, providing the economy with the monetary ammunition. As a result, Japan managed to grow by more than 10 percent per annum in real terms in the 1960s, a pace that caused observers to talk about a “miracle.”
Challenge to BoJ Control

There was a fly in the ointment. In the early postwar years there was still lingering (though gradually declining) interference from other institutions, especially MoF and MITI, which made recommendations about priority sectors.44 The Bank of Japan could largely outmaneuver the Economic Planning Agency and MITI, but it could neutralize MoF only partially.45 The Ministry of Finance gradually became removed from the credit allocation decisions.46 However, it allowed this to happen because it was secure in the knowledge that it could interfere in the central bank’s actions at any time if it felt it necessary. This was due to the Bank of Japan Law. Apart from the marginal change that resulted from the introduction of the nominal Policy Board in 1949, the law was still the same one that had been introduced in 1942, when the control bureaucrats were in charge. Many of the “New Dealers” in the occupation forces had not been convinced of the need to make the central bank independent from and unaccountable to the government—an idea they considered undemocratic. As a result, legally speaking, the central bank remained a quasi-government agency, subordinated to the Ministry of Finance.
Meanwhile, MoF enjoyed far-reaching legal powers over the entire economy in the postwar era. During the war, MoF had to report to the military-backed government and its Cabinet Planning Board. Its powers had also been restricted by the even more powerful Home Ministry. But after the war, the military had disappeared, the Home Ministry had been disbanded, and the Cabinet Planning Board had become the subordinated Economic Planning Agency. The Finance Ministry was quick to take advantage of the power vacuum. In charge of government budgeting, taxation, customs, financial sector supervision, international capital flows, and fiscal and monetary policy, it had the best cards of all government agencies. And it did not hesitate to play them. So it also continued to take some interest in credit allocation in the early postwar era.
One way to obtain greater independence was to obscure the actual credit policies taken. The importance of window guidance credit controls was systematically downplayed in public.47 Simultaneously, MoF was reluctantly allowed to exert influence over interest rates, which the Bank of Japan referred to as important in public while not placing much emphasis on them in its actual monetary policy implementation.48 Whenever MoF inquired about the BoJ’s quantitative or allocative policy, Ichimada and his staff would engage in complex discussions full of technical jargon to make the process appear impenetrable to nonexperts—as it indeed was even to many BoJ staff. Arguing that “there are many technical considerations when conducting operations like the adjustment of the quantity of funds in the market,” Ichimada demanded that “therefore, this should be left up to the Bank of Japan.”49
Another strategy, successfully implemented only from the 1960s onward, was to establish bond markets. This would enable the central bank to engage in complex bond purchase or sales transactions, not to mention repurchase agreements and derivative transactions that created a picture of an immensely complex monetary policy, while in actual fact not achieving much more than producing significant commissions for the brokers involved (who were often retired former BoJ staff).50 While the Federal Reserve had an open market desk making gross transactions worth tens of billions of dollars per year, and accounting for a large part of all government securities transactions, the Bank of Japan had no such desk, and no such patronage for the securities industry.51 In the 1950s and early 1960s, there was practically no government bond market, and the stock market remained a sideshow. Thus the financial system consisted really only of direct credit creation by the BoJ and the banks. This was efficient, as bond and stock markets do not create money. But it was also uncomfortable for the BoJ, because it operated in the public spotlight without leeway for independent operations. Any central banker realized that with such simple operations, the Bank of Japan was far too transparent.
The BoJ Fights Back

More pressing to Ichimada was, however, to extricate the Bank of Japan from the power grip of the ministry that the Bank of Japan Law represented. Ichimada’s stature ensured that the BoJ’s operational independence was not challenged in practice. But he wanted more. So he soon proposed that, as a purely technocratic institution, the BoJ should be made legally independent.52
In 1954, having been the longest-serving Bank of Japan governor, Ichimada became minister of finance. Now his control over monetary policy was legal. The surprising move also allowed him to support the Bank of Japan officials loyal to him. Since the job gave him the upper hand over the Ministry of Finance, he immediately started to lobby for a reduction in the powers of his own ministry and for an increase in the powers of the Bank of Japan. This did not make him popular. But Ichimada was not afraid to show his teeth. An open power struggle developed between the ministry bureaucrats and the central bank.
Revision of BoJ Law

Ichimada and his colleagues at the Bank of Japan lobbied the politicians for a revision of the Bank of Japan Law. They had the support of the banking community. The bankers were a captive audience and basically had to fear informal but painful sanctions if they did not back the central bank.53 At the same time, they probably hoped that an independent central bank might more closely represent their interests.54
In 1956, the LDP government established an investigation committee to consider changes in the Bank of Japan Law. MoF made sure that the committee included some of its own men. It ended up as a forty-five-member assembly of academics, bankers, journalists, and representatives from both MoF and the BoJ.55 Meanwhile, in December 1956 the prime minister changed, and with him the cabinet lineup. Suddenly, Ichimada was out of a job and Ikeda became finance minister. What happened next was fortunate for Ichimada and the BoJ: In 1957, the economy was heating up so much that a balance-of-payments crisis loomed. The politicians knew whom to call to tame the economy. Ichimada was suddenly back as finance minister. Thanks to tight window guidance, the economy slowed. In the end, Ichimida was finance minister for all three Hatoyama cabinets, as well as the first cabinet under Kishi.56
Not by Price Stability Alone

The pro-BoJ forces did not push for outright independence. Too many politicians, with their wartime experience of a subordinated central bank, felt that as an unelected body, the BoJ could not have independent power. So the BoJ modestly argued for some leeway in the implementation of monetary policy and that the goal of central bank policy as stipulated in the BoJ Law should be changed from “supporting government policies” and “maintaining economic growth” to “maintaining price stability.” The 1942/1947 BoJ Law indeed failed to mention price stability. Instead, Article 1 states that the objective of the Bank of Japan was to pursue national policy “in order to enhance the total economic power of the nation.” The BoJ calculated that the change in the policy goal would imply de facto independence. For it could then refuse MoF or government policies if it wanted to, by arguing that these policies were not in the interest of maintaining price stability.
The government committee swallowed the BoJ’s arguments. In 1958, it recommended that the BoJ should have freedom to decide monetary policy, while MoF would only be able to request a delay of a BoJ decision. It also recommended that price stability should become the main objective of BoJ policy. Keidanren (the Federation of Economic Organizations, Japan’s powerful umbrella lobby group of all business associations) endorsed the proposal in 1959 and 1960. Its position paper had been drafted by the Federation of Bankers’ Associations.57
Hung Jury

But the Ministry of Finance and its allies among the politicians objected. A group of former bureaucrats, including Shinji Arai from MITI, high-growth thinker Osamu Shimomura from MoF, as well as independent intellectuals that had long favored the war economy system, such as Kamekichi Takahashi, fiercely opposed the recommendations.58 Shimomura had been one of the former MoF control bureaucrats trained at MoF’s foreign exchange control department in the early phase of credit allocation.59 He knew well that the credit control mechanism was the core of the successful system of a mobilized economy and the key tool to create high nonin-flationary growth. In his opinion it probably was too powerful and important a tool to leave in anyone’s hands but the government’s. The government, they felt, should be able to pursue policies of high growth and a stable currency without being dependent on a central bank that might follow its own agenda. It seems that they realized what a thousand years earlier the emperors of the Sung Dynasty knew, namely, that only a government that controls the creation and allocation of money is actually in charge.60
Their lobbying bore fruit. In June 1958, Finance Minister Ichimada was replaced. He had made too many enemies to reach the post that he was rumored to have been designated for—the prime ministership. In 1959, a subcommittee recommended that final directive power over the Bank of Japan would remain with the ministry. Tadashi Sasaki, Ichimada’s right-hand man and now in charge of the Bank of Japan as deputy governor, publicly denounced the conclusion. The main committee remained split between those favoring MoF’s view and those favoring the BoJ’s stance. The views remained so entrenched for the coming year that when the committee had to present a final draft, it instead offered two alternative plans for government action. Plan A would leave ultimate decision-making power over monetary policy in the hands of the minister of finance. Plan B would give independence to the BoJ and grant the finance minister only the power to delay BoJ decisions.61
The BoJ Lost the First Battle

In April 1960, the new finance minister, Eisaku Sato (brother of Prime Minister Nobosuke Kishi and nephew of their uncle Yosuke Matsuoka, the great industrialist of the Manchurian war economy), declared that with two conflicting recommendations from the committee, he could not introduce new legislation to change the BoJ Law.62 Although Sato did not hail from MoF and did benefit from financial contributions by big business to LDP coffers, it seems that he appreciated the power of the credit allocation system and was not willing to pass the control levers out of the hands of the government.
The BoJ Law was not changed. The Ministry of Finance had won the first round in the battle for supremacy over Japan. But it was a hollow victory. In 1963, as part of the liberalization policies in the run-up to Japan’s entry into the OECD, the Emergency Financial Order (Kinyū Kinkyū Sochi Rei) was repealed.63 This removed a potential legal basis for MoF involvement in credit allocation. MoF initially still tried to influence the allocation of private-sector bank loans through the Council on Financial Institutions and Fund Allocation,64 which was staffed by members from MoF, the BoJ, and banks. During its lifetime, the Council mostly implemented the fund allocation plans submitted by the Ministry of International Trade and Industry (MITI). MITFs Industrial Finance Subcommittee and policy planning department compiled the fund allocation plans, and increasingly discussed their implementation directly with the Bank of Japan.65 When MITI discussed with the BoJ’s Banking Bureau which sectors should receive funds, MoF stayed out of the discussion. Researchers thus concluded in the 1960s that window guidance “is rather free of Ministry of Finance interference because the process of establishing ceilings poses a number of technical problems and because the details of the operations are kept quite secret.”66 As a result, the BoJ was fully in control of the economy and was solely responsible for the swings in the business cycle of the 1960s and 1970s.67 However, the BoJ’s dominant influence over the creation and allocation of money was still in a precarious state: According to the Bank of Japan Law, MoF was still in charge of whatever the central bank did, and could, if it so wished, intervene at any time in the central bank’s credit policies.
Now It’s There, Now It’s Gone

Having made themselves unpopular among many, the leaders of the BoJ felt it opportune to adopt a lower profile. Already in October 1958, when the government committee deliberated the BoJ Law, the BoJ had removed window guidance from public view by abolishing it under the pretense that it had become ineffective. Officially, the Bank of Japan now supervised and monitored the private banks’ reserve position—which until then had not been an active policy tool.68 But in actual practice the reserve requirements were fixed such that a certain desired credit expansion of the entire system would result. In other words, window guidance continued in practice.69
Defeated BoJ Flexes Its Muscles

When Hayato Ikeda became prime minister in 1960 and his cabinet made the “income doubling plan” its major policy aim, fiscal expenditures increased by more than 25 percent per year. This was possible only because of the extremely high growth, which boosted tax revenues beyond everyone’s expectations. But high growth was the result of the BoJ’s expansionary credit policies. Having previously abolished window guidance, in 1964, the Bank of Japan, under Deputy Governor Sasaki, suddenly reintroduced the credit controls, broadened their scope to further include trust, regional, and mutual banks, and used them to slow the economy.
It was foreseeable to Sasaki what would happen: Economic growth dropped. While it clocked up to 11 percent in 1964, it dropped sharply to 5.8 percent in 1965.70 Fiscal revenues were hit sharply. For the first time in many years, revenues failed to meet the original revenue projections. A sizable fiscal deficit loomed, but the Fiscal Law still said that no government bonds could be issued to fund it. Sasaki was probably not unhappy to find that politicians began deliberating a change of the law.
But events seemed to get somewhat out of hand when stocks crashed in response to the profit slowdown. As small investors pulled their money out of the market, the fourth biggest broker, Yamaichi Securities, experienced a run by its customers. Finance Minister Kakuei Tanaka was quick to take appropriate action. He went straight to the Bank of Japan and demanded unlimited credit for Yamaichi Securities and an increase in credit creation for the economy. Although the Bank of Japan argued that fiscal policy should be loosened, its subordinated legal status meant that it could not openly defy such clear-cut and justified direct demands. It had no choice but to pump in the needed money.71 The window guidance loan quotas were raised.
As window guidance had again caught some public attention, it was once more abolished in July 1965. Or had it done its job? While the BoJ loathed Tanaka’s energetic intervention, the central bank had managed to extract one major concession from the politicians and MoF: Tanaka agreed to change the Finance Law, making the issuance of bonds possible. In November 1965, the first batch of Japanese government bonds (JGBs) came onto the market. This change tipped the power balance between MoF and the BoJ distinctly in favor of the BoJ.
The BoJ had won another battle. With bonds available as a means to fund government spending, politicians and MoF were less likely to demand extra money from the BoJ—and hence they were less likely to challenge its control over credit creation.72 At the same time, the Finance Law did not allow the central bank to underwrite newly issued government bonds. So the BoJ could not be easily forced to monetize fiscal policy. This meant that it now had the power to render fiscal policy ineffective, by deciding whether to back it with credit creation or not. A gap had opened between monetary and fiscal policy.
In reality, there had been no need for the government to borrow in the markets via bond issuance, because it could instead have asked the BoJ to create new money to fund productive and thus noninflationary spending. This would have rendered fiscal policy effective, as it would have been backed by credit creation. But those days were over. The government was now going to fund fiscal stimulation by borrowing through bond issuance, which also raised the economic burden. Money printing is free, but bond issuance forces several generations under the yoke of interest, and interest on interest.
The Bank of Japan had not succeeded in changing the Bank of Japan Law and was not likely to do so in the near future. However, the new Finance Law was a good second best. It was the thin end of the wedge. It meant that the golden days of fiscal virtue of the Ministry of Finance were numbered. From now on, politicians could spend by borrowing from investors and large financial institutions. Given this option, politicians would inevitably push to use it—especially when BoJ credit controls had slowed the economy. When they wanted to spend more, therefore, they would no longer put pressure on the BoJ, but instead exert it on MoF. So the Ministry would ultimately preside over an ever-increasing national debt mountain. That could not be good for its reputation or standing.
“The Ghosts That I Called …”

Meanwhile, the BoJ was experimenting with its credit controls. It found that it could use them to fine-tune bank lending without using the bullying techniques of Ichimada. The war economy structure played into its hands. If banks were left to their own devices, they would compete fiercely against each other to gain greater market shares. To do that, they had to dump their product. Hence they would end up lending excessively. As in other industries, window guidance controls were the necessary cartel to curb excessive competition. This meant that the Bank of Japan could quite easily increase bank lending simply by setting high loan growth quotas or by temporarily claiming that window guidance had been abolished. This happened, for instance, in the mid-1960s, when the BoJ wanted to accelerate the economy again, after the Finance Law had been changed. It told the banks that there was no more window guidance. Credit creation rose, purchasing power in the private sector soared, and consequently asset prices rose, domestic demand expanded, and imports were sucked in.
During the 1960s and 1970s, window guidance was repeatedly abolished and then quickly reintroduced.73 Since the BoJ presented itself as champion of free markets, credit controls were an embarrassment. They also had no legal basis. Official publications either failed to mention window guidance or downplayed its role by calling the credit controls “voluntary.” The game of abolition and reinstatement continued throughout the postwar era. It served to keep the controls ambiguous. In reality, monthly and quarterly hearings were never abolished, and it was here that the informal power to control and allocate credit was exerted. Banks always had to receive approval for the lending plans, and the Banking Department used the threat of sanctions, such as reduced loan growth quotas, to keep the banks’ “plans” identical with its own.
Bank of Japan Smoke Screens

Having learned his lesson, Ichimada admonished his successors: “It is better for the BoJ not to attract attention and remain as quiet as the forest of a rural shrine.”74 Its dubious legal status, and the claim that it was purely “voluntary,” helped to downplay the role of window guidance. Researchers who examined the controls were fobbed off with a number of other smoke screens. One was to argue that window guidance was just a loan ceiling, without any qualitative allocation of loans across industrial sectors. But in actual fact it was a quota that was not to be left unused. All loans were broken down not only into sectors (such as loans to individuals, wholesale/retail, real estate, construction) and more detailed subsectors (iron and steel, chemicals, etc.) but also by size of company (small and medium-sized businesses versus large businesses) and by use (equipment funds, working funds).75 All large-scale borrowers had to be listed by name.
Another argument put forward by BoJ staff was that controls were never effective and hence not important. Yet banks were punished for over- or undershooting their loan growth quotas. Compliance was assured by the monopoly power of the central bank to impose sanctions and penalties, such as cutting rediscount quotas, applying unfavorable conditions to its transactions with individual banks, or reducing window guidance quotas.76 All these would cost banks dearly. In order not to fall behind the competition, they had no choice but to play the game and always meet their quotas.77 Contemporary researchers therefore concluded that window guidance was always implemented by the banks.78
The BoJ countered by arguing that the controls may have been effective in the early postwar era, but soon afterward, as the economy became more sophisticated, they lost their impact. What is true is that they were much more visible in the early postwar era, because there were hardly any other financial tools. But the mere fact that the BoJ increased the number of its policy tools subsequently does not mean that the original tools were not the most important ones.79 Until the 1970s, researchers examining the BoJ’s operations could not fail to conclude that, in reality, window guidance was still the main policy tool. It was so powerful that it rendered other policy tools mere support mechanisms.
To convince the world that window guidance was not important, the BoJ stepped up its “research” publications, produced by its Institute for Monetary and Economic Studies and its Research and Statistics Department. Since the 1970s, most publications have clearly downplayed the importance of window guidance in theory and practice. In 1973, in its English-language book on its conduct of monetary policy, the BoJ claimed that, really, it followed orthodox central banking policies: “Window guidance is, in its nature, a supplementary tool of orthodox instruments of monetary policy—that is, Bank rate, open-market operations and reserve deposit requirements. It is used more as a weapon of monetary restraint than otherwise… It must be stressed that it is a form of moral suasion, so that it presupposes cooperation on the part of financial institutions.”80
The BoJ publications gradually moved interest rates to center stage, claiming that the central bank was making monetary policy by manipulating the official discount rate or call rates. To shift public attention, the Bank of Japan increasingly introduced open market operations and developed a market for short-term paper, in which it could intervene by buying and selling.
Monetarism as Smoke Screen

To remain in charge of monetary policy and conduct it independently, if not by law, then at least in reality, not only did the BoJ make the public believe that its main policy tool was interest rate control, but Bank of Japan publications also propagated a framework that seemingly explained the determination of its monetary policy: monetarism. An article published by the Bank of Japan in 1975 emphasized the importance of the proper level of the money supply.81 In 1978, the Bank of Japan officially introduced monetary targeting, a procedure by which the central bank selects a certain measure of the so-called money supply, such as M2+CD, and at the same time announces a specific target for its growth rate that was to be attained in the next time period, such as the coming six months.
Most countries that introduced monetary targeting failed. The Bank of England went through a number of monetary targets without success. It finally abolished the procedure entirely in the mid-1980s. The Bank of Japan was far more successful. It met its monetary targets with the utmost precision, awing monetarists all over the world.82 The monetarists were pleased. The BoJ seemed living proof of their beliefs. Meanwhile, in international central bankers’ meetings BoJ staff were smug in the knowledge that their policy had little to do with traditional monetarism.83 By precisely controlling credit creation through its window guidance it could, as a side product, also achieve any targeted goal for deposit measures such as M2+CD.84
The advantage for the BoJ was that according to monetarism, the central bank should set money supply growth targets in order to serve the sole objective of price stability. Monetarism “thus makes a strong case for the independence of the central bank. It is small wonder then that central bankers should use monetarism as a shield with which to defend themselves against the multifarious political pressures that may undermine their autonomy. BoJ officials pay serious attention to monetarism not because they believe in the veracity of the doctrine but because it may help them keep external pressures from intruding on the autonomy of their monetary control. In short, the BoJ’s monetarism is a political tactic. The Bank’s autonomy was greatly enhanced during the latter half of the 1970s…. The ‘monetarism’ that the BoJ emphasized after the mid-1970s should be regarded as the Bankers’ ploy to guard their own autonomy in the face of such political pressures.”85
As time went by, more and more economists, commentators, and government officials had forgotten about the key role played by window guidance credit controls. Indeed, by the early 1980s it had sunk into obscurity. As in the days of Kublai Khan’s China, the absolute rulers over the country were the ones who created and allocated purchasing power. Henceforth, they could act from behind the scenes.

Japan’s First Bubble Economy

Triumph of the War Economy

The peacetime war economy was highly successful. In the 1950s and 1960s, Japan grew virtually continuously at double-digit growth rates. In 1959, the economy expanded 17 percent in real terms, while inflation remained modest. In 1960, leading economists made the stunning case that Japan could double its national income within the coming decade. Ex-MoF war economy control bureaucrat and economist Osamu Shimomura argued that Japan could probably even raise its GDP two and a half if not three times in this period.1 In the event, from 1960 to 1970, Japan’s real GDP rose from ¥71.6 trillion to ¥188.3 trillion—up 2.6 times. By 1970, Japan had overtaken Germany and soared from the ashes to become the number two economic power in the world.
It had not yet become public or media perception, but the increasing trade surpluses of the 1970s made it appear to U.S. trade negotiators as if Japan had triumphed over the United States after all. Not during the war perhaps, but after the war with its fully mobilized economy that was directed by the guidance of government officials. However, its very success reduced the world’s and especially the United States’ tolerance for Japan’s economic system. The first major trade dispute erupted in the 1960s, concerning textiles. The first round of trade liberalizations had taken place in 1961, but the U.S. side was dissatisfied and demanded abolition of Japanese import restrictions in order to reduce the trade imbalance. Bilateral trade negotiations were bogged down by discussions about individual tariffs and quotas. Meanwhile, U.S. trade deficits with Japan grew from $400 million in 1967 to $1.2 billion in 1968 and $1.6 billion in 1969. The United States attempted to limit Japanese exports of synthetic textiles and wool. But the textile dispute was stuck in “quagmire negotiations” from 1969 to 1970. The Japanese side argued that the U.S. proposal to limit Japanese textile exports violated the principle of free trade.2 That was true. However, Japan failed to point out that its entire economic system had been created as a bulwark against manufactured imports and was geared toward maximum exports. Likewise, the U.S. failed to point out that, like any aspiring emerging economy, it had achieved its own economic success also thanks to protectionism and government intervention. Free market economics provided the arguments for the dominant power to gain access to other markets.
In the 1970s, the Japanese automobile and consumer electronics industries were on the ascendancy. In 1970, the U.S. television maker Zenith filed a suit charging that Japan was dumping television sets in the United States. This was hard to prove. Indeed, the true cause of Japanese companies’ incredible competitiveness was not explicit dumping by individual companies. It was systemic. Japan’s economy was designed to dump its products onto the world markets, a whole nation engaging in social dumping. In 1971, OECD countries had an overall trade surplus of $7.4 billion. Of these, $5.8 billion was accounted for by Japan.
As in other industries, American and European market leaders did not know what had struck them. Sure that their products were superior to Japanese “cheap mass production,” they failed to recognize the single-minded determination of Japan’s corporations to gain market share—a policy that took no prisoners. It was aimed at annihilating overseas competitors.
The United States had consented to the maintenance of the mobilized war economy in Japan because of the Cold War and the expansion of communism in Asia. The price had been high. The war economy, with its relentless orientation toward market-share expansion and disdain for profitability, could not fail to drive many American and European companies out of business. First in textiles, then in steel and shipping, one industrial sector after another was being usurped by the Japanese economic machine. The once-proud U.S. consumer electronics firm Zenith stopped producing radios in 1982. It is today owned by Korea’s LG Electronics group.
Revaluation

Remedies were being discussed. The Ministry of Finance quietly began looking into a revaluation of the yen. But a group of internationally minded officials and intellectuals in Japan realized that the war economy system itself would have to be changed for America to get its way. Eventually, Japan would have to introduce freer markets and open itself up to imports, thus allowing foreign companies to sell their products in Japan. But these reformers were in a minority. A system that had been created during the war and which had become increasingly entrenched in the decades of postwar success was not dismantled easily. Vested interests had been created in the bureaucracy that thrived on the power provided by the licensing system, businesses that earned monopoly profits in closed domestic markets and politicians that received support from the vested interests. Most of all, ordinary Japanese benefited from the wealth the system had created for them and distributed relatively equally. How could a general consensus be established that Japan needed to change?
The first doubts among the broader public about Japan’s economic structure were sown in the mid-1970s. In many ways, this episode represented a test run of the much bigger and more far-reaching events of the 1980s and 1990s. It certainly provided an important learning and testing ground for key Bank of Japan officials.
Busting the Dollar Standard

From the early postwar years and until 1971, the major world currencies were pegged to the U.S. dollar. For Japan, the exchange rate was ¥360/$ (the figure said to have been chosen by U.S. banker Joseph Dodge after he learned that the name for the Japanese currency, yen, also meant “round” or “circular”).3 The U.S. dollar was in turn fixed to the gold price, and the U.S. Federal Reserve was officially obliged to convert dollars into gold on demand (to foreign treasuries or central banks).
As we saw in chapter 3, the dollar peg was convenient for the United States, because it enabled it to print more dollars that the world had to accept. In the 1960s, the Federal Reserve encouraged U.S. banks to step up credit creation. More and more dollars were created, and they spilled over as foreign investment. With these dollars, U.S. companies undertook large-scale purchases of European corporations—”le défi Americain.”4
In 1971, when the French realized that the Americans printed money and bought up Europe, they called the United States’ bluff. They took all those dollars that had been flooding into France and brought them to the United States, demanding that they be converted into gold. This was the famed French raid on Fort Knox. Of course there were not enough gold reserves. Consequently, in August 1971, in what is often called the “Nixon shock,” the United States had to suspend the convertibility of dollars into gold. The fixed exchange rate system collapsed and the U.S. dollar fell sharply on world markets.
Japan was taken by surprise. The BoJ and MoF waited another ten days before abandoning the pegged exchange rate. During this time, the BoJ worked hard to keep the yen weak. To do so, it printed money aggressively, then went out and sold these yen to buy U.S. dollars in the foreign exchange markets. Its foreign exchange reserves jumped by U.S. $5 billion in the space of the single month of August. Then, the yen rose, triggering the short-lived Smithsonian Agreement, which fixed it at ¥308/$ in December 1971.
The BoJ continued to attempt to weaken the yen by creating purchasing power. It did this by buying up domestic assets, such as bonds, and paying with newly created cash. Moreover, it felt that it needed to stimulate domestic demand sharply, because the sudden strengthening of the yen was going to hurt exports. So it also used its window guidance control mechanism to make banks create significantly more credit. What were at the time record amounts of liquidity were pumped into the economy.
In the end, the negative shock to exporters ended up being smaller than feared, because the yen had been greatly undervalued during the dollar peg system. Moreover, Japan’s economic structure essentially remained closed to manufacturing imports. Most imports consisted of raw materials that were needed for processing and eventual reexporting. The strong yen made the raw material imports cheaper. All in all, the new exchange rate was not an insurmountable problem for exporters.
The First Bubble Economy

So it turned out that the monetary stimulus by the Bank of Japan was greatly overdone. Banks, struggling to meet the high window guidance loan quotas ordered by the Banking Department of the BoJ, virtually begged firms to borrow money from them. Already flush in liquidity and fully invested in productive projects, the firms used the bank loans to fund unproductive activities: They embarked on speculative land purchases. This happened at a time when Prime Minister Kakuei Tanaka’s “Plan for Rebuilding the Archipelago” and the Industrial Relocation Promotion Law he had pushed through while still MITI minister encouraged construction. Given the policy incentives and the seemingly limitless liquidity from the banks, many companies joined the land rush. As the value of land as collateral rose, banks became even more eager to fund the growing land speculation. Land prices exploded in 1972 and 1973. Capital gains on land holdings produced substantial paper profits. That made the firms’ stocks attractive. With excess credit creation spilling over into the stock market, a hitherto unprecedented stock boom occurred. The Nikkei 225 stock index rose from ¥3,000 in March 1972 to ¥5,000 by the end of 1972. Capital gains by firms were enormous: In 1972, land capital gains amounted to ¥15 trillion and stock gains to ¥5 trillion.
The BoJ-induced credit boom was so large that it began to spill over from asset markets into the real economy. As investment and consumption demand picked up, consumer prices and wholesale prices started to soar. A lot of money was chasing a limited amount of assets and goods. The excess money was heating up most markets. The craze for speculation spread to golf club memberships, art and antiques, jewelry, and rare coins.5
All this happened before the oil shock of November 1973. The sudden jump in oil prices did not assuage the situation (although it was mitigated by the strong yen). Triggered by the oil shock, a stampede on certain consumer staples followed. This sometimes reached hysterical proportions, such as with the legendary Osaka “toilet paper run.” In 1974, the consumer price index rose 26 percent year-on-year (YoY) and the wholesale price index 37 percent. The crazy prices began to create social friction between those who owned land or had access to bank finance and those who did not.
It is often thought that the pre-oil-shock asset inflation was the result of Prime Minister Tanaka’s stimulatory fiscal policy. However, as we have seen, fiscal policy can affect the economy only if it is monetized. Thus the monetization—in other words, the BoJ’s credit policy—remains the key variable. The best test of this argument is a comparison of the early 1970s and the late 1990s. In both periods there was significant fiscal stimulation. Indeed, the fiscal stimulation of the mid- to late 1990s was far larger than the fiscal stimulation of the early 1970s. There is even the similarity of sharply rising oil prices, as between December 1998 and January 2000 oil prices almost tripled. Although Japan’s dependence on oil has fallen, it is clear that this supply shock puts upward pressure on prices. Traditional theory makes us expect an inflationary boom in the late 1990s in Japan. However, during this time the largest deflation since the 1930s was recorded. This shows that we have missed a key variable. What is the main difference between these two time periods? It is neither fiscal policy nor oil prices, but the quantitative credit policy of the Bank of Japan.
The First Big Bust

By 1973, it had become clear that excess credit creation was being used merely for speculative land and asset transactions, thus pushing up asset prices. Urban land prices jumped by more than 50 percent from 1972 to 1974. Since these loans had been used speculatively, it was also clear that in aggregate, banks could not expect them to be paid back: only credit creation that is used for productive purposes can be paid back from the income streams the projects generate. Credit creation used for speculation must eventually turn into bad debts. That will hurt banks, which then reduce lending. As a result, economic activity falls and the economy moves into recession—a classic case of a bank-based boom/bust cycle.
Again, it was the Bank of Japan that acted as the catalyst for a turn in the business cycle through its key policy tool, window guidance. From the first quarter of 1973, it imposed tight window guidance loan growth ceilings. First, it reduced loan growth to the modest growth rate of 12.7 percent YoY. In the second quarter, it imposed a reduction of the loan increase quota compared to the same period a year earlier (by 16 percent). The tightening continued, with the window guidance loan increase quotas in the third quarter down by 24 percent YoY, in the fourth quarter down by 41 percent YoY, followed by a stunning drop of 65.4 percent YoY in the first quarter of 1974.6
The tight credit controls lasted two full years, until early 1975. Bad debts began to pile up in the banking system. Many small firms that had exposed themselves too aggressively to real estate and housing loans in the boom years found that they were insolvent. As this became apparent, a number of shaky credit associations faced full-scale bank runs. The Ministry of Finance and the Bank of Japan were forced to dispatch officials to Aichi Prefecture to reassure residents that their deposits in the local credit union were secure.
As the banks became paralyzed by the bad debt, they reduced lending. Small firms were hurt first, but eventually the whole economy suffered, as total credit creation slowed and economic activity therefore had to decelerate. Business profits nose-dived, slumping 84 percent in 1975. Industrial production dropped 19 percent between late 1973 and early 1975. Inventories soared and capital expenditure shrank. Capacity utilization fell by 25 percent in 1975 compared to early 1973, leaving almost one-quarter of productive plant and equipment idle in 1975. Unemployment soared. The number of unemployed people rose to a postwar record by the end of the 1970s. Real GDP growth dropped precipitously from around 15 percent in the 1960s to virtually nil in 1974—and Japan sank into its biggest postwar recession.7
After high inflation, deflation became a problem: Prices started to fall in 1975. The Bank of Japan watched as its roller-coaster window guidance policy created the most severe postwar recession. The slump indeed marked the end of Japan’s so-called high-growth period. Japan had enjoyed two decades of double-digit growth—the fastest-growing large economy in the world—but by 1974 growth had come to a screeching halt.
Mieno’s Debut

The recession lasted longer and was more severe than had been anticipated. Despite a string of fiscal stimulus packages, such as in February, March, and June 1975, and a repeated reduction in interest rates, the economy did not respond. Increased public works spending and infusion of credit by the public Housing Loan Corporation in 1976 merely raised the fiscal deficit. With rising unemployment benefits, by early 1976, not only the private sector but also the public sector looked shaky.
In late 1976 industrial production finally recovered, and reached its previous peak levels of October 1973 again. Japan’s worst postwar slump was ending. The reason? The necessary and sufficient condition for economic recovery had been an increase in credit growth. In late 1975 and early 1976 the Bank of Japan had raised its window guidance loan growth ceilings. Who was at the controls of the economy? The vice governor of the Bank of Japan was somebody called Haruo Maekawa. From April 1975 to February 1978, the head of the Banking Department, in charge of implementing window guidance, was Yasushi Mieno.
Crisis Stimulus for Rethinking

When real GDP growth, after twenty years of almost continuous double-digit growth, suddenly contracted, it did not fail to trigger a lot of soul-searching. Many observers were puzzled about the relatively long and sharp downturn and began to see the Japanese economic structure as the main culprit. Indeed, in times of serious crisis, the system, whatever its form, is likely to be blamed for the crisis and voices are likely to call for significant changes. The slump spawned many studies at think tanks, including at MITI, which concluded that Japan would not be able to maintain the previous high economic growth rates based on its export orientation. Instead, it would have to revamp its economic structure.
Structural problems suddenly seemed a burning issue. There were a number of depressed industries in the manufacturing sector whose era seemed to have ended: shipping, petrochemicals, electric blast furnaces, soda, cardboard, and sugar refining. MITI advised that these be transferred overseas, into other parts of Asia. It recommended that Japan become a headquarters nation, overseeing factories in many countries, such as in Asia and America. The domestic economy needed to move up the ladder to higher-value-added sectors. Moreover, with the fiscal situation becoming critical, Japan’s demographic problem was highlighted. Things looked bleak: a rapidly aging society with a pay-as-you-go pension system whose funds had been used up in vain attempts to stimulate the economy.
Calls for Japan to shift from export orientation toward expansion of domestic demand increased.8 To boost consumption, however, the structural impediments that had reinforced the savings bias and anticonsumption environment needed to be changed. Japan’s mobilized war economy had been focused on scale maximization in strategic, mainly export, industries. However, the quality of life and standard of living of the domestic population had been neglected. Living space, housing, and medical facilities needed to be created. It was at this time that the critique of the Japanese as “workaholics living in rabbit hutches” was heard overseas.
Recession Blamed on Japan’s System

A whole list of problems with the Japanese economic system suddenly became apparent thanks to the crisis. In the early 1980s a contemporary wrote about the shock of the 1970s as follows: “It is undeniable that the existence of inefficient and often self-righteous public corporations, the expansion of subsidies to agriculture due to over-protective policies, the inefficient national health care system, excessive administration intervention by the government in private enterprise, the proliferation of government-related institutions, an unclear division of responsibilities between the public and private sectors, and an unclear definition of the roles of the central government and local governments have combined to create swollen fiscal budgets and an enormous government bureaucracy.”9
In the late 1970s, leading economists and public figures felt that “Japan is at an important crossroads now” and that “the time has come for a basic reexamination of public choices.”10 The so-called U.S.-Japan Wise Men’s Group reported in 1981 that there was a need for Japan to make much greater efforts to open its domestic markets to the inflow of goods, services, and capital to a degree equal to that of the United States.11
Sakakibara’s Debut

Thanks to the crisis, serious criticism of the bureaucracy, including the hitherto all-powerful and almost untouchable Ministry of Finance, was heard in public for the first time in the postwar era. More and more observers argued that the Japanese tradition of a “strong nationalist bureaucracy” was now an obstacle. Even former bureaucrats called for deregulation, administrative reforms and a reduction of the size of the bureaucracy.12
Two promising young Ministry of Finance officials, members of the small career-track elite, joined the increasingly outspoken and critical debate about the future of Japan’s economic system. Both had taken time off from MoF for a stint in academia. One was Yukio Noguchi, who has ever since remained in academia, and the other is Eisuke Sakakibara, who subsequently rejoined the ministry and rose to become vice minister of finance in 1997. Twenty years before, in 1977, in a pathbreaking article (“Analysis of the MoF-BoJ Kingdom”) in the highbrow magazine Chūō Kōron, Noguchi and Sakakibara were the first and only public figures to clearly identify and acknowledge the true nature of Japan’s economic system. They called it the “wartime system for total economic mobilization.”
Noguchi and Sakakibara correctly pointed out how the Japanese economy was far more market-oriented in the 1920s, how the control bureaucrats had introduced the postwar system during the war, and how this mobilized economy had remained fully in place in the postwar era. They also felt that this system could not continue to function with the current international environment. To them, the slump of the mid-1970s seemed evidence that the wartime system was “on the point of collapse.”13 “From our standpoint, the wartime system for total mobilization of economic resources is at last coming to an end, and from now on we must grapple with the real task of postwar reconstruction.”14 Not considering the possibility of a reform that might preserve some of the obvious advantages of the system, they instead called for a fundamental transformation of Japan’s economic, social, and political system in the image of the United States.
The reality was that this system was far too successful to be abandoned easily. It had created many beneficiaries, such as business groups, powerful bureaucrats, and intermediary politicians, but also including the majority of the Japanese population, whose living standards had risen rapidly. In the end, the deep shock of the 1970s was not big enough to be able to say good-bye to the war economy. Noguchi therefore had to repeat his “farewell to the war economy” nearly twenty years later.15
Credit Control Also Manipulates Public Opinion

The leaders at the Bank of Japan took note. They knew that the Bank of Japan was the only player that could create a recovery: Ministry of Finance policies to boost the economy were aimed at lowering the discount rate or fiscal stimulation. Neither could work so long as the Bank of Japan did not expand credit creation. Banks needed to be given money to write off their bad debts and clean up their balance sheets to be able to lend again. Meanwhile, the Bank of Japan, by acting as the banker to the country, could boost the economy by printing money. But as long as the BoJ failed to do this, the slump would continue.
By the 1970s, the BoJ’s smoke screen concerning credit controls had been operating for a decade, and few observers, even at MoF, were aware of the real root cause and the crucial role of window guidance.16 Neoclassical economics was beginning to make inroads in Japan, and the economics sections of the BoJ churned out papers showing that interest rates were the key monetary policy tool. Further, the BoJ was semiofficially following monetarism. Hence the BoJ’s role remained obscured.17 The public blamed MoF and the economic structure for the crisis.
Second Round Won

Visible elites can stay in power only as long as they deliver the goods. While Japan’s economy was expanding at double-digit growth rates, people did not mind the strong grip on power by the government officials and especially the Ministry of Finance. The first and biggest postwar slump immediately triggered far-reaching critique of the mobilized economic system, including the legally most powerful bureaucracy, the Ministry of Finance.
Whether by accident or not, the decision makers at the Bank of Japan had won their second battle against MoF. When the BoJ finally let the economy recover in 1976, MoF was still licking its wounds. Yet the events of the 1970s were little more than a test run. It cannot be denied that the Bank of Japan had gained valuable experience in the mechanics of the creation and propagation of a real estate-based credit boom and the collapse that must follow.

The Ebb and Flow of the Yen

Hot Money

We have arrived in the 1980s: an era of financial deregulation in the industrialized countries, and one of globalization of the capital markets. The supervision of banking and securities industries was loosened, cartels in the financial sector were uprooted, and firms were exposed to heightened competition. Most industrialized countries lifted their restrictions on the movement of capital. As the international mobility of money increased, huge sums could be transferred between countries and between different kinds of assets in a split second.
Although the 1980s were also an era of booming international trade, the flow of goods and services was outclassed by the volume of rapidly expanding capital flows. During that decade the quantity of financial cross-border transactions reached a multiple of more than twenty times trade flows.1 Foreign exchange transactions reached half a trillion dollars in a day.
The increased use of offshore financial centers free from regulation further amplified the volume of “hot money” that was chasing highest returns around the globe. Large-scale institutional investors grew in importance. Hedge funds, designed to make profits from market crashes, grew exponentially in size and began to dominate foreign exchange markets. Dealers, in front of keyboards and green monitors, had at their fingertips the execution of big-ticket international investment transactions that could affect countries in far-flung corners of the world. A switch in the beliefs of fund managers could send a torrent of money from one country to another, moving exchange rates and bond and stock markets worldwide. Or so it was said.
Japanese Money Flooded the World

Though it may have appeared as if most industrialized countries increased their capital exports, in reality the money originated from only a few places. Since the 1970s, the top capital exporters, namely, the United States, Japan, Germany, France, Italy, United Kingdom, Canada, Holland, Denmark, Switzerland, and Saudi Arabia, had accounted for about 85 percent of all reported long-term international capital flows. But in 1987, 86.6 percent of the net capital exports of these countries were due to Japan alone.2
From the mid-1980s until the end of the decade, Japanese foreign investment all but dominated international capital flows. Only forty years after defeat in the Pacific War, Japan seemed to hold the key to international money flows. The “global” phenomenon of international capital flows was first and foremost a Japanese phenomenon.
Japanese long-term capital flows multiplied from a net inflow of more than $2 billion in 1980 to an outflow of nearly $10 billion in 1981. However, they literally exploded over the next four years, multiplying by a factor of almost seven to reach a historic $65 billion in 1985. Then, over the next year alone, they doubled again, blowing up to a massive $132 billion. In 1987 another record was set when a tide of $137 billion swept over the exchanges, followed by outflows of $ 131 billion the following year. In 1987 the net long-term capital outflows were almost twice as large as the already record-breaking current account surplus. This financial tsunami easily overtook even the OPEC surpluses of the 1970s.3
The money began to reshape the world in Japan’s image. Outbidding or swallowing rivals, Japanese money bought financial and real assets all over the world. Japanese factories opened in greenfield sites in Scotland, Wales, and Northern England. Japanese cars were manufactured in the Midwest of the United States. Icons of U.S. business prowess, such as the Rockefeller Center, Columbia Pictures, and even Pebble Beach Golf Course, fell into Japanese hands. Japanese restaurants and hotels sprang up in the world’s major cities to cater to Japan’s corporate raiders. Hawaiian real estate came to be dominated by Japanese investors. The same happened in parts of California and the most attractive parts of Australia. Asia was stuffed with Japanese factories, turning into Japan’s new sweatshop. It seemed that slowly but surely—perhaps not even that slowly—the world was coming to be owned by the Japanese.
This created fear and drew resentment. Labor unions in the United States started to mobilize their members against the Japanese threat. Economists developed strategies for the United States to avoid being completely owned by Japan. Some voices warned that Japan had lost the war but was now winning the peace by economic means.4 Management gurus urged business leaders all over the world to adopt Japanese-style techniques as the last resort to withstand le défi Japonais.
Direct Investment Dwarfed by Portfolio Investment

Most analyses of Japanese money flows divide them into portfolio investment, which is “financial” investment, for instance, in government bonds, and foreign direct investment (FDI), which comprises purchases of “real” assets by foreigners, such as real estate and companies.5 Japanese net foreign direct investment (FDI) rose from $2 billion in 1980 to $6 billion in 1985. Outflows then accelerated further: by the following year overseas direct investment had more than doubled to $14 billion and more than doubled again by 1988, reaching $34 billion. In 1989 and 1990 Japan’s outflow of direct investment, at $45 billion and $46 billion respectively, was the largest in the world. By 1988 more than half of all FDI was directed at the United States and Europe.6
Though Japanese foreign direct investment reached historic proportions, until the late 1980s they made up only a small part of the long-term outflows, the greatest part being due to portfolio investments. Net portfolio outflows rose from $1.9 billion in 1983 to $23.6 billion in 1984—multiplying by a factor of twelve—and then more than quadrupled again in the following two years to peak at $101.4 billion.7
These remarkable developments could not fail to leave a strong impact on international securities markets. In the 1980s, international bond markets had become unthinkable without the ubiquitous Japanese presence. At their peak in 1986, 77 percent of total net portfolio outflows were directed into bonds, the rest into foreign stocks and shares. Almost 90 percent of investment in foreign securities was in U.S. Treasury bonds.8 Japanese money mopped up a staggering 75 percent of all Treasury bonds auctioned off in 1986.9 Portfolio flows peaked in 1986, while foreign direct investment rose steadily in importance. In 1990, at $48 billion, foreign direct investment had taken the lead over portfolio investment and Japan became the world’s number one provider of direct investment.10
Actual Japanese Capital Outflows Were Even Larger

Despite the staggering sums, the actual extent of Japanese foreign acquisitions in the 1980s is still understated by the official figures. The true figures will probably never be known. The gap between data and reality did not open accidentally. Faced with criticism of both the trade surpluses and the large foreign acquisitions, the International Finance Bureau of the Ministry of Finance concocted a clever way of reducing both figures. The trick was to count capital outflows as imports of goods. Miraculously, both figures “improve” in one stroke. Such creative accounting was undertaken with items such as offshore gold accounts and aircraft leasing.11
In the mid-1980s, a gold rush seemed to have hit Japan. In the first half of the 1980s, Japan had already become the world’s foremost importer of gold bullion. In 1984, 192 tons of gold were shipped to Japan. In 1986 this had risen to almost 600 tons—making up half of the entire world production of gold by noncommunist countries.12 This helped reduce the trade surpluses, because it boosted imports. It is not surprising, then, that the one-off import of 300 tons of gold to mint coins in celebration of the sixtieth anniversary of the late Emperor Hirohito’s reign was booked through New York.13
Gold purchases were far larger than gold shipments, however: Much of the gold bought by Japanese investors never reached Japan. Trading houses offered to store “imported” gold in London in order to reduce transportation costs. Japanese securities houses aggressively pushed so-called gold savings accounts, which nominally constituted gold investments—and hence gold imports. However, the gold “purchases” were conducted on paper only and gold never physically moved from the foreign countries involved. But on a balance-of-payments basis such investments were counted as imports to Japan. In 1990 this capital outflow reached about $6 billion.14 The authorities’ liberalization of gold transactions in 1982 had set off the process. MoF also gave the licenses for the gold accounts, and it ordered the memorial gold coins.15 None of these capital outflows was listed in the capital account. Instead, they lowered the trade surplus by that much.
Some other ways to artificially reduce the trade surplus had been well tested in the past. In the late 1970s, when Japan’s current account surplus had already produced trade friction with other countries, a scheme dubbed the “samurai plan” was devised by MITI and some of Japan’s top banks, and was later supported by the Ministry of Finance.16 This scheme would allow cosmetic changes of the current account surplus. When foreign parties wanted to buy big-ticket items, such as aircraft, from other foreign parties, Japanese banks would step in, buy the item, and lease it to the one who wanted it. The Ministry of Finance would provide the foreign exchange reserves to the government-owned Export-Import Bank, which would finance the deals. Both Japanese commercial banks and the lessor would make sizable profits from this taxpayer-financed transaction.
Whenever an airline bought aircraft from a foreign manufacturer, Japan’s government could potentially use it to reduce the recorded current account surplus, as the transaction would appear to be an import to Japan. It was crucial, though, to maintain the legal fiction that the lease was only temporary, since normally financing leases would not count as imports. In 1979, MITI thought that the scheme was a “trump card in reducing the surpluses” by an estimated $800 million in fiscal 1979 alone.17 The Ministry of Finance, worried that the IMF might see through the scheme, called it off after a year. However, in the 1980s, with the trade surplus ballooning again, a more sophisticated version of the leasing scheme, involving overseas subsidiaries of Japanese firms and banks, was finally implemented. Japan became a major player in the international aircraft leasing market, with the biggest aircraft-leasing firm fully owned by a Japanese company.
In addition to these misrepresentations of capital outflows, many capital exports took place that are not recorded at all: The size of the “errors and omissions” item in the Japanese balance of payments was often larger than the entire current account surplus. In 1989 in Japan, capital outflows amounting to ¥3 trillion were unaccounted for and listed in the balance of payments as “errors and omissions.” That was almost half the size of the officially registered net long-term capital outflow of ¥6.6 trillion.18 At the time the IMF warned that international statistics on international capital flows have become so patchy that “it has become difficult to ascertain each country’s true capital (or current) account position and, therefore, how much saving the country has been providing to, or absorbing from, the rest of the world.”19
Many acquisitions by Japanese companies were not measured by the balance of payments at all. One way of evasion is to finance them via Japanese bank subsidiaries in London or New York. The bank sends the money from its Tokyo head office to foreign affiliates as an “interoffice transfer,” which is not recorded as long-term capital export in the balance-of-payments statistics. Better still would be to send the money abroad as an interoffice transfer and then reimport it as official capital inflow. As a result, the officially recorded long-term capital outflows will appear that much smaller. Precisely such a scheme was introduced in the 1980s, when Japanese banks offered so-called impact loans to domestic customers. Under this system, a Japanese borrower took out a dollar loan. That was immediately swapped into yen, rendering it a normal yen loan for the borrower. But the loans were booked through offshore centers and then counted as long-term capital imports in the balance-of-payments statistics. In other words, a domestic transaction (a yen loan) was booked in such a way that it would appear as a capital import in the statistics and would therefore reduce the total net capital export figures of the Japanese balance of payments.20
The Mystery of Japanese Money

Although the precise figures may never be known, the officially published figures of Japanese foreign investment were already large enough to worry many observers, not least because they seemed to defy economic logic. In the 1970s, Japanese capital flows followed the textbooks: They were roughly equal in size to Japan’s trade or current account surplus. Thus money earned from Japanese net exports was merely “recycled” back abroad as foreign investment. Trade movements appeared to be the driving force, to which capital flows adjusted.
In the 1980s, this textbook scenario had disappeared. Now the momentum did not originate in the current account. Long-term capital outflows preceded the current account surplus in timing and by far exceeded it in size. Japan was purchasing far more assets abroad than it could afford due to its exports. To fund its international shopping spree in the 1980s, Japan actually had to borrow foreign currency.21
Economists had a hard time explaining this phenomenon. Some thought that the abolition of capital controls must have been responsible. Indeed, legal regulations were eased gradually over the 1980s, with benchmark changes of the foreign exchange law in 1980. However, most large institutional investors stayed well below their legal foreign investment limits in the second half of the 1980s.22 Moreover, the question remained why investors suddenly chose to invest so much abroad. Another frequently cited explanation was that Japan’s capital exports were due to Japan’s high national savings. But this ex post facto accounting identity does not tell us anything about why Japan’s savings were so large.
In their empirical work, most researchers disaggregated long-term capital flow figures into portfolio investment and foreign direct investment and then tried to build models that could explain them separately. The main model explaining portfolio investments was based on standard portfolio diversification: Investors are assumed to reduce risk by holding a diversified portfolio. The model can be tested by checking whether the information available on asset returns (in Japan as compared to the rest of the world) is sufficient to explain the actual investment pattern. In practice, this boiled down to checking whether the differential between Japanese and foreign interest rates could explain Japanese capital flows.
Unfortunately, these models failed to explain Japanese portfolio investment.23 When the interest differential did not move much, Japanese foreign investment increased. Even when the relative returns moved against foreign investment, Japanese money continued to flow out. That was particularly puzzling when the yen rose significantly in the mid- 1980s, for it meant that Japanese investors lost money over a protracted time period, as foreign investments lost their value in terms of the yen.24 In the two years between January 1985 and January 1987, approximately 40 percent of the cumulative value of Japanese overseas investment had been wiped out in yen terms. Despite this, Japanese investors continued to invest in sizable amounts in U.S. and other foreign assets. This anomaly persisted over several years despite the fact that the intention of the Plaza Agreement—namely, to strengthen the yen—was not in doubt.
It had to be admitted that serious studies of Japanese foreign investment “have not been particularly successful in explaining the rapid growth of capital outflows” and many a report ended with the words that Japanese foreign investment was “hard to understand,” “counterintuitive,” or “something of a mystery.”25 The dramatic surge of Japanese foreign investment remained an enigma for the experts.
Reversal of the Tide

Economic models of Japanese foreign investment focused on the period of rapidly rising foreign investment. They failed to explain them and were even more helpless in explaining the events of the 1990s. In 1991, as the Japanese current account was heading for new record surpluses, topping $90 billion, net long-term capital outflows had suddenly vanished. Japan recorded $40 billion worth of net inflows of long-term capital, the first in more than a decade. Japanese investors became net sellers of foreign securities in record figures.26 Japan remained a net seller of foreign assets throughout 1991. From manufacturers to banks and real estate firms, Japanese money was suddenly retreating on all fronts.27
With increasing losses on their foreign investments, it had become apparent even to the last believers in the “profit motive” that Japanese corporations, and in particular the country’s financial institutions, had not invested for profits. There were hardly any profits. As it turned out, even giants had not bothered to conduct cash-flow analyses and profit projections about their numerous foreign acquisitions.28
Researchers struggled to explain the puzzling aberration of a record current account surplus accompanied by a sizable long-term capital account surplus. Standard analyses failed to provide an explanation of the extraordinary movements of Japanese foreign investment in the 1980s and the early 1990s. This gap in the economic understanding of the world could be excused if it concerned the capital account behavior of, for instance, the Principality of Liechtenstein. But the lack of understanding of the determinants of capital movements of the biggest capital exporter in history, whose money has directly affected companies, governments, and lives in many countries all over the world over a period of more than a decade, should not be excused easily. It is well worth researching what was behind these dramatic events.29

The Great Yen Illusion

Credit Bubble and Bust

Mysterious Land Prices

In the 1980s, Japanese capital outflows were not the only phenomenon that puzzled economists. From the mid-1980s onward, land and stock prices appreciated tremendously. Between January 1985 and December 1989, stocks rose 240 percent and land prices 245 percent. In many countries, land prices tend to appreciate in line with GDP growth, thus leaving the ratio of land values to GDP around 1. In the United States it was as low as 0.7 in 1989. But in Japan it had risen to 5.2.1 By that time, real estate prices had reached unprecedented levels. Using market values, one could calculate that the value of the garden surrounding the Imperial Palace in central Tokyo was worth as much as all the land of the entire state of California. Although Japan is only l/26th of the size of the United States, its land was valued four times as high. The market value of a single one of Tokyo’s twenty-three districts, the central Chiyoda ward, exceeded the value of the whole of Canada.
Such figures should have told us that something was wrong. But economists are trained to believe in “market outcomes.” So they tried to justify the extraordinarily high land prices. Some thought land scarcity was the reason. But even in crowded Tokyo, the ratio of available office space to the total land surface was merely 40 percent at the peak. Rather than being scarce, land was being used inefficiently.2 Almost two-thirds of Japan’s population is concentrated in the six major cities, where land prices are high, while land in sparsely populated provincial areas, remote from the six cities, is relatively inexpensive.
Another favorite explanation for the high real estate prices was that the productivity of land was simply extremely high. If that was true, it should have been reflected in rents. But rents failed to appreciate as much as land prices. In the late 1980s, residential land prices in Tokyo were up to 100 times higher than in New York City. Rents were only four times New York’s levels. Calculating the theoretical value of land based on rents, and taking interest rates and other variables into account, economists conceded that market prices were far above the prices that economic theory predicted.3 Land prices remained a puzzle to the experts.
Speculation

The answer to the puzzle could be found by asking one of those involved in the land-buying binge of the late 1980s. One would have soon found that they did not acquire land to earn money from renting out office space. Their main aim was to make a quick buck by selling the land soon after. To them, land was simply an asset—one that was about to appreciate further.
The same forces seemed to be propelling stock prices to dizzying levels. From 1984 to 1989, the Nikkei 225 stock index rose on average by 30 percent per annum. In December 1989, it peaked at an all-time high of ¥38,915. Just as with land prices, share prices had risen far above what economic models could explain, for instance by corporate profits. The ratio of share prices to corporate earnings doubled in those five years from 35 to 70. The expected income stream from owning a part of the company could no longer explain the stock price. Studies used a variety of explanations, such as low interest rates, to make sense of such stock prices. But they all concluded that stock prices could not be explained by standard theories.4 Somewhat embarrassed, one major study suggested that stock prices could, at best, be explained by rising land prices. Companies who owned land were valued higher as land prices rose. But that left us none the wiser, as land prices had remained an enigma.
Free Money

Companies didn’t mind if experts could not explain asset prices. They ran to the punch bowl while the party lasted. Firms borrowed money and invested. Or they issued new stock or corporate bonds. Little of that was invested productively. Most went straight back into stocks or real estate. With asset prices rising, even staid manufacturers could not resist the temptation to try their hand at playing the markets. They initially entrusted substantial sums to their stockbrokers, who had set up so-called tokkin accounts in which they engaged in discretionary speculative investments in the financial markets. Soon they expanded their finance and treasury divisions to handle the speculation themselves. The frenzy reached such proportions that many leading manufacturers, such as the carmaker Nissan, made more money through speculative investments than through their core manufacturing business.5
Laymen wondered how this could be possible. Too difficult to explain, the experts said. It was financial technology. The increased sophistication of financial markets had delivered the wonders of zai-tech.6 Many firms felt there was no time to ask questions; time was money. So they joined in setting up zai-tech operations—subsidiaries devoted to full-time speculation. Firms set up real estate subsidiaries, banks set up nonbank financial firms to lend to real estate firms, and individuals mortgaged their land to get into the game. And all were buying land and stocks.
Economic Boom

Not all the hot money gushing around the economy in the late 1980s was used for pure speculation. Substantial amounts found their way into corporate investment programs. Firms were finally able to implement all those projects that lack of money had forced them to shelve. They now splashed out. New factories were rolled out on greenfield sites in Japan and overseas. The latest machinery equipment was ordered and a generation of production facilities upgraded. Shiny new marble-clad corporate headquarters rose in Tokyo’s posh business districts. Luxurious employee residences were built in the suburbs, and glitzy resort facilities with tennis and golf courses for corporate entertainment sprang up by the sea and in the mountains. Tokyo Bay was filled up by land reclamation projects. Real estate firms competed to construct the tallest building in the world.
Aggregate investment soared, leading Japan on one of the biggest capital expenditure sprees in peacetime history: Between 1985 and 1989,¥303 trillion worth of capital investment took place.7 Each year, Japan on average invested an amount equivalent to the entire GDP of France.8 Corporate expense accounts ballooned as managers entertained each other lavishly and spent fortunes on corporate golf club memberships. Like the Nikkei index, the index for golf club memberships had become a widely watched barometer of the state of financial markets, and it only pointed one way: up.
As companies aggressively hired employees, the labor market boomed—so much so that there was a general fear of a serious labor shortage. Companies started to invite final-year university students on expensive trips to holiday resorts to entice them to sign up and get them away from other companies. Unemployment hit a record low of 2 percent in March 1990. With such a tight labor market, personal incomes rose and consumption expenditures grew strongly. Hence nominal GDP, which consists of consumption, investment in plants and equipment, government spending, and net exports, was pushed up to a growth rate of 5.5 percent on average from 1986 to 1990.9 Factories operated at maximum capacity utilization.
More Mysteries

Yet despite the high growth rate and tight labor market, inflation, as measured by the consumer price index, remained surprisingly low. In 1987 and 1988, the problem appeared to be deflation, as the consumer price index actually dropped. Japan’s economic miracle seemed to deliver just the right amount of growth for everyone to be happy and inflation to remain subdued.
A “new era” had dawned in Tokyo. Japan’s economic performance in the 1980s attracted many admirers. Literally thousands of articles were written about the Japanese “new” miracle economy, and theories abounded as to just how Japan managed to succeed so brilliantly while other countries had problems with long-term unemployment and inflation. A common explanation by economists was that high and rising productivity explained the impressive performance of Japan’s economy.
The Breakdown of the Monetary Model

It should have worried observers that economists failed to explain any of the unusual developments of the 1980s in Japan. Economists were puzzled to find that they could not even explain Japanese GDP growth. Until then, economists had believed they had a good grip on what determines GDP growth. Although there are many theories in modern macroeconomics about the economy (classical/neoclassical, Keynesian, monetarist, and fiscalist, to name the most important ones), they are all based on the fundamental relationship between money and the economy. They all assume that the money supply is proportional to nominal GDP. Economist Milton Friedman even called this relationship the most stable in economics, with its reliability approaching that of a law of the physical sciences.10
That science was in trouble. In the Japan of the 1980s, the links between the so-called money supply measures, such as Ml or M2, and economic activity had broken down. GDP and money supply did not grow in line with each other. Money supply growth exceeded GDP growth. The “velocity” was not constant anymore, which implied that the “demand function for money” had broken down. This meant that something was seriously wrong with all of modern economics—whether classical, Keynesian, or monetarist—for all varieties relied on the stable relationship between the money supply and GDP.
The problem was also a practical one. With money and GDP parting ways, monetary policy, the main tool to influence the economy, had lost its effectiveness. If economic growth was not linked to the money supply anymore, then manipulating money could not produce the desired target GDP growth rate.
Things got worse. The most popular explanatory variable in economic models, the interest rate, failed to explain economic growth or asset prices. It is often said that the low official discount rate of 2.5 percent, maintained from February 1987 to May 1989, was the cause of the bubble. But interest rates were also not in any stable relationship with asset prices or economic growth.
Japan had troubled economists for a while. It seemed to defeat the cherished tenet of classical economics that only free markets could lead to economic success. Japan was obviously full of regulations, cartels, and other obstacles to trade and competition. According to classical economics, it should have been an economic disaster zone.11 Yet Japan’s economic growth was so high in the postwar era that it was called a “miracle.” This high growth seemed to recur in the 1980s. Asset prices, GDP, and capital flows all moved in ways that models could not explain. Economists could not make head or tail of Japan’s strange economy.
Revenge of the Nerds

However, the “Goldilocks” “new economy” did not last. Economists were startled again when asset prices tumbled from 1990 onward. Between January 1990 and December 1994, stock and land prices halved. Many companies and individuals who had borrowed money to purchase land speculatively found themselves unable to service their debts, let alone repay the principal. Corporate and individual bankruptcies soared to postwar highs. Japanese investors pulled out of their overseas investments in a stampede. Previously unheard of, several Japanese banks and securities firms became insolvent. The boom of the 1980s turned into the bust of the 1990s, the biggest economic slump since the 1930s.
Some economists seemed relieved. The downturn was evidence that, after all, Japan’s economic system was not so successful. What had previously been praised about Japan—the close ties between the government and the private sector, the monitoring by main banks, the family-style corporate system—were suddenly nothing but cronyism, corruption, and lack of transparency. The system was quickly blamed for the recession. Both inside and outside Japan, voices began to call for a reformation of the Japanese economic structure, as already happened in the 1970s. However, this time the voices did not recede for a decade.
Money Is the Answer

Japan’s structure is not responsible for the bubble of the 1980s or the slump of the 1990s. Traditional theories could not explain Japanese asset prices, because they neglected the role of credit creation. From about 1986 onward, banks increased credit creation aggressively. Loan growth of the city banks averaged about 15 percent in the late 1980s, and total loan growth remained above 12 percent most of the time. Meanwhile, the ability of the economy to service these loans—national income—only grew about half as fast.12 It was a classic case of unproductive excess credit creation: money was produced by the banking system but not used productively. Instead, it was used for speculation or conspicuous consumption.
As more money was created out of nothing and injected into the real estate market to buy land, demand for land rose. Since the supply of land is fixed, land prices had to rise. This created capital gains for the speculators. And that attracted even more speculation.13
Seemingly Safe and Sound

The rising land prices further encouraged the bankers to lend. Especially since the banking crisis of 1927, the Japanese banking system has relied on collateral, and this has almost always meant land collateral.14 Large firms belonging to the same business groups as the banks could receive loans without security. But the majority of borrowers could obtain loans only if they could also put up land as collateral. In that case, banks hardly cared to ask what the loans would be used for. The alternative method, widespread in the United States, was to calculate the expected cash flow of the proposed investment project. However, Japanese banks considered the cash flow projection method too risky. How could bankers assess correctly how many goods a company would be able to sell?
Banks preferred the collateral method, as it was simple. The loan officers checked the annually published official land prices of each area, the rosenka, and then lent up to 70 percent of this market value. The 70 percent rule was imposed on banks by the Ministry of Finance, which wanted to provide a safety margin. Even if land prices dropped by 30 percent, there would be enough collateral to cover the entire loan.15
The land collateral principle fitted into the designs of the policymakers who were directing credit toward strategic industries and did not want consumers to be able to borrow money. Most land holdings in the big cities have been in the hands of large firms, and this helped them raise funds. As city center land prices soared, companies were assured of an ever-increasing flow of liquidity from banks. Throughout the postwar era, land had therefore been a pillar of the Japanese financial system.
Land prices climbed steadily for much of the postwar era. There were interruptions, such as after the bubble of the early 1970s, when land prices dropped. But to the generation of loan officers on the job in the mid-1980s, it seemed as if land prices could not fall. Many economists encouraged them in this view, arguing that demand for land was likely to rise: In the 1980s, globalization and internationalization were key buzzwords and foreign financial institutions expanded their operations in Tokyo. They needed office space. Moreover, as the speculative frenzy took off and more financial firms were founded, demand for land in central business districts was boosted. Since most forecasters simply project current trends into the future, real estate analysts predicted a continued rise of land prices right into the next century.
A classic bubble had developed: Rising prices led to further investments, which pushed up prices even more. However, it was not based on economic fundamentals. Like all bubbles, it was simply fueled by the rapid creation of new money by the banking system.
The Fallacy of Composition, Again

Individual loan officers could hardly have seen the danger: They considered land prices as a given variable, one they could not hope to influence. Thus they extended loans on the basis of it. But as all other loan officers did the same and stepped up lending for real estate purchases, land prices were driven up. Banks, therefore, suffered from the fallacy of composition. Each bank considered land as safe collateral without realizing that the collective action of banks was driving up land prices and hence was far from safe, depending on ever-rising bank loans to fuel real estate speculation. Consequently, banks systematically underestimated credit risk. Each bank thought that its real estate loans were safe. However, as soon as the total supply of loans for real estate transactions fell, so would land prices.16
The share of total outstanding bank loans that was accounted for by real estate speculation is striking. By the end of 1989, real estate loans had reached 12 percent of total loans of all banks. However, loans to the construction sector were equally used for real estate speculation, accounting for another 5.4 percent of total outstanding loans. Further, many companies and banks had set up nonbank financial institutions that borrowed money from banks and then lent it to real estate speculators (another 10 percent of total loans). In total, “bubble” loans already summed up to 27 percent of total loans, an absolute sum of ¥98.9 trillion or 25 percent of 1989 nominal GDP. In the late 1970s, the share of these three “bubble” sectors was only 15 percent, or 9.9 percent of nominal GDP.17
In reality, there was more. Many loans officially classified as lending for other purposes were in actual fact diverted to real estate speculation. “Service sector” loans, for instance, soared in the late 1980s, and many were used for speculative investments. Even some of the straight “manufacturing” loans, officially used for operations or plant and equipment investment, had in actual fact found their way into zai-tech speculative investments. This meant that far more than a third of total credit creation had been used for wasteful purposes, instead of productive investments.18
Easy Money

Normally, banks choose clients from among a large number of loan applicants, turning down a significant percentage. From 1986 to 1987, banks were liberal in their lending attitude. But from 1987 onward, the tables had turned: It was the bankers who were aggressively pursuing potential customers. After large-scale borrowers had already borrowed as much as they wanted, the banks actively courted even small real estate and property development firms in an attempt to drum up more borrowers. Banks competed fiercely against each other to expand their loan books.
When banks become keen to expand their loan books, they may not be able to do much to increase productive credit creation. That is determined by the fundamentals of the economy, namely, the quantity of factor inputs (land, labor, capital, technology) and the quality of their use (productivity). But banks can increase unproductive credit creation almost at will. All they need to do is give borrowers the prospect of substantial capital gains. This can be done by focusing on collateralized loans—loans where an asset class, such as land or stocks, is used as a rationing and credit allocation device. By raising the ratio of the loan value to the valuation of the land, banks attract more borrowers who think they can make a profit. As the banks raise the appraisal value of collateral, its price is pushed up, thus providing capital gains to the borrowers and rendering their investment profitable. Both banks and borrowers feel encouraged to engage in further such activities, and as word gets around, more and more individuals and companies want to join the game.19
This is what the loan officers at Japan’s banks did in the late 1980s. Instead of the current rosenka land values, loan officers anticipated the land value of the next year—for instance, by assuming the repetition of the price increase from the previous year. So while the official loan/valuation ratio stayed at 70 percent, their “estimate” of the valuation had risen such that borrowers could receive 100 percent or more of the current market value of land collateral. Soon even this was not enough. Loan officers started to employ the estimated land value two years on. Banks made increasingly exaggerated assessments of the land value, so that the actual ratio of land value to loan often jumped to 300 percent or more.20
Anecdotes abound about how banks were soliciting loans at bargain interest rates, pursuing clients like street peddlers. For instance, the owner of a small real estate development company reported how in late 1987 he had been visited by a branch manager of a major city bank with which he had previously had no business dealings. The branch manager did not just offer his services, but literally urged the man to borrow money from the bank. Whatever interest rate he wished to pay, the bank would agree to, he was assured. “Please, just borrow money, and don’t even think about the interest rate and payment schedule,” the branch manager told him. When the business owner retorted that he did not need money, the branch manager pulled out information about a specific real estate project that had been identified by bank staff. The branch manager explained that there was a piece of real estate in a shopping area of Tokyo that could be bought for ¥600 million. Since the banks had to stick to the 70 percent loan/collateral value ratio, they could normally only have lent ¥420 million to purchase this plot. But the bank drew up a sales contract for ¥1.1 billion for the piece of property concerned. Based on this contract, the bank then extended a loan over ¥770 million to the real estate developer. While the 70 percent loan valuation ratio was apparently maintained, in actual fact it was far beyond 100 percent.21
There are other documented cases where bank loan officers, pressed hard by their superiors to extend more loans, actively searched for potential borrowers and offered to generously fund the speculative purchase of a piece of land—already chosen and its value “estimated” by the loan officer—with “guaranteed” capital gain.
Banks quite clearly were desperate to get rid of their money. To the layman, this was a strange phenomenon. People soon dubbed it “kane amari” (excess money). Only economists, analysts, and those working in the financial markets or for real estate firms knew better. They dismissed such a simplistic analysis. Land prices were going up due to far more complicated reasons than just excess money, they claimed. Ordinary people simply did not understand the intricacies of advanced financial technology. The experts, who had studied finance and economics at university, knew that market prices were always right and therefore land prices were justified.
The Classic Credit Bubble

The ordinary man in the street turned out to be wiser than the experts. Kane amari was an accurate description of what was going on. Banks gave out too many loans and hence created too much money. The money was not mainly used for consumption; thus consumer prices remained modest. It was used for financial transactions, thus creating asset price rises—asset inflation, or what is now called the “bubble.”
Just as in the early 1970s, individual banks did not recognize that they were collectively pushing up land prices. It was the same process that fueled the real estate boom in Scandinavia in the 1980s. It also fueled the mortgage lending and house price boom in the United States and United Kingdom in the 1980s. The same process also created the “golden twenties”: In the 1920s, U.S. banks lent with stocks as collateral. The principle remained the same. As each bank took the stock price as given, it created new money for stock transactions. With more money in the stock market, stock prices had to rise. Each bank thought it was safe accepting a certain percentage of the value of the stock as collateral, but the actions of all banks together drove up the overall market. More and more money was created. The same bank-driven credit boom was at work in the 1990s in Korea, Thailand, Indonesia, Malaysia, and, of course, also the United States. It is invariably the same story. And what happens after a credit boom is also always the same: a credit bust, a banking or financial crisis with scandals, and a recession.
Disaster Looms When Debt Rises Faster than Income

Bank loans can be called the borrowing of the nation. The ability to service loans depends on income generation. That is GDP growth. The visible problem was that in the late 1980s, Japanese bank loans grew by double digits, while nominal GDP rose by no more than 6 percent.22 Loan growth in excess of GDP growth is one approximation of unproductive credit creation. All this money was not used to create more national output, but to play the land and stock markets, creating nothing but debt. Given the extent of credit creation, it was not difficult to conclude that Japan was heading for disaster. Whether one considers an individual, a company, or a country, if total borrowing rises faster than income is growing, at one stage the borrower will not be able to pay back all those loans.
Asset prices rise only as long as new money enters the market. All it takes to burst a credit-driven asset bubble is for loan growth to slow. Then the whole credit pyramid must collapse like a house of cards. Asset prices would fall. That would leave many speculators heavily exposed, for they need asset price rises to service their loans, let alone repay them. Thus they are forced to sell the asset. As more speculators sell, asset prices fall. More speculative borrowing schemes unravel. Many speculators are driven into bankruptcy. That creates large bad debts for the banks. In aggregate, it is easy to estimate the ultimate scale of the problem: When the bubble bursts, all the speculative lending must turn into bad debts.
Bust: The Story of the 1990s

This, of course, is precisely what happened in the 1990s in Japan. In mid-1989, banks suddenly restricted loan growth. Half a year later, stock prices peaked. Then land prices stopped rising. As no more newly created money entered the asset markets, asset prices could not rise further. Speculators had to cover their positions and started to sell. In 1990 alone, the stock market, as measured by the Nikkei 225 index, dropped a precipitous 32 percent. Land prices also started their sharp decline. Some highly speculative plots of land in commercial districts saw their “market value” drop by 80 percent or more. More and more real estate speculators became “distressed.” As they went bankrupt, banks got their first taste of bad debts in decades. They realized that the problem could easily escalate. So they became cautious. Very cautious. They drastically reduced the amount of new loans to real estate, construction, and nonbank financial firms. This, however, had to push asset prices further down, because less and less new money was coming into the market. So bankruptcies rose.
As banks began to realize the enormous scale of potential bad debt—the majority of the ¥99 trillion in “bubble” loans were likely to turn sour—they became so fearful that they not only stopped lending to speculators, but also began to restrict loans to manufacturing firms that had nothing to do with the bubble.
The Credit Crunch

The Japanese wartime and postwar corporate system with its subcontracting relationships is built like a corporate hierarchy, with a small number of large firms at the top and a large number of small firms at the bottom of the food chain. The small and medium-sized firms are too small to issue corporate bonds and are therefore entirely dependent on bank loans for their external funding. Not surprisingly, they have remained the biggest customers of the banks, despite the inroads made by speculators in the 1980s. The snag is that lending to small firms is always riskier than lending to large firms. So in the early 1990s, when banks became burdened with bad debts and more averse to risk of default, they reduced their lending to small firms. From 1992 onward, small firms suffered from a credit crunch.23
The implications for the economy were enormous: Small firms are Japan’s number one employer, accounting for 70 percent of total employment. The impact was immediate, because small firms never had the luxury of lifetime employment and seniority pay. These structures had been reserved by the war economy bureaucrats for the larger firms. In recessions the small firms quickly reduce bonuses and pay, and they lay off staff. Since they are the main employer in Japan, actual unemployment started to rise from 1992 and disposable incomes dropped. As employees of small firms quite rightly started to worry about their jobs, they spent less and saved more. As consumption slumped, companies could sell fewer of their products. Yet they had just finished new factories and expanded their production capacities. Inventories of unsold goods piled up. Prices were driven down. Even the large firms had to start cost-cutting measures. Labor markets worsened further. In short, Japan was in a full-blown recession.
That was predictable. With paralyzed banks reducing loan growth, total credit creation in the economy shrank. Less purchasing power was available. Consequently, GDP growth had to slow drastically. Thus, from 1991 onward, Japan’s economy slid into the longest and deepest postwar recession since the 1930s. Unemployment soared to postwar records. Probably more than five million Japanese lost their jobs and did not find employment elsewhere.
Again, most economists were puzzled. They had not predicted an economic slump. To the contrary, as the official discount rate was reduced (nine times altogether since 1991), they predicted an economic recovery, believing that interest rates were a good predictor of economic growth. When this author warned in late 1991 that Japanese banks would be driven to the brink of bankruptcy and a massive credit crunch would produce a major recession, the established experts dismissed the prediction.24 How could Japan, which was seemingly taking over the world, whose exports had conquered global market shares, and whose money was buying up assets around the earth, suddenly fall into a full-blown recession?
The recession also lasted longer than expected, for the simple reason that economic growth takes place only when there is more credit creation. Falling interest rates did not help as long as credit creation remained small. Yet as late as 1993 and 1994, most economists in Tokyo denied that there was a credit crunch. Their theories simply did not include credit creation, the very process that is at the heart of every economy.
Mysteries Solved by Credit

Credit variables tell a simple story. Figure 9.1 shows bank lending to the real estate sector and land prices. As can be seen, there is a high correlation (which is also confirmed by statistical tests).25 Credit also explains why the traditional money supply measures did not have much of a link with GDP anymore. Money was increasingly used for transactions that are not part of GDP at all, namely, speculative financial and real estate transactions. We should expect nominal GDP growth to be closely correlated only with that part of credit creation that was used for GDP transactions. In other words, we should expect total loans minus the three bubble sectors—real estate, construction, and nonbank financial institutions—to be closely correlated to nominal GDP growth. Figure 9.2 shows that this is indeed the case. Our index for GDP-based credit creation explains not only the boom years of the 1980s but also the sharp collapse in GDP growth from 1991 onward.26
Finally, our credit model also explains the mystery of Japanese foreign investment that swept across the world in the 1980s and collapsed in 1991: Japan simply printed money and bought the world.

Figure 9.1  Bank Lending to the Real Estate Sector and Land Prices

Source: Japan Real Estate Institute; Bank of Japan

Figure 9.2  Credit Creation Used for GDP Transactions and Nominal GDP in Japan

Source: Economic and Social Research Institute; Cabinet Office, Government of Japan, Bank of Japan
While it is illegal for individuals to print money and go on a shopping spree, central banks have a license to print as much as they wish. Yet it is not easy for a country to just print money and then go shopping all over the world. To buy foreign assets, domestic currency must be converted. Under flexible exchanges, foreign exchange dealers would observe unusually strong demand for the foreign currency—say, the U.S. dollar—and a large supply of the currency of the country concerned. This would immediately affect exchange rates. In addition, foreign exchange dealers keep an eye on key economic indicators of the countries whose currency they deal in. If there was high inflation in a country, this would be seen as evidence that the central bank was printing too much money. So the value of that currency would fall.
There is a snag. The currency of the country that is printing too much money does not weaken automatically. Foreign exchange dealers act on information they receive, and this affects exchange rates. So if the traditional indicators that the dealers watch do not pick up the excess money creation in the country concerned, and if the country has a current account surplus, so that there is demand for its currency (because it is selling its products successfully to the world), then printing a lot of extra money and trying to exchange it for U.S. dollars might work. A neat financial trick could be pulled off: The country can just print money and buy foreign assets. Economists call the phenomenon in which prices do not reflect monetary changes “money illusion.”
Yen Illusion: Japan Printed Money and Bought the World

What happened in the 1980s in Japan may be one of the biggest bouts of money illusion ever witnessed. Not only did domestic investors and bankers suffer from money illusion, but so did the rest of the world. Effectively, Japan printed money and went out to buy the world. The usual measure of inflation is the consumer price index. As we have seen, though, the excess credit creation was not used to buy goods and services. Most of the excess money went into financial transactions, producing asset price inflation. Thus the CPI remained stable, growing 1.3 percent on average in the second half of the 1980s. The overall WPI, thanks to declining prices of imports, actually fell, on average, 2.7 percent in the second half of the 1980s, having grown 2.3 percent in the first half.27
Any suggestion that the soaring capital outflows were connected to the Japanese bubble was dismissed by leading economists. They argued that high land prices could not possibly affect capital flows: When the Japanese sold their land, they sold mainly to other Japanese. This would therefore not increase their overall ability to invest abroad, as the seller of the land would have more money but the buyer would have less—a zero-sum game.28 In actual fact, land prices were driven up by excess credit creation. This extra money could also spill abroad. In practice this could take the direct route of a large Japanese real estate developer borrowing from a Japanese bank and buying prime real estate in Hawaii, California, New York, or elsewhere. It could also take an indirect route: The excess credit creation boosted the assets of financial institutions, such as life insurers. Having more money available, they had to invest more. Portfolio diversification implied that foreign assets should also be bought—from real estate to U.S. Treasuries or whole foreign companies.

Figure 9.3  Net Long-Term Capital Flows and Bank Lending to Real Estate Firms

Source: Bank of Japan; Ministry of Finance
We would therefore expect that Japanese foreign investment should be proportionate to speculative credit creation. Figure 9.3 plots Japanese foreign investment against real estate loans. As can be seen, there is a close correlation, quite unusual for such volatile financial data. Japan created new hot money and then bought up the world. Despite the enormous capital outflows, the yen did not weaken. To the contrary, it rose 106 percent from 1985 to 1987.29
Japan had pulled off the same trick that the United States had used in the 1950s and 1960s, when U.S. banks excessively created dollars. Corporate America used this hot money to buy up European companies. While the United States had the cover of the dollar standard, Japan’s cover was its significant trade surpluses, which convinced observers that the yen had to be strong. As the yen did not weaken, the world suffered from the biggest bout of money illusion on record—the Great Yen Illusion.30

How to Prolong a Recession

Seven Lean Years

By mid-1995, Japan’s recession had already lasted far longer than most economists had predicted. Analysts and investors who had been holding out for a full-blown recovery—and there were many in the first half of the 1990s— became gloomy as they surveyed the economy. The yen had risen to around ¥80/$—unthinkable for many just half a year earlier. Exporters were under pressure, demand in the economy faltered, production growth slowed, inventories built up, and firms cut costs to stay in business. Increased competition and deregulation put further deflationary pressure on the economy. Price destruction made consumers postpone purchases as the layoffs pushed up unemployment to a new postwar high. Meanwhile, the banking system was weighed down by bad debts.
Unexpected by most observers, the economy staged a sudden recovery in 1996, growing by around 4 percent. But this was not sustained: The economy slumped again in 1997 and 1998. It seemed to take the yen with it this time. It collapsed to nearly ¥147/$ on June 15, 1998, around 80 percent weaker than its peak in April 1995. Yet the weak yen did not help the Japanese economy. To the contrary, most analysts now considered it as a sign of weakness and of capital flight from a country that seemed headed toward economic meltdown.
Attempts by the authorities to stimulate the economy had been to no avail: The downward spiral was accelerating and had turned into a vicious cycle of contracting demand, falling prices, squeezed companies, and further contracting demand. Few economists thought about recovery.
Yet most observers were once again surprised by a sharp recovery of the economy in 1999 and a more than 50 percent rise in the Tokyo stock market. But the stock market peaked in the first quarter of 2000 and both market and economy slumped once again in mid-2000 and 2001. By early 2002, most commentators had given up hope of a speedy recovery. There had been too many false starts. Each time the economy recovered, it seemed to sink back into recession soon after.
Who Is the Perpetrator?

Since 1991, the government and the Ministry of Finance have been trying to boost the economy by using interest rates. The Bank of Japan lowered the official discount rate (ODR) ten times in the 1990s, beginning with the first reduction in July 1991, before which it stood at 6 percent. Prior to September 1993, it was lowered seven times, reaching a historical low of 1.75 percent. The ODR was further lowered to 1.0 percent in April 1995 and to 0.5 percent in September 1995. In October 1995, the uncollateralized overnight call rate (officially declared the “target operational rate”) was “guided” below the ODR for the first time (at around 0.47 percent). Three years later, in October 1998, the Bank of Japan lowered the call rate further to a new record low of 0.33 percent. In February 1999, it fell to 0.1 percent—what at the time was called a “zero interest rate policy.” After a temporary hike in August 2000, the call rate was lowered again to 0.12 percent in March and 0.02 percent in April 2001. In September of that year, the ODR was lowered to 0.1 percent and the call rate to 0.003 percent. After that, it fell to a wafer-thin 0.001 percent.
Due to the apparent failure of monetary policy, the politicians had been pushing for Keynesian fiscal stimulation. During the 1990s, over a dozen large-scale government spending packages had been implemented, amounting in aggregate to over ¥145 trillion—also apparently to no avail.
If both the monetarist and the Keynesian prescriptions did not work, many economists thought, what was there left to do? They started to listen to those voices that argued that the recession was due to Japan’s economic system. The only way out was to introduce deep structural changes, such as deregulation and opening of markets. By 1998 a broad consensus had emerged in favor of a historic structural transformation. Business leaders, politicians, and, surprisingly, even members of the bureaucracy argued that fundamental change was necessary.
Such a conclusion had become very tempting, especially as the U.S. economy went from strength to strength during the 1990s. High economic growth, record low unemployment, low inflation, and rising asset prices seemed to usher in a new economic era in America. This was said to have been the result of productivity gains stimulated by free markets. Since 1996, the annual G7 summit had become a platform for the U.S. president and his treasury secretary to assert the superiority of U.S.-style capitalism. If a country wanted to be successful, they would frequently proclaim, deregulation, liberalization, and privatization were necessary. With Japan and the rest of Asia in a slump, U.S. pressure, and with it the pressure of international organizations, mounted for them to abandon their old economic systems and introduce the successful model demonstrated by the United States.
It had been conveniently forgotten that only a decade earlier the tables were turned. In 1991, the U.S. economy was in recession. U.S. banks had lent too much to real estate speculators in the 1980s, and by 1990 bad debts were threatening even the largest U.S. banks. The banks had become risk-averse, less able and less willing to lend. As a result, small firms, dependent on bank funding, received insufficient funding. As they laid off staff, demand slumped. With credit creation shrinking, the economy contracted in 1991.
At the time, pessimism about the U.S. economic structure was about as widespread as optimism a decade later. Many authors were even advocating that the United States introduce the Japanese system, which, shortly after the peak of its 1980s bubble, seemed superior. In 1991, most commentators expected Japan to overtake the U.S. economy by the turn of the millennium. The twenty-first century was going to become the Japanese century.1
What we learn from this is that the assessment of what constitutes a successful economic structure is not independent from the business cycle. During times of boom, commentators are quick to credit the economic system. A slump is seen as proof that the economic structure is at fault. In actual fact, both are merely reflections of the business cycle. And that is determined by credit creation.
Government Spending Ineffective

During much of the 1990s, however, most observers analyzing Japan argued that credit growth was slow only because there was no demand for loans in the economy. Their policy prescription: Domestic demand had to be boosted by government spending, and then loan demand would also rise. For a decade, the government followed their advice, thus boosting government debt to historic levels and ruining Japan’s fiscal virtue.
Yet we saw already in chapter 4 that the credit market is supply-determined. Money is different from apples and oranges—there is always demand for it. There are always enough entrepreneurs who would like to borrow money and invest in risky projects. Potential credit demand is so large that if banks raised interest rates to equalize demand and supply, the interest rates would rise enough to disqualify conservative and sensible investors, leaving only the high-risk entrepreneurs as bank clients. That is why banks keep interest rates below what would be the market clearing rate and instead select their borrowers: Banks ration credit. The mac-roeconomic result is the virtually permanent supply-determination of the credit market.
Meanwhile, fiscal spending could not boost demand, because it does not create money. It transfers purchasing power into the hands of, for instance, the construction industry, which receives large-scale government orders. Many economists simply add up these amounts of extra government spending and expect that GDP will be boosted by that amount.2 Again, the fallacy of composition has struck, which is due to the neglect of the government’s need to fund its fiscal expenditure. The question is how the fiscal spending is funded. In the case of pure fiscal policy, dominant during the 1990s, the Ministry of Finance would issue government bonds to raise the money. Thus the money for the fiscal stimulation of the private sector is taken from the private sector itself. Investors, such as life insurers, have to pull the money for the purchase of government bonds out of other investments. We see that fiscal policy does not create new purchasing power but merely reallocates already created purchasing power. Pure fiscal policy is largely growth-neutral.3 Indeed, over the 1990s it has been shown that for every yen the government spent in fiscal stimulation, private demand shrank by one yen.4
Put simply, credit creation determines the size of the economic pie. Fiscal policy determines how that pie is divided up between the private sector and the government. For unchanged credit creation, increased fiscal spending must therefore reduce the amount of purchasing power available in the private sector. Hence, without an increase in credit creation, the private-sector share of the national income pie must shrink (quantitative crowding out). In particular, the main customers of banks, the small firms, suffered from the credit crunch for most of the 1990s. That depressed consumption and hence GDP.
Print Money

For more net new transactions to take place, more purchasing power is necessary. This allows an increase in the economic pie. The necessary and sufficient condition for an economic recovery is the creation of new purchasing power. Purchasing power is created by the banking system and the central bank. Policies to create a recovery therefore had to aim at increased credit creation of either one or both of these. Even if policies to help banks were slow in showing results, this would not prevent an immediate recovery—if the central bank fulfils its mandate and creates new purchasing power instead. Since 1992, a recovery in Japan could have been triggered at any time. A sufficient condition would have been for the Bank of Japan to switch on the printing presses.5
Inflation would not have resulted from such money creation. If the economy were operating at full capacity, printing too much money would indeed lead to inflation. That is why under circumstances of deflation and unemployed resources, printing more money will increase demand and reduce deflation. Inflation occurs only once the economy has expanded sufficiently for all factors of input to be fully used, for unemployment to be reduced to a minimum, and for all factories to operate at full capacity; on top of that, demand is boosted beyond this full capacity. In other words, once an economy is fully reflated and growing at the maximum potential growth rate, the central bank would have to slow the printing presses. But in Japan’s predicament of the 1990s, there was no such worry.
Money Printing Increases Demand

Of course, “printing money” does not merely mean an increase in paper money. We have seen that nowadays the majority of money takes the form of “book money” or, more correctly, “computer money.” The central bank can increase that at any time, without limit, by simply buying assets from the private sector and paying with newly created credit. Economically speaking, it does not matter what the central bank buys. It could buy neckties, toothpaste, or real estate.
The Bank of Japan could, for instance, go out and purchase the house of Mr. Harada. It could entice him to sell by offering a price above the market rate. That would not be a problem for the Bank of Japan, because it could print the money, or, more precisely, create new purchasing power that previously did not exist. It does not matter to Mr. Harada whether he gets the money in the form of paper currency or a BoJ transfer to his bank (which simply means that his bank will get a credit in its books with the Bank of Japan and he in turn will get a credit in his books with his bank). Mr. Harada now has more purchasing power available, and he most likely will use at least a small part of it to buy something else— another house, for example. He transfers the newly printed cash to the seller. That person then goes out and buys something from someone else, and so on. Suddenly, more economic transactions take place, and the reverberations are felt throughout the economy. Increased demand has been created by the BoJ out of nothing.
Central Bank Credit Creation

In reality the Bank of Japan does not buy much real estate (although it has acquired many real estate properties, such as houses, clubs, and recreation facilities for the use of its staff). In order to inject large amounts of money in a short time, the central bank tends to buy government bonds, bills, and commercial paper issued by corporations. When the Bank of Japan buys such paper in the markets, it helps the economy just as much as if it purchased a piece of land.
This can easily be visualized: With the banks paralyzed by bad debt, many medium-sized and small firms are suffering from the credit crunch. One way out is for them to issue debt certificates, such as commercial paper or corporate bonds. This paper can then be bought by the Bank of Japan, which in exchange hands over new yen notes to the firms. Banks may act as intermediaries by first discounting the bills, which the central bank rediscounts. But this does not change the analysis. As a result, the firms are able to receive money that did not exist before. Smaller firms can also receive the funds indirectly, in the form of trade credit from larger firms that issue such debt paper. The result would be the same. When the banks are not doing their job of lending and creating new money, the Bank of Japan can step in and act as a banker to the nation.
There is another way to illustrate how simple “money printing” helps the economy. We have found that pure fiscal spending funded by bonds that are bought by investors cannot stimulate new economic growth. No new purchasing power is created; old purchasing power is merely diverted. But fiscal policy can be made effective if it is backed by credit creation. If the government bonds are not sold to private investors but are bought or underwritten by the central bank, then credit creation increases, and the fiscal stimulation serves to inject this new money. What makes the difference in that case is not the fiscal spending but the action of the central bank to create money. Alternatively, the government can switch funding of the public sector borrowing requirement from bonds to simple loan contracts from banks.
Print Money and Create Parks

London boasts 26.9 square meters of park space per capita, New York 29.3 square meters, and Paris 11.8 square meters. Tokyo, however, comes last in a long list of the world’s major cities, with 5.3 square meters per head.6 Moreover, Tokyo has the least park space of all the big Japanese cities. A good way to boost demand, stimulate the economy, invigorate the real estate market, and at the same time increase the quality of life in Tokyo would be for the Bank of Japan to print money and buy up land all over Tokyo to turn into parks and facilities that can be used by the public.7 Printing money to boost park space per head to the relatively low Parisian level could, depending on area and price, inject almost ¥70 trillion into the economy—not dissimilar to one estimate of the size of the bad debts. Of course, other, even more productive uses could be made of newly printed money. Facilities could be established that address public needs, such as an improved medical system or welfare infrastructure for the elderly. In a sense, the recession of the 1990s represented an opportunity to print enormous amounts of money and use them in a beneficial way without what would normally be the price to pay, namely, inflation. Even direct handouts by the central bank to each taxpayer—for instance of ¥2 million each—would be feasible, without any costs. They could simply be considered refunds from the central bank (for failing to deliver the goods).
All these examples serve to demonstrate just how easy it would have been to create an economic recovery as early as 1992 or 1993 to the benefit of Japan and beyond. Millions of unemployed would have found jobs. It was entirely feasible to create a recovery throughout the lost decade of the 1990s if the right policies had been taken.
History Proves That It Works

Printing money to boost demand is not just a nice theoretical idea. It has been tried and tested. We have already seen how the BoJ under Ichimada and the government’s Economic Stabilization Board successfully reflated Japan’s economy right after 1945, when the banks were in far worse shape than in the 1990s, and when the economy had been devastated by carpet bombing. There are other examples, for instance, the 1930s, when the world was gripped by the Great Depression, which triggered the structural transformation of Japan. Just as in the 1990s, the problem was that banking systems shut down, first in the United States, then Germany, Japan, and other countries.8 As we saw in chapter 4, banking systems are fundamentally fragile because they are based on what many would consider fraud: Banks do not actually have the money that they guarantee is being deposited with them. This becomes clear particularly when the money is lent out simultaneously over ninety times for unproductive, speculative purposes and hence in aggregate there is little hope of its being paid back. U.S. banks during the 1920s, for instance, had lent too much to speculators, driving up stock and land prices.9
However, Germany and Japan were the first countries to pull out of the Great Depression. While the U.S. central bank failed to reflate and allowed many banks to go bankrupt, the German and Japanese central banks started to print money sooner. Although it is often said that it was fiscal policy that stimulated the Japanese and German recoveries, it was in fact the creation of new credit that made fiscal policy effective. There is no known example of a country where aggressive central bank money printing did not stimulate demand. Whenever a credit bust follows an excessive credit boom, a recovery happens only after the banks or the central bank expands credit creation again.
Solving the Banking Problem

While the central bank has to kick-start the economy, simultaneously the problem in the banking system needs to be solved. After a decade of failed attempts, it may be appealing to think of this bad debt problem as being complex beyond imagination, but in actual fact it is an issue that could be solved immediately, at zero cost to anyone. And it should have been solved long ago. While banks are burdened with significant amounts of bad debt, they will not fulfill their role of lending and creating money. The only solution is for banks to write off their bad debts and delete them from their books. Since accounts are made up of assets and liabilities (loans are assets for banks, and deposits are liabilities; equity is on the liability side) and the two must always balance, simply deleting the bad assets will not do. Liabilities would exceed assets—which is one definition of insolvency. So in order to be able to write off the bad debts, the banks need to put something else on the asset side of their balance sheet. These are called reserves, and they are put in place of the hole that the write-offs would create in the balance sheet. Put simply, the banks need money.
So what we need to do is to give money to the banks. We are relieved to find that the problem is not more complicated than that. For money, as we know, can be created, either by banks themselves or by the central bank. The simplest solution is therefore for the Bank of Japan to print money and give it to the banks.10 Of course, the Bank of Japan would like to obtain something in return, in order to list it on the asset side of its own balance sheet. These are details. The banks could issue a debt paper, which states that they borrowed the money from the Bank of Japan (for instance, at zero interest). Or they could issue new shares, such as preferred shares, which the Bank of Japan would then buy. Alternatively, they could transfer ownership of the land they own to the Bank of Japan.
Bad Debt Problem Can Be Solved in a Day

If it so wished, the Bank of Japan could have solved the bad debt problem in its entirety within one morning. What it needed to do was to purchase all bad debts from all banks at face value, and pay for them through the creation of new money. The banks would have welcomed this idea, for they would have received cash in excess of market value for loans that had gone bad. What about the Bank of Japan? Would it not suffer huge losses? Actually, no. By purchasing the bad debts at the nominal face value of the 1980s, the central bank would appear to make a loss (since their market value is now much lower). However, the central bank, having a license to print money, always makes a gain: It has zero fund-raising costs and can obtain something that has some value (even if only 10 cents on the dollar) for free. The true cost for the Bank of Japan is zero. It creates the money out of nothing and therefore always gets a good deal. In practice, transferring the cash to the banks does not even involve printing presses, as most of the money is created online in the Bank of Japan’s computers. Since the banks all have accounts with the BoJ, it could use its electronic transfer system to rid the banks of all the bad debts within seconds—instead of taking over a decade.
There are of course many variations on this theme. For example, if the central bank is reluctant to show any such assets on its balance sheet, a government institution could be used that buys the bad debts from the banks and itself is funded by issuing bonds or bills to the central bank. The possibilities are there, if there is a will to solve the bad-debt problem.
Not only would there be no costs to the Japanese central bank, more importantly, there would also be no costs to the economy or society at large. If, instead, government money (i.e., tax money) is used to bail out banks, then the taxpayers will have to refund the money in the future. If the BoJ simply prints the money, taxpayers do not incur a liability. Since the economy has been in the grip of deflation, this would also not produce what is normally the cost of excessive credit creation, namely, inflation. In this situation, at best we would get less deflation— which would be a good thing.
How to Stimulate Bank Credit

Alternatively, money could be transferred to the banks by helping them make sizable profits. There are several ways in which this can be achieved. One way is for the central bank to corner a market to help the banks—in effect creating a mini bubble in a certain market in which banks invest heavily, providing large profits for them. This turns out to be a relatively common technique by central banks to help their banking systems. Another, more transparent way would be to use the banks’ ability to create credit to fund fiscal spending. As we saw, the main reason fiscal spending has been ineffective is that it was not linked to greater credit creation. By borrowing from the private sector through bond issuance, quantity crowding out occurred. This would not be the case, however, if the government changed its method of funding the public-sector borrowing requirement. Instead of issuing bonds, it could enter simple loan contracts with the banks. The banks would be eager to lend, as the government is a zero-risk borrower. Unlike the bond market, bank credit creates new purchasing power. The money spent by the government would not be withdrawn from the economy but would be newly created—thus addressing the cause of the recession, namely, a lack of credit creation. No crowding out would occur.11 Net demand would increase. Such a method is of course particularly useful at times when the central bank refuses to monetize fiscal spending by buying government bonds. Finally, if the Bank of Japan really wanted to create a recovery, it could also have used its window guidance mechanism to simply “guide” bank lending higher.
Moral Hazard Principle

Should the central bank bail out the banks and create a recovery? Economists are concerned with an incentive problem, referred to as “moral hazard.” To avoid it, those who create problems should know that they face some kind of penalty. If banks expect to be bailed out, there would be no incentive for them to avoid reckless lending. This principle already tells us that taxpayers should not be made to fund any bank bailout, because the bad debts were not their respsonsibility.12 Thus it is often argued the Japanese banks should not be bailed out at all. But there are also problems with this argument. First, it is now almost twenty years too late. We should have worried about it in the early 1980s, when banks engaged in excessive lending. However, since the mid-1990s, the main problem has been too little lending. Thus one could bail out the banks on this occasion, and after the bailout make suitable institutional changes to avoid future reckless lending of the type that occurred in the 1980s. To do that properly, however, one would have to examine closely just why the banks were lending so aggressively during the 1980s.
Second, the above argument assumes that the banks were the main perpetrators of the lending-driven bubble of the 1980s. Indeed, it has been shown that bank lending explains the bubble.13 However, we have not yet established just why the banks were lending so much.
How Much Money Has the BoJ Created?

Many of the above ways to boost bank credit would have taken some time to implement. Since Japan’s economic downturn became painful for small firms and hence the majority of the Japanese people from 1992 onward, already at that time the fastest method to kick-start the economy should have been adopted. In Figure 9.2 in chapter 9 we measured bank credit creation in the real circulation (i.e., without the bubble sectors) and saw that it had fallen sharply from 1990 onward. A year later, nominal GDP growth also fell. Credit creation remained minimal and even turned negative in late 1994—resulting in negative nominal GDP growth in early 1995—for the first time in postwar history; indeed, the first time since 1931.14 In such circumstances, where bank credit creation is collapsing, it is the duty of the central bank to counteract this and do what banks are not doing—step in and create more credit.

Figure 10.1  Bank of Japan Credit Creation (as measured by Profit Research Center’s Leading Liquidity Index)

Source: Bank of Japan; Profit Research Center Ltd.
No doubt, the BoJ has been holding in its hands the key for an economic recovery. Let us therefore check just how much money the Bank of Japan has been creating during the 1990s. First, we need to measure its credit creation correctly. Since the central bank has to buy something from the private sector when it creates money, and since it has to sell something to neutralize purchasing power, a more accurate measure of central bank credit creation is found by simply adding up all its transactions in all markets.15 Many economists, when analyzing the central bank, confine themselves to adding up what the Bank of Japan calls “short-term money market operations,” because they are conveniently announced on a daily basis. However, these operations do not represent the total net credit creation of the BoJ. Instead, the net credit creation of the BoJ is best measured by adding up all its transactions. Figure 10.1 shows one such measure—based on figures released by the central bank. Assuming that the Bank of Japan has supplied accurate data, this should provide a reasonably useful measure of the Bank of Japan’s credit creation.16
Aggressive Money Printing in 1998 and 2001

We see from this chart that in the 1980s, from around 1986 onward, the Bank of Japan stepped up its credit creation significantly. This was to be followed by a sharp reduction in credit creation: In 1992, our index fell into negative territory. This implies that the Bank of Japan was withdrawing purchasing power from the economy. It engaged in the opposite of credit creation. Credit creation remained minimal still in 1993; in 1994 it rose somewhat, only to fall sharply again and turn negative in March 1995. From around May 1995 until early 1997, credit creation rose, but fell once more later in 1997. While the index has been on an up trend, this was marred by frequent periods of significant credit reduction. In other words, for most of the 1990s, the BoJ did not print money aggressively, or sufficiently for a lasting recovery.
In March 1998, the Bank of Japan suddenly boosted credit creation sharply. Our index reached the highest level since January 1974, when the BoJ was supplying the funds for the 1970s real estate bubble. This was good news for Japan and, indeed, was followed by a sharp economic recovery in 1999, and a stock market rise exceeding 50 percent. Unfortunately, the central bank turned off the taps with almost equal vigor in 1999, and went beyond this by actively withdrawing money from the economy for much of that year. This could not fail to end the nascent recovery. Indeed, by 2001 the economy was once again in the midst of another deflationary round, with demand falling and prices declining faster again. In June 2001, the central bank changed its monetary policy once more and sharply increased the quantity of its credit creation.17 As expected, this contributed positively to the economy in 2002, despite the severe slump in 2001 and early 2002. But will any recovery last? The Bank of Japan’s policy so far has not been one that is aimed at creating a sustained economic recovery. Instead, we had temporary minor recoveries within one long recession.
Why Did the BoJ Not Fully Reflate?

It is often said that the job of central banks is to counteract business cycles and create a stable economy. That is also what the proponents of the U.S. Federal Reserve argued in the early twentieth century when they wanted to persuade Congress that a central bank was necessary. However, upon analyzing the monetary policy of the Bank of Japan over the past decade, it becomes clear that Japan’s central bank did not engage in countercyclical monetary policy. To the contrary, it created more purchasing power at times when there was already too much—the late 1980s—and it created far too little purchasing power, even decreased purchasing power, at times when there was already too little and a credit crunch squeezed the entire economy—the 1990s. Why was the BoJ following such a policy course? It is time to take a closer look at just what the BoJ has been up to.