werner 4 5
The Alchemy of Banking
Money
Conscious institutional design by the war economy bureaucrats created the structures for a growth-oriented economy. The designers likened their system to an “organism” that worked like a body. Structures alone, however, are like a body without blood. What is missing in our description is the lifeblood of an economy, the liquid that is oiling the wheels of commerce: money.
Since humans abandoned barter several thousand years ago, money has been at the center of economic activity. It is therefore not surprising to find that money, its creation and allocation, also took center stage in Japan’s war economy.
Just What Is Money?
Unlike the leaders of Japan’s war economy, many economists today dispute the crucial role of money. It may surprise many readers, but it is probably fair to say that many economists do not know what money is.1 Things were easy when only gold and silver were used as money. But in a modern financial system it is not so obvious how to measure money. Most economists define money as the sum of central bank cash and bank deposits. However, it is not clear whether only short-term, long-term, other types, or all types of bank deposits should be included in such a measure. That is why central banks now publish a whole menu of so-called money supply measures—deposit aggregates ranging from the narrow MO (cash in circulation and bank deposits with the central bank) to M4 or wider aggregates (including all types of deposits).
Despite the multitude of measures, none of them seems to be particularly useful, because none of the M-aggregates has a stable link with economic growth.2 This is a headache. One of the few things most economists agree on is that money supply growth and economic growth should move closely together. But in the 1980s, money supply measures in many countries expanded much faster than GDP growth.3 By the mid-1980s, both the Bank of England and the U.S. Federal Reserve had announced that they had lost faith in the M1, M2, or M3 type of money-supply measures and were abandoning monetary targets altogether. Since then it has become quiet around monetary theories.
Big Interest in Rates
Today, most economists have no interest in the role of money in the economy. The latest macroeconomic theories argue that money is “neutral”—just a veil over the tangible economy. Economic research, these economists advise, can therefore safely ignore money.4 The big mysteries in economics—why we still have business cycles, stock market booms and busts, large-scale unemployment, and crises—are said to have nothing to do with money.
Though ignoring the quantity of money, mainstream modern economics pays close attention to its price—the rate of interest. The question whether the U.S. Federal Reserve will raise interest rates or not galvanizes experts and millions of investors. Unlike the quantity of money, interest rates can be accurately measured, and the latest data are available frequently. Many economists also believe that interest rates indirectly tell us about money. If interest rates are low, they say, there will be more money, and if they are high, the money supply must be shrinking.
Money Mattered to War Bureaucrats
While today such neoclassical economics is most widespread, in the 1930s the similar theories of classical economics were taught at leading U.K. and U.S. universities. The conclusions were the same. The war economy bureaucrats studied the classical theories. But they could not explain events very well. Links between money supply and growth were weak (such as in the United States in the 1920s). There was also no unique connection between interest rates and the quantity of money. Sometimes interest rates were low, but the quantity of money could be low as well. Worst of all, sharp reductions in interest rates, such as in the 1930s in the United States, did not seem to stimulate the economy (while for a long time in the 1920s rising interest rates did not seem to slow the U.S. economy).
When the world was in the grip of the Great Depression, classical economists argued that lowering interest rates would be enough. No government intervention was necessary, as the free markets would stimulate the economy on their own. But the invisible hand seemed to create more and more unemployment and starvation in the United States, where the recession lasted almost a decade. The reform bureaucrats instead turned to the anticlassical theories developed by German economists. They offered a different explanation of how the economy works. Much of their insights were drawn from a detailed study of history, which they believed offered important clues to an understanding of the economy—and the role of money.
The Power of Money
Going back in history, we find the oldest advanced monetary system in China. It lasted for several hundred years, until the era of Mongolian rule. It is at this time that a detailed description was delivered to Europe in the form of Marco Polo’s report of his twenty years spent in Kublai Khan’s China in the late thirteenth century. Marco Polo was a trained merchant, and his book The Travels is full of information and insights concerning the Chinese economy. He did not fail to give an account of the most advanced monetary system at the time.
The world’s first paper money was launched in the tenth century in China by the ruling Sung Dynasty. In this advanced monetary system, there was no doubt about what money was: the paper money issued by the emperor and stamped by his seal. He was the central bank. No other institution was allowed to create money, on penalty of death.5
The emperor was directly in control of the money supply. This meant that he could stimulate demand by creating more paper money, or cool the economy by taking paper out of circulation. He also determined who could gain control over food, raw material, weapons, and the latest technology, by creating and allocating paper money at will. He was an absolute ruler in every sense, in control of all the resources of his empire.6 Marco Polo vividly describes this advanced monetary system, which had been in place when he visited China under the rule of Kublai Khan:
It is in this city of Khan-balik that the Great Khan has his mint; and it is so organized that you might well say that he has mastered the art of alchemy. I will demonstrate this to you here and now. You must know that he has money made for him by the following process, out of the bark of trees—to be precise, from mulberry trees (the same whose leaves furnish food for silkworms). The fine bast between the bark and the wood of the tree is stripped off. Then it is crumbled and pounded and flattened out with the aid of glue into sheets like sheets of cotton paper, which are all black. When made, they are cut up into rectangles of various sizes, longer than they are broad…. And all these papers are sealed with the seal of the Great Khan. The procedure of issue is as formal and as authoritative as if they were made of pure gold or silver. On each piece of money several specially appointed officials write other names, each setting his own stamp. When it is completed in due form, the chief of the officials deputed by the Khan dips in cinnabar the seal or bull assigned to him and stamps it on the top of the piece of money so that the shape of the seal in vermilion remains impressed upon it. And then the money is authentic. And if anyone were to forge it, he would suffer the extreme penalty.
Of this money the Khan has such a quantity made that with it he could buy all the treasure in the world. With this currency he orders all payments to be made throughout every province and kingdom and region of his empire. And no one dares refuse it on pain of losing his life. And I assure you that all the peoples and populations who are subject to his rule are perfectly willing to accept these papers in payment, since wherever they go they pay in the same currency, whether for goods or for pearls or precious stones or gold or silver. With these pieces of paper they can buy anything and pay for anything.7
Marco Polo also describes what today we would call open market operations conducted by the Great Khan through purchases of gold, silver, precious metals, or other supplies from his subjects:
Several times a year parties of traders arrive with pearls and precious stones and gold and silver and other valuables, such as cloth of gold and silk, and surrender them all to the Great Khan. The Khan then summons twelve experts, who are chosen for the task and have special knowledge of it, and bids them examine the wares that the traders have brought and pay for them what they judge to be their true value. The twelve experts duly examine the wares and pay the value in the paper currency of which I have spoken. The traders accept it willingly, because they can spend it afterwards on the various goods they buy throughout the Great Khan’s dominions….
Let me tell you further that several times a year a fiat goes forth through the towns that all those who have gems and pearls and gold and silver must bring them to the Great Khan’s mint. This they do, and in such abundance that it is past all reckoning; and they are all paid in paper money. By this means the Great Khan acquires all the gold and silver and pearls and precious stones of all his territories.8… And all the Khan’s armies are paid with this sort of money.
I have now told you how it comes about that the Great Khan must have, as indeed he has, more treasure than anyone else in the world. I may go further and affirm that all the world’s great potentates put together have not such riches as belong to the Great Khan alone.9
Marco Polo’s description seemed wildly exaggerated to his fellow Europeans. We now know, however, that he was giving what amounts to an accurate description of the monetary system prevailing at this time in the Mongolian Empire. Even his estimation of the Khan’s wealth as far exceeding that of his counterparts in the rest of the world might well have been accurate.
At the time, European kings and princes could only dream of such wealth or such power over the economy and their dominions. Things had developed quite differently for them in Europe. The rulers there failed to understand the true nature of money. To them, only gold or other precious metals could be money. But if gold is the main currency, it is impossible for a ruler to control the money supply. Gold cannot be created at will. Rulers tried, though in vain. Thanks to their efforts, chemistry got an early start in the form of the doomed attempts at creating gold through alchemy.
Compared to their colleagues in China, European rulers could not really be considered fully in charge. They could not control the resources in their countries. Kings had to compete with their own subjects for resources. A government that does not control the money supply has hardly any influence over its economy. Such a government is not sovereign. The great Kublai Khan, emperor of China and the Mongolian Empire, would probably have shaken his head in disbelief if he had known that European rulers could not issue money to implement public-sector projects. Instead, European governments had to rely on taxes. Often tax levels were already close to the pain threshold, and money was still needed for government investments or expenditures. If the kings and princes still wanted to build roads, hospitals, and castles or raise an army to defend their country, more often than not they had to borrow money. No matter how absolutist or all-powerful they may have called themselves, when it came to money most European rulers had to ask for help.
The Goldsmiths’ Alchemy
So who was in control in Europe? It seemed that whoever had accumulated a lot of gold would be able to stake the biggest claim on resources. In reality things were a little subtler. Although precious metals were the main means of payment, it turned out that they were too heavy and too cumbersome, and it was too dangerous to transport them each time when going shopping for larger items. Gold wasn’t even safe at home. Soon the richer merchants and landowners started to look for safe places to store their gold and silver. Who better to entrust one’s gold to than the goldsmiths, whose job was to work with gold and jewels and who therefore had safe storage places? They were well established and independently rich, so there was little risk that they would make off with anyone’s gold.
When gold was deposited with a goldsmith, he would write a receipt to certify that it was in his custody. Depositors found this convenient: Why bother taking out the gold for each purchase when the new owner of the gold would deposit the gold back with the goldsmith again anyway? Since the goldsmith was well known, soon the deposit receipts themselves were accepted in lieu of payment. The deposit receipts had become money.
By about the thirteenth century, paper money therefore also had its debut in Europe. However, it was crucially different in its form, function, and implications from China’s paper money. It was issued not by the government but by a private group of businessmen.10
The Biggest Trick in History
Most crafts in medieval times were organized in trade guilds. So were the goldsmiths. At their regular meetings they must have discussed the phenomenon of a lot of gold lying idly in their vaults as many depositors used the receipts as money. They probably realized fairly quickly that they could make extra profits if they lent out the gold in the meantime. The risk of getting caught without gold was low if they helped each other in case of unexpected withdrawals.
The moment the goldsmiths lent out some of the deposited gold to earn extra interest, two things happened. First, the goldsmiths committed fraud. Their deposit receipts guaranteed that the gold was deposited with them. Their customers relied on the fact that the gold was there. But it was gone, lent out. So the goldsmiths strove to keep this from the public. As long as the public did not know or did not understand, there was no problem.
Second, new purchasing power was created. While the receipts for the gold were used to purchase goods in the economy, the gold itself, when lent out, provided someone else with additional purchasing power that had not previously existed. The total amount of purchasing power in the economy increased. The goldsmiths had expanded the money supply. But unlike in China, where the government made the decision over creation and allocation of purchasing power, in Europe it was the goldsmiths who could dictate who would receive money. Though unknown to the public, the goldsmiths’ actions affected everyone. As they created more money, the number of claims on scarce resources increased.
Things became even better for the goldsmiths. They found that demand for loans remained steady. When they had already lent out most of their gold, they were unwilling to let the opportunity slip to earn more interest. So they figured that they could further expand their lending by giving their borrowers deposit receipts instead of gold. Put simply, the goldsmiths could “print” money! By doing so, they could provide purchasing power to whomever they liked. This time, three things happened: First, the number of claims on resources, the money supply, increased further. This created a larger potential for economic booms or inflation of consumer or asset prices. Second, the fraud reached significant proportions, as they issued fictitious deposit receipts far in excess of the gold left in their vaults. This created even larger profits — borrowers would pay back in real money what the goldsmiths had not owned. It also created a larger potential for crises when depositors would demand their money back. Third, banking was born.
Penniless Monarchs in the Bankers’ Kingdom
The goldsmiths soon gave up working with gold and jewels. They had hit on a far easier and far more lucrative business. They charged interest for issuing paper slips that cost them nothing to produce! They became wealthier and henceforth would be known as bankers.
The bankers had managed to do what kings, emperors, and alchemists had failed to do—they were creating money. They had found the philosopher’s stone.11 They were the central bank of their time.
This had fundamental implications that were to change the course of history, for it meant that the allocation of new purchasing power was not under the control of the government. Europe’s monarchs did not see through the deception. They naively believed that the bankers had large amounts of gold. When governments needed money and could not raise taxes further, they too thought they had to borrow from the bankers.
The irony was that the bankers were just doing what the kings could have done themselves: issue paper money. Yet because the monarchs came to rely on their bankers to fund large ventures, ultimately the bankers gained great influence over national policies. Soon it became doubtful who was really in charge of the country. The Old Testament says that the borrower is servant to the lender.12 Thus it came that the kings often had become servants. Bankers were the masters who created and allocated purchasing power.
The bankers, of course, had their own interests to look after. Greatest opportunities beckoned when a monarch spent a lot of money—and hence created national debt. Some princes were wise and failed to borrow. Then the bankers had to wait for helpful circumstances such as wars between princes. Wars are a prime cause of borrowing and national debt. In times of war even the thriftiest prince would be in need of money. Was it surprising if, in exchange for their invaluable services, bankers would ask not only for interest payments but also for special privileges, rights, titles, and lands? If the monarch was recalcitrant, his war fortunes could suddenly falter. Those bankers would do particularly well who had connections to colleagues in other countries, including to bankers on the other side of the front lines, who funded the ruler of the enemy country. Then the temptation must on occasion have arisen to collude with the enemy’s bankers, because such “rational” behavior would maximize their joint benefit. Together, they could then decide which king was going to win—the one who had granted them the greatest privileges. They could simply issue more money to their favorite and, with deepest regrets, report to the other that they had run out of cash. If the latter didn’t believe them that there was no more money he could simply be shown their empty vaults. After his defeat the spoils could then be divided. Too bad for all those soldiers who had died in the process.13
While Kublai Kahn and his predecessors were absolutely in control of their country through their control of the money supply, in Europe it was the reverse: The rulers came to be controlled by money and by those who were in charge of its issuance. Not the kings, but their financiers were in charge.
Money Is Credit
Until the advent of central banks (in the United States as recent as 1913), private banks therefore printed and issued paper money when someone took out a loan. The English language bears witness to this process, as even today, paper money slips are referred to as “bank notes.” At the time it was still clear how money should be measured: It was the sum of gold circulating and all the paper money issued by the banks.
On the surface things seemed to change when central banks were introduced. These institutions, usually founded and owned by the most influential bankers, had received the monopoly rights to print paper money.14 Thus all other banks became dependent on them. This did not mean, though, that the banks stopped creating money. Bank money creation merely took a less visible form. If someone wanted to borrow from a bank, the bank could open an account and create a new deposit entry.15 This is “book” money, or bank money. It worked as well as gold or paper money. So even today, private banks create most of the money supply. Currently, in most countries less than 10 percent of the money supply is paper money issued by the central bank. As in the days of an advanced goldsmith credit economy, banks today create and allocate the vast majority of purchasing power in the economy.16
The classical economists thought that the way to measure this bank money creation was to count all bank deposits. This is probably due to the fact that the old bank notes were called deposit receipts. But on a net basis, the banks issued new deposit receipts only when they granted new loans. Modern M-type deposit aggregates do not measure circulating money. They measure savings. The modern equivalent of the deposit receipt issuance by banks is not the accumulation of bank deposits but the extension of loans. Bank credit measures the money that is actually circulating.17
Seeing Trees, Not the Forest
Another reason why classical and modern neoclassical theories do not usually recognize the role of banks may be their focus on microeconomics, and the static nature of the theories. Thus economists often would only analyze one single bank, or one deposit or loan transaction. Combine this with the usual textbook treatment of the credit creation in a fractional-reserve banking system, and the true money creation power of banks is obscured. This is why in most finance or money and banking textbooks, banks are today described as financial intermediaries that merely accept deposits with one hand and extend these as loans with the other. Banks are just like the stock market or other financial intermediaries, these textbooks say: institutions that transfer money from savers to investors.18
Banks’ power of credit creation should not be played down, but explained in a way that makes this enormous power obvious—such as by pointing out that a bank does not just hand out a deposit to others as a loan once—but more than ten times. If you deposit $1,000 with a bank, and if the central bank requires banks to hold reserves of 1 percent, it is tempting to assume that the bank will lend out $990 and keep $10 (1 percent of $1,000) as reserves (as most textbooks also describe it). This is not what happens. Based on your $1,000 in new deposits, the first bank can already lend $99,000 (and keep your $1,000, which is 1 percent of $100,000 as reserves). How is this possible? Where does the bank get the extra $99,000 from?
The truth is, banks don’t have money. They simply create it by granting “credit” to someone. This does not cost them anything, as loans are created out of nothing. In the 1930s, this credit creation process took the form of a manual entry into the bank’s loan book ledger. Today it is but an entry into the bank’s computer. The more loans banks give out, the more deposits will be written into existence. If one bank gets more deposits than another, the excess deposits are passed along to the other banks that have a shortage (through the interbank market).
The Life Cycle of Money
The life cycle of money begins when money is born by the extension of bank loans. It does its job while circulating as purchasing power in the economy. The more credit a bank creates, the more purchasing power is exerted in the economy and used for transactions that otherwise would not take place. When the borrower spends the money, the receiver is likely to deposit it again with a bank. This is when money is “retired” from circulation. By drawing it from a deposit account, it can be mobilized again. Newly created purchasing power is eliminated again from circulation—money “dies,” so to speak—when the loans are paid back.
The power to create money makes banks special, and quite different from stock or bond markets, which can only reallocate already existing purchasing power.19 It also makes them more fragile. Austrian school economists remain convinced that banking is founded on fraud: the banks’ promise that the money is deposited with them is not kept—nor could it be kept should everyone insist upon it.20 That is why the bankers wanted to have a central bank, to step in and print cash when necessary.
Credit Is Supply-Determined
A correct measure of the “money supply” is simply the sum of central bank credit creation (injected as a result of the net buying and selling of assets by the central bank) and private bank credit. Credit aggregates therefore have a far better correlation with economic activity than the M-measures of deposits that are emphasized in central bank publications.21 They also easily beat the information value of interest rates.
The trouble with interest rates is that they are not uniquely related to the quantity of credit. They can’t be, because banks keep interest rates artificially low, in order to ration the credit market, and select among potential loan applicants those they prefer. In rationed markets, not the price, but the quantity determines the outcome. Interest rates can be low, and credit growth very fast. But credit growth can also be slow. That depends entirely on the banks’ decisions.22
This means that the entire industry of interest rate watchers and analysts could spend their time more fruitfully in other ways. When interest rates go up, it is not clear that the economy will slow. Likewise, declining interest rates are no indication that the economy will accelerate. Economic growth is determined by the quantity of credit, not its price.
There is No “Capital Shortage”
Without an understanding of the credit creation process, economic theories also had to get other concepts wrong, such as the role of savings and the determinants of growth. Classical economics assumed that there is a given amount of savings, which pose a limit for loan extension and hence investment. In reality savings are not limited at any moment in time. They are not a constraint on loans or investment. If more money is required for investment, banks can simply create it.23
Occasionally economists worry about a “savings shortage” or “capital shortage,” which they feel is holding back growth. There is no such thing. Savings do not impose a limit on economic growth. If necessary, banks can create more money, and hence create more deposits, which are savings. This will surely raise nominal spending and investment and hence nominal growth.24
The crucial question is, of course, whether the newly created credit is used for productive purposes or not. If new money is used unproductively, it is going to drive up prices. If it is used productively, it will not result in inflation. This is easy to achieve when economic resources are idle and there is unemployment. So especially during recessions, it is easy to ensure that new credit is used productively. Hence new money creation will result in a recovery, not inflation.25
The facts about money are simple. Yet they are not well known. Introductory textbooks of economics briefly mention that banks create money. But all the theories that follow ignore this fact. It took many centuries for Europeans to rediscover the truths that had been known in China as early as the tenth century and recognize that money was intrinsically based on the laws of the state and hence could be usefully employed by the government for economic development. Many European economists did discover the truth about money and banks in the eighteenth and nineteenth centuries, such as John Law in Scotland and France, and Adam Mueller and Georg Knapp in Germany.26 However, all their theories were soon superseded and are now forgotten.
It was fortunate for the bankers that a group of economists existed, the classical and neoclassical economists, who could be relied upon to argue that money—and hence banks—did not matter. In the battle for ideas the old and new classical economists had either the better arguments or the better funding. In any case, their theories became widespread and dominate the economics profession today.27
Credit: Key Tool for a Controlled Economy
Some wartime thinkers and reform bureaucrats followed a different creed of economics. They studied their German economists well and thus came to understand the truth about money and banks. They realized that the power of banks and the central bank to create and allocate credit rendered them key levers to control the economy and allocate resources.28 Like the Chinese emperors, they wanted to control money, in order to gain control over the country.
The institutional design of the war economy system created the framework within which resources could be allocated to produce economic growth. But it was the monetary system that was used for the actual implementation of resource allocation and output creation. It is money that holds the key to understanding Japan’s success since it embarked on economic warfare in the 1930s.
Credit
The Economic High Command
Shifting from the Stock Market to Bank Funding
The paramount goal of the reform bureaucrats was to maximize economic growth—which would also maximize war production. By definition, growth is due to investment. And to invest, firms need money. External fund-raising can take the form either of bank borrowing or of issuance of debt and equity—borrowing from the securities markets. In the 1920s and early 1930s, Japanese firms mainly obtained external funding from the stock market. Similar to the United States today, between 1934 and 1936 bank borrowing in Japan accounted for an average of 18 percent of firms’ liabilities, with equity finance responsible for 81 percent. However, less than ten years later, firms had switched the source of funding radically toward bank borrowing. In the period from 1940 to 1950, on average 60 percent of firms’ liabilities consisted of bank borrowing and only 40 percent consisted of equity financing. The predominance of bank financing persisted until the late 1980s: In 1965, 89 percent of banks’ liabilities were bank borrowings; in 1970, 85 percent; and in 1980, 87 percent.1
Again, the change of a major feature of the economic system—the switch from market funding to bank funding—did not happen by coincidence or due to market forces. The visible hand of the government purposely placed bank lending at the center of the war economy. Government officials saw many advantages in bank funding and hence suppressed funding from the stock or bond markets. Instead they used bank credit as the main tool to allocate resources within the war economy system.
Bankers Have a Heart for Managers
One reason why the war economy bureaucrats preferred bank funding was that they strove to empower managers over shareholders. Equity finance would have put shareholders in charge, and that might have directed the economy toward profits, not quantitative expansion. Bank borrowing eliminated this threat.
Instead of shareholders, company management was now monitored by their bankers, who had to ensure that their loans were not wasted. But the bankers were managers themselves. The separation of ownership and control, which was engineered by the control bureaucrats, also included banks. This meant that from the late 1930s onward, individual shareholder influence over banks had been minimized. Also, the bankers were less interested in profits than in growth. Instead of charging high interest rates, they therefore wanted to boost their lending. That would be possible only if companies grew fast and hence had a further need for borrowing. Thanks to bank financing, corporate managers had found a natural ally in their bankers.
Another reason was speed. In a state of war, priority industries must raise large amounts of money quickly. Bank financing beats market financing when it comes to speed and ease of fund-raising. All that is necessary for a firm to obtain funds from a bank is the decision by the loan officer, who can make the money available at the stroke of a pen. Equity financing or even debt issuance involves many more steps and participants, from lawyers drawing up the deals to underwriting and placement in the market. This can take months of preparation and execution. War planners could not afford such a leisurely pace.
Banks Boost Savings
Providing money to key industries is only one side of the tasks authorities faced during the war effort, however. As priority industries increasingly obtained purchasing power and laid claim to the available—and limited—national output, prices would be driven up if consumption demand was not at the same time reduced. Continued strong private consumption would pit firms against consumers in the competition for scarce resources. To avoid inflation and the social instability that could follow, authorities had to ensure that consumers increasingly withheld their purchasing power. Individuals needed to be encouraged to save.
In a stock-market-based financial system, savers would have to be encouraged to buy stocks or corporate bonds. But as savings instruments for the broad masses, these involve risks and require careful research. In a state of war, individual savers could hardly be expected to put their savings in bulk into debt and equity. Losses of savings may have caused social instability.
With a bank-based economic system, the authorities could simply guarantee depositors’ money. Should a bank be allowed to fail, the central bank could bail out depositors. At least the principal of a household’s savings was thus guaranteed. In exchange for high security, however, savers had to accept lower returns. This allowed more funds to remain invested.
From about 1937 onward, government officials encouraged savings with annual savings campaigns. The media were used to spread the message that spending is bad and saving is good. Local bank, credit union, and post office branches acted as the collectors of people’s savings, ensuring that purchasing power would be withheld. Bureaucrats discouraged all other forms of saving by effectively making them equivalent to bank saving, and stocks became like bonds or deposits, yielding a fixed, administered return. That yield was pushed down so as not to compete with bank deposits.
Bankers, the Money Creators
By far the most important reason why war planners preferred bank funding as the main conduit of resource allocation was that banks create most of the money in the economy. And they make the crucial decision of who will get this money. Their actions thus have a profound impact on equity, growth, efficiency, and inflation. By withholding purchasing power from one sector and allocating newly created money to another, the entire economic landscape can be reshaped.
Given this pivotal role of the banks, it is not surprising that the reform bureaucrats and war planners had developed a strong interest in them. The German economists they read argued that banks and economic growth were crucially linked.2 Economic growth can be accelerated if the inputs used—land, labor, capital, and technology—are increased. As we saw, the war bureaucrats had already found efficient ways of organizing the labor market and firms’ management in order to ensure effective mobilization of land and human resources. The banks served as their main tool to maximize capital and technology inputs, direct resources and steer growth.
How to Fund Growth: Print Money
Technology is indeed nothing but new, more efficient ways of rearranging given resources. It is like a new recipe, which delivers a tastier and superior output that is then valued more by consumers. Innovators and creative entrepreneurs that have hit on a new recipe often have a problem, though: They have no money to found a company that could implement their idea on a large and viable scale. The entrepreneur could either get funding in the markets or borrow from a bank, and may not mind how the money is obtained. But for the whole economy there is a crucial difference. If an investor funds the entrepreneur, the investor would have to pull money out of other investments (such as bonds, stocks, bank deposits, or even other venture firms). As a result, already existing purchasing power would be diverted to a new use, and some other economic activity would have to be scaled down. Despite the innovation, there is no economic growth, as the national income pie is determined by the quantity of credit creation, which remains unchanged. By contrast, if the entrepreneur instead borrows money from the banking system, additional purchasing power would be created and no previous projects need to be stopped.
Productive and Unproductive Credit Creation
This sounds almost too good to be true. Could all new and good ideas be funded just by central bank money printing or bank loans? In principle, yes. Normally, the worry is that excessive money creation would result in inflation. However, as long as the money is used for productive projects that also increase output, there won’t be inflation; although more money has been created, the money was used so cleverly that there is now also more output. Both credit and output would rise, and prices would stay the same. What many classical and neoclassical economists failed to recognize is that credit both provides the demand for new goods and allows their creation. It therefore simultaneously brings about both the demand for and supply of new goods. If, on the other hand, extra money was created that was then used not to implement new technologies and create more output, but simply for consumption or speculation, more money would chase an unchanged number of goods and services. Prices would be driven up and inflation would ensue.3
There is a downside, though. In a free market economy, banks can create credit and allocate it to anybody they wish, even to borrowers who put it to unproductive use. Ultimately, though, this would also not be good for the banks, because lending for unproductive purposes is much riskier. Only when it is used productively is credit likely to generate the income that is necessary to pay interest and repay the principal. However, banks do not find it easy to recognize the actual risk involved in their loans. Each bank might think it will get the money back on its real estate loans. But taken together, all banks will end up lending more money to the real estate sector than can be used productively. As a result, money is created, but no new output and no new income can be derived from it. Eventually lenders will be unable to pay back the loans. As the excessive credit creation turns into bad debts, banks become more risk-averse and reduce lending. This slows economic growth.
Putting a Check on Bankers
Banks are special, since they serve the public function of creating and allocating money. But it is not clear that bankers, when left to their own devices, allocate funds such that the welfare of the entire community is enhanced. Banks may decide not to extend loans to a farmer who wants to introduce organic farming techniques, because it might consider these ventures too risky or not profitable enough, and instead allocate purchasing power to a real estate speculator who does not add to social welfare. German economists were particularly critical of the U.S. experience of the 1920s, when banks were encouraged to create money and give it to speculators, who wasted it. They argued that the crucial function of banks to create and allocate purchasing power had to be utilized for the common good of the nation.4 Even though a government may be democratically elected, the bankers are not. The bank owners often belonged to a small number of families who had wide-ranging power, sometimes over entire countries. Commentators noted that especially in a U.S.-style democracy, bank credit should be regulated by the government to maintain equity and fairness. U.S. founding father Thomas Jefferson was for this reason always opposed to the establishment of a privately owned central bank, and the U.S. Constitution was designed to grant the right to issue money specifically only to the U.S. government.5 The Japanese war economy bureaucrats agreed that they needed to monitor the activities of banks carefully. At the same time, they realized that bankers could be turned into their allies and helpers in doing their job. By “guiding” the banks, officials could direct newly created money to productive projects.6
Controlling the Controllers
Control over credit creation, however, had to include the central bank. The supply of money used in an economy is made up of the sum of the credit creation of the banks and the central bank. The latter can increase or reduce the amount of money in the economy. But it also wields enormous direct control over the credit creation of banks.7
Given their different understanding of the role of the state—namely, to serve the community—the Japanese bureaucrats could not accept that, even in supposedly democratic countries, the central banks were owned by private bankers.8 How could one expect the U.S. Federal Reserve system, the Bank of England, and the German Reichsbank to serve the public interest when in fact they were partly or wholly owned and controlled by private bankers?9 And closer to home the question was pressing: How could the Bank of Japan be left a joint-stock company, in large part in private hands?
In line with the German economists whose books they had studied, the Japanese war economy theorists believed that the central bank should be controlled by the government. And it should, in turn, exert control over banks to regulate the quantity and allocation of money creation, such that it would serve the nation’s interests.10
When the reform bureaucrats realized the importance of banking in shaping the economy, they started to study how central bankers supervised the banks.11 Some central banks claimed to use reserve requirements as a policy tool. Others said they set the official discount rate and thus encouraged or discouraged credit. In reality, neither tool was very effective. The discount rate or short-term interest rates were not necessarily related to economic activity. And the reserve requirements were too blunt a tool to be used strictly. If many banks failed to meet the reserve requirement, the central bank would be forced to lend enough money to the banks so that they would meet it, thus defeating the purpose. The alternative, though, was to watch how banks would try to borrow money from each other to meet the requirements, pushing up interest rates so sharply that it could disrupt the economy. Due to this problem, central bank officials often say that they cannot control the money supply. Yet there is a way for them to control the quantity of purchasing power created by banks—they can set loan-growth targets to banks.
The Secret Control Tool
This was a method pioneered by the German central bank, the Reichsbank. It already had gained invaluable experience during the First World War and in the 1920s in restricting overall credit growth to desirable levels and also in allocating the newly created money to preferred sectors. During the 1920s, the Reichsbank, under its president Hjalmar Schacht, also provided strict “guidance” to the banks regarding their loan extension. The discount rate—the short-term interest rate at which banks could officially borrow from the central bank—was still announced, but it had become more of a public relations tool. By 1924, inflation had been brought under control. But the Reichsbank’s “guidance” continued virtually uninterrupted for years—indeed, until 1945.12
The procedure was simple: Each bank had to apply to the central bank for its loan contingent for the coming period. The banks then proceeded to allocate their contingents among borrowers. Once the contingent was used up, the central bank would refuse to discount any further bills presented by that bank and would punish further credit expansions. Since there was no legal basis for these credit controls, the Reichsbank relied on “moral suasion,” that is, informal administrative pressure under the threat of sanctions that could be highly costly for the banks. One internal Reichsbank memo of 1924 dryly notes that the central bank wields “substantial means of exerting pressure,” which “it will not hesitate to employ.”13
Schacht, Credit Dictator
The credit control system imposed in Germany handed enormous power to the central bank. Since the Reichsbank had been made independent from the government after the hyperinflation of 1924, it could do as it wished.14 It was only a small step further to give the banks detailed instructions about the sectoral, regional, and qualitative allocation of their credits. Reichsbank president Schacht made ample use of this power. By giving instructions to banks about what type of industrial sector and even which companies to lend to—and which ones to cut off from lending—Schacht engaged in a far-reaching structural economic policy, favoring specific regions, sectors, and institutions that he considered “productive” and pushing for corporate restructuring. The latter was getting fashionable in Germany, the United States, and Japan under the label “rationalization.” Schacht argued that to advance rationalization, firms must merge and “uncompetitive” firms must be forced into bankruptcy. Schacht put such structural changes above the need to stimulate the economy. Consequently, unemployment remained a problem throughout the 1920s.15
Commentators noted that “many injustices and disagreements about the details are unavoidable.”16 Numerous observers argued that in a democracy such vital decisions could be made only by parliament and the elected government. Indeed, the Reichsbank had become the actual German government, easily superseding the fragile and short-lived Weimar governments in terms of influence on the economy. Governments fell at a hectic pace, but Schacht remained firmly enthroned from 1924 until he resigned in 1930, a period that turned out to be crucial for Germany’s later development. Contemporaries recognized in him a “credit dictator” or “economic dictator” and called the Reichsbank Germany’s “second government.”17
Introducing Credit Controls in Japan
In Japan, the reform bureaucrats had studied the Reichsbank’s methods and realized the enormous potential offered by central bank credit controls over the banking system.18 They had dispatched officials to Berlin, based in the Japanese embassy or more directly at the Reichsbank. This included Hisato Ichimada, who had been sent by the Bank of Japan, and who featured prominently as the Bank of Japan’s postwar credit dictator (see the next chapter).
The first law to start up the controlled war economy—initially called a “quasi-war economy,” since the measures were partial and the country was officially not at war—was the Capital Flight Prevention Law of 1932 and the Foreign Exchange Control Law of 1933. They were aimed at preventing money from being transferred abroad, and also served to regulate imports. The staff of the newly created foreign exchange control section inside the Ministry of Finance became an experienced core of economic controllers, adept at directing the flow of funds.19
Having come to power with the beginning of open hostilities in China in 1937, the reform bureaucrats moved to control the allocation of money through the Temporary Funds Adjustment Law of 1937. This law brought banks and their investment and loan decisions under strict control by the central bank and the Ministry of Finance. Funding through the stock market was reduced to a trickle, and the banking system was relied upon for resource allocation.
It was now time to use the central bank for the purposes of the war planners. “In the period before World War II, and particularly before 1932, the Bank of Japan did not have a close relationship with the commercial banks and the money market except in times of crisis, when it acted as lender of last resort.”20 In 1942, the war leaders brought the Bank of Japan directly under the control of the government and its finance ministry by translating Hitler’s new Reichsbank Law of 1939 and introducing it as the new Bank of Japan Law.21 Together with the capital flow and foreign exchange control laws, this completed the system of financial controls.
The 1942 law stated clearly that it was the central bank’s job to work toward the full mobilization of resources to achieve maximum output growth. Article 1 stated that “the purpose of the Bank of Japan shall be to adjust currency, to regulate financing and to develop the credit system in conformity with policies of the state so as to ensure appropriate application of the state’s total economic power.” Article 2 stated that “the Bank of Japan shall be operated exclusively with a view to accomplishing the purposes of the state.”22
To simplify the credit allocation regime, the number of banks was drastically reduced, from about fourteen hundred by the end of the 1920s to a mere sixty-four by the end of the Second World War. Similar to the control associations in various industries, the banks were organized in so-called financial control associations under the umbrella of the National Financial Control Association. As in other industries, it stayed in place in the postwar era, as the Japan Bankers’ Association.23
Bank of Japan at the Control Levers
Banks were ideal as bureaucratic tools to direct resources. All that was needed was to impose detailed guidelines on bank lending, which the banks would have to follow. In order to ensure that firms with nonpriority investment projects would not compete for scarce resources by raising funds in the stock market, various administrative measures were employed to restrict equity finance and corporate debt issuance.
The Bank of Japan acted as the control center of the creation and allocation of purchasing power. Its governor headed the National Financial Control Association, which was operated by the BoJ and implemented the resource allocation plans worked out by the Cabinet Planning Board. The plan was structured on a top-down basis: First, the needed output was decided upon. Then a hierarchy of manufacturers, subcontractors, and raw-material importers was determined. Finally, the banks were required to ensure that purchasing power was made available for all the firms involved to be able to acquire the inputs into their production process. While shareholder influence was eliminated, competition was ensured on all levels, because the employees of companies and also of the banks were made to compete in ranking hierarchies for promotion and other rewards.
Thanks to them, resources could be allocated to industries of strategic importance—during the war it was the munitions industry. Based on plans for the overall output needs, borrowers were classified into three categories: A for critical war supplies, such as munitions and raw-material companies, B for medium-priority borrowers, and C for low-priority borrowers that manufactured goods for domestic consumption and items considered “luxuries.” The allocation of loans to sectors in the B category was restricted, and lending to sectors classified as C was almost impossible. The manufacturers included in category A would be assigned a “main bank,” whose job it was to ensure that enough loans were given to the firm in order to meet its production targets. The firms were themselves part of a hierarchy of subcontractors and related firms, which were grouped so as to ensure fast and efficient production of allotted output targets.24
This system quickly reshaped the economy. It ensured that only priority manufacturers received newly created purchasing power. Low-priority firms and industries were weakened, while the strategic firms and sectors grew rapidly. Manufacturers of luxury items, if not yet transformed for war production (such as the piano maker Yamaha, which retooled to produce aircraft propellers—a wartime legacy that enabled the firm to diversify into motorbike production after the war), simply could not raise any external funds. Purchasing power was not used for unnecessary sectors or unproductive purposes. Loans were allocated to achieve the goals of the war economy: maximization of the desired type of output.
Credit Controls Maintained After War
During the war the desired type of output was munitions. In the postwar era it was manufacturing of industrial and consumer goods. The system of controls worked so efficiently that it was completely carried over into the postwar era. A large number of the postwar links between companies in the various business groups, their subcontractors, and their main banks originated in the wartime credit allocation system.25
Making sure that banks complied with the bureaucratic lending guidelines was not difficult. During the war, the mobilization laws stated plainly that the private sector had to do what it was told by the bureaucracy, with extremely heavy penalties for noncompliance. In the postwar era, this was replaced by other incentives to comply with bureaucratic wishes.26 But even without these tricks, banks had to do as they were told in the postwar era, since the vagueness of the legislation that hailed from the war era gave great power to the bureaucracy.27 On that basis, government officials could issue administrative orders or notifications (tsutatsu), similar to the wartime imperial decrees issued by the bureaucracy. Private-sector institutions were not in a position to argue with the government. Banks were just as dependent on the bureaucracy as the firms were dependent on the banks. Bankers’ resistance was further reduced by the continuation of the loan guarantee system, which minimized credit risk and ensured that banks would be bailed out if lending turned sour.
Economic growth would have been lower if Japan had followed laissez-faire policies without official intervention. Industries not crucial for investment and high growth, as well as consumers, would have competed for limited purchasing power. Indeed, given the abundance of labor in the postwar economy, a free market economic system would have tended to allocate resources toward labor-intensive industries, making it difficult for Japan to build up heavy industries. Without credit controls, too much money would also have been allocated to highly unproductive uses, such as real estate speculation or luxury consumption. Moreover, it would not have been possible to keep interest rates at artificially low levels, subsidizing the preferred industries. Finally, free capital flows would probably have created the types of problems that occurred in Thailand and Korea in the late 1990s, when fixed exchange rates encouraged large-scale borrowing from abroad (largely needlessly, since domestic banks could have created the money), which triggered a crisis when foreign investors pulled out. Given the crucial link between credit and growth, it is no exaggeration to say that a major reason for Japan’s successful postwar economic development has been the system of financial controls, which “guided” credit to high-value-added sectors and made the most of the wartime economic structure.28 The financial sector was the “general staff behind the battlefield in this total war called high economic growth.”29
Money
Conscious institutional design by the war economy bureaucrats created the structures for a growth-oriented economy. The designers likened their system to an “organism” that worked like a body. Structures alone, however, are like a body without blood. What is missing in our description is the lifeblood of an economy, the liquid that is oiling the wheels of commerce: money.
Since humans abandoned barter several thousand years ago, money has been at the center of economic activity. It is therefore not surprising to find that money, its creation and allocation, also took center stage in Japan’s war economy.
Just What Is Money?
Unlike the leaders of Japan’s war economy, many economists today dispute the crucial role of money. It may surprise many readers, but it is probably fair to say that many economists do not know what money is.1 Things were easy when only gold and silver were used as money. But in a modern financial system it is not so obvious how to measure money. Most economists define money as the sum of central bank cash and bank deposits. However, it is not clear whether only short-term, long-term, other types, or all types of bank deposits should be included in such a measure. That is why central banks now publish a whole menu of so-called money supply measures—deposit aggregates ranging from the narrow MO (cash in circulation and bank deposits with the central bank) to M4 or wider aggregates (including all types of deposits).
Despite the multitude of measures, none of them seems to be particularly useful, because none of the M-aggregates has a stable link with economic growth.2 This is a headache. One of the few things most economists agree on is that money supply growth and economic growth should move closely together. But in the 1980s, money supply measures in many countries expanded much faster than GDP growth.3 By the mid-1980s, both the Bank of England and the U.S. Federal Reserve had announced that they had lost faith in the M1, M2, or M3 type of money-supply measures and were abandoning monetary targets altogether. Since then it has become quiet around monetary theories.
Big Interest in Rates
Today, most economists have no interest in the role of money in the economy. The latest macroeconomic theories argue that money is “neutral”—just a veil over the tangible economy. Economic research, these economists advise, can therefore safely ignore money.4 The big mysteries in economics—why we still have business cycles, stock market booms and busts, large-scale unemployment, and crises—are said to have nothing to do with money.
Though ignoring the quantity of money, mainstream modern economics pays close attention to its price—the rate of interest. The question whether the U.S. Federal Reserve will raise interest rates or not galvanizes experts and millions of investors. Unlike the quantity of money, interest rates can be accurately measured, and the latest data are available frequently. Many economists also believe that interest rates indirectly tell us about money. If interest rates are low, they say, there will be more money, and if they are high, the money supply must be shrinking.
Money Mattered to War Bureaucrats
While today such neoclassical economics is most widespread, in the 1930s the similar theories of classical economics were taught at leading U.K. and U.S. universities. The conclusions were the same. The war economy bureaucrats studied the classical theories. But they could not explain events very well. Links between money supply and growth were weak (such as in the United States in the 1920s). There was also no unique connection between interest rates and the quantity of money. Sometimes interest rates were low, but the quantity of money could be low as well. Worst of all, sharp reductions in interest rates, such as in the 1930s in the United States, did not seem to stimulate the economy (while for a long time in the 1920s rising interest rates did not seem to slow the U.S. economy).
When the world was in the grip of the Great Depression, classical economists argued that lowering interest rates would be enough. No government intervention was necessary, as the free markets would stimulate the economy on their own. But the invisible hand seemed to create more and more unemployment and starvation in the United States, where the recession lasted almost a decade. The reform bureaucrats instead turned to the anticlassical theories developed by German economists. They offered a different explanation of how the economy works. Much of their insights were drawn from a detailed study of history, which they believed offered important clues to an understanding of the economy—and the role of money.
The Power of Money
Going back in history, we find the oldest advanced monetary system in China. It lasted for several hundred years, until the era of Mongolian rule. It is at this time that a detailed description was delivered to Europe in the form of Marco Polo’s report of his twenty years spent in Kublai Khan’s China in the late thirteenth century. Marco Polo was a trained merchant, and his book The Travels is full of information and insights concerning the Chinese economy. He did not fail to give an account of the most advanced monetary system at the time.
The world’s first paper money was launched in the tenth century in China by the ruling Sung Dynasty. In this advanced monetary system, there was no doubt about what money was: the paper money issued by the emperor and stamped by his seal. He was the central bank. No other institution was allowed to create money, on penalty of death.5
The emperor was directly in control of the money supply. This meant that he could stimulate demand by creating more paper money, or cool the economy by taking paper out of circulation. He also determined who could gain control over food, raw material, weapons, and the latest technology, by creating and allocating paper money at will. He was an absolute ruler in every sense, in control of all the resources of his empire.6 Marco Polo vividly describes this advanced monetary system, which had been in place when he visited China under the rule of Kublai Khan:
It is in this city of Khan-balik that the Great Khan has his mint; and it is so organized that you might well say that he has mastered the art of alchemy. I will demonstrate this to you here and now. You must know that he has money made for him by the following process, out of the bark of trees—to be precise, from mulberry trees (the same whose leaves furnish food for silkworms). The fine bast between the bark and the wood of the tree is stripped off. Then it is crumbled and pounded and flattened out with the aid of glue into sheets like sheets of cotton paper, which are all black. When made, they are cut up into rectangles of various sizes, longer than they are broad…. And all these papers are sealed with the seal of the Great Khan. The procedure of issue is as formal and as authoritative as if they were made of pure gold or silver. On each piece of money several specially appointed officials write other names, each setting his own stamp. When it is completed in due form, the chief of the officials deputed by the Khan dips in cinnabar the seal or bull assigned to him and stamps it on the top of the piece of money so that the shape of the seal in vermilion remains impressed upon it. And then the money is authentic. And if anyone were to forge it, he would suffer the extreme penalty.
Of this money the Khan has such a quantity made that with it he could buy all the treasure in the world. With this currency he orders all payments to be made throughout every province and kingdom and region of his empire. And no one dares refuse it on pain of losing his life. And I assure you that all the peoples and populations who are subject to his rule are perfectly willing to accept these papers in payment, since wherever they go they pay in the same currency, whether for goods or for pearls or precious stones or gold or silver. With these pieces of paper they can buy anything and pay for anything.7
Marco Polo also describes what today we would call open market operations conducted by the Great Khan through purchases of gold, silver, precious metals, or other supplies from his subjects:
Several times a year parties of traders arrive with pearls and precious stones and gold and silver and other valuables, such as cloth of gold and silk, and surrender them all to the Great Khan. The Khan then summons twelve experts, who are chosen for the task and have special knowledge of it, and bids them examine the wares that the traders have brought and pay for them what they judge to be their true value. The twelve experts duly examine the wares and pay the value in the paper currency of which I have spoken. The traders accept it willingly, because they can spend it afterwards on the various goods they buy throughout the Great Khan’s dominions….
Let me tell you further that several times a year a fiat goes forth through the towns that all those who have gems and pearls and gold and silver must bring them to the Great Khan’s mint. This they do, and in such abundance that it is past all reckoning; and they are all paid in paper money. By this means the Great Khan acquires all the gold and silver and pearls and precious stones of all his territories.8… And all the Khan’s armies are paid with this sort of money.
I have now told you how it comes about that the Great Khan must have, as indeed he has, more treasure than anyone else in the world. I may go further and affirm that all the world’s great potentates put together have not such riches as belong to the Great Khan alone.9
Marco Polo’s description seemed wildly exaggerated to his fellow Europeans. We now know, however, that he was giving what amounts to an accurate description of the monetary system prevailing at this time in the Mongolian Empire. Even his estimation of the Khan’s wealth as far exceeding that of his counterparts in the rest of the world might well have been accurate.
At the time, European kings and princes could only dream of such wealth or such power over the economy and their dominions. Things had developed quite differently for them in Europe. The rulers there failed to understand the true nature of money. To them, only gold or other precious metals could be money. But if gold is the main currency, it is impossible for a ruler to control the money supply. Gold cannot be created at will. Rulers tried, though in vain. Thanks to their efforts, chemistry got an early start in the form of the doomed attempts at creating gold through alchemy.
Compared to their colleagues in China, European rulers could not really be considered fully in charge. They could not control the resources in their countries. Kings had to compete with their own subjects for resources. A government that does not control the money supply has hardly any influence over its economy. Such a government is not sovereign. The great Kublai Khan, emperor of China and the Mongolian Empire, would probably have shaken his head in disbelief if he had known that European rulers could not issue money to implement public-sector projects. Instead, European governments had to rely on taxes. Often tax levels were already close to the pain threshold, and money was still needed for government investments or expenditures. If the kings and princes still wanted to build roads, hospitals, and castles or raise an army to defend their country, more often than not they had to borrow money. No matter how absolutist or all-powerful they may have called themselves, when it came to money most European rulers had to ask for help.
The Goldsmiths’ Alchemy
So who was in control in Europe? It seemed that whoever had accumulated a lot of gold would be able to stake the biggest claim on resources. In reality things were a little subtler. Although precious metals were the main means of payment, it turned out that they were too heavy and too cumbersome, and it was too dangerous to transport them each time when going shopping for larger items. Gold wasn’t even safe at home. Soon the richer merchants and landowners started to look for safe places to store their gold and silver. Who better to entrust one’s gold to than the goldsmiths, whose job was to work with gold and jewels and who therefore had safe storage places? They were well established and independently rich, so there was little risk that they would make off with anyone’s gold.
When gold was deposited with a goldsmith, he would write a receipt to certify that it was in his custody. Depositors found this convenient: Why bother taking out the gold for each purchase when the new owner of the gold would deposit the gold back with the goldsmith again anyway? Since the goldsmith was well known, soon the deposit receipts themselves were accepted in lieu of payment. The deposit receipts had become money.
By about the thirteenth century, paper money therefore also had its debut in Europe. However, it was crucially different in its form, function, and implications from China’s paper money. It was issued not by the government but by a private group of businessmen.10
The Biggest Trick in History
Most crafts in medieval times were organized in trade guilds. So were the goldsmiths. At their regular meetings they must have discussed the phenomenon of a lot of gold lying idly in their vaults as many depositors used the receipts as money. They probably realized fairly quickly that they could make extra profits if they lent out the gold in the meantime. The risk of getting caught without gold was low if they helped each other in case of unexpected withdrawals.
The moment the goldsmiths lent out some of the deposited gold to earn extra interest, two things happened. First, the goldsmiths committed fraud. Their deposit receipts guaranteed that the gold was deposited with them. Their customers relied on the fact that the gold was there. But it was gone, lent out. So the goldsmiths strove to keep this from the public. As long as the public did not know or did not understand, there was no problem.
Second, new purchasing power was created. While the receipts for the gold were used to purchase goods in the economy, the gold itself, when lent out, provided someone else with additional purchasing power that had not previously existed. The total amount of purchasing power in the economy increased. The goldsmiths had expanded the money supply. But unlike in China, where the government made the decision over creation and allocation of purchasing power, in Europe it was the goldsmiths who could dictate who would receive money. Though unknown to the public, the goldsmiths’ actions affected everyone. As they created more money, the number of claims on scarce resources increased.
Things became even better for the goldsmiths. They found that demand for loans remained steady. When they had already lent out most of their gold, they were unwilling to let the opportunity slip to earn more interest. So they figured that they could further expand their lending by giving their borrowers deposit receipts instead of gold. Put simply, the goldsmiths could “print” money! By doing so, they could provide purchasing power to whomever they liked. This time, three things happened: First, the number of claims on resources, the money supply, increased further. This created a larger potential for economic booms or inflation of consumer or asset prices. Second, the fraud reached significant proportions, as they issued fictitious deposit receipts far in excess of the gold left in their vaults. This created even larger profits — borrowers would pay back in real money what the goldsmiths had not owned. It also created a larger potential for crises when depositors would demand their money back. Third, banking was born.
Penniless Monarchs in the Bankers’ Kingdom
The goldsmiths soon gave up working with gold and jewels. They had hit on a far easier and far more lucrative business. They charged interest for issuing paper slips that cost them nothing to produce! They became wealthier and henceforth would be known as bankers.
The bankers had managed to do what kings, emperors, and alchemists had failed to do—they were creating money. They had found the philosopher’s stone.11 They were the central bank of their time.
This had fundamental implications that were to change the course of history, for it meant that the allocation of new purchasing power was not under the control of the government. Europe’s monarchs did not see through the deception. They naively believed that the bankers had large amounts of gold. When governments needed money and could not raise taxes further, they too thought they had to borrow from the bankers.
The irony was that the bankers were just doing what the kings could have done themselves: issue paper money. Yet because the monarchs came to rely on their bankers to fund large ventures, ultimately the bankers gained great influence over national policies. Soon it became doubtful who was really in charge of the country. The Old Testament says that the borrower is servant to the lender.12 Thus it came that the kings often had become servants. Bankers were the masters who created and allocated purchasing power.
The bankers, of course, had their own interests to look after. Greatest opportunities beckoned when a monarch spent a lot of money—and hence created national debt. Some princes were wise and failed to borrow. Then the bankers had to wait for helpful circumstances such as wars between princes. Wars are a prime cause of borrowing and national debt. In times of war even the thriftiest prince would be in need of money. Was it surprising if, in exchange for their invaluable services, bankers would ask not only for interest payments but also for special privileges, rights, titles, and lands? If the monarch was recalcitrant, his war fortunes could suddenly falter. Those bankers would do particularly well who had connections to colleagues in other countries, including to bankers on the other side of the front lines, who funded the ruler of the enemy country. Then the temptation must on occasion have arisen to collude with the enemy’s bankers, because such “rational” behavior would maximize their joint benefit. Together, they could then decide which king was going to win—the one who had granted them the greatest privileges. They could simply issue more money to their favorite and, with deepest regrets, report to the other that they had run out of cash. If the latter didn’t believe them that there was no more money he could simply be shown their empty vaults. After his defeat the spoils could then be divided. Too bad for all those soldiers who had died in the process.13
While Kublai Kahn and his predecessors were absolutely in control of their country through their control of the money supply, in Europe it was the reverse: The rulers came to be controlled by money and by those who were in charge of its issuance. Not the kings, but their financiers were in charge.
Money Is Credit
Until the advent of central banks (in the United States as recent as 1913), private banks therefore printed and issued paper money when someone took out a loan. The English language bears witness to this process, as even today, paper money slips are referred to as “bank notes.” At the time it was still clear how money should be measured: It was the sum of gold circulating and all the paper money issued by the banks.
On the surface things seemed to change when central banks were introduced. These institutions, usually founded and owned by the most influential bankers, had received the monopoly rights to print paper money.14 Thus all other banks became dependent on them. This did not mean, though, that the banks stopped creating money. Bank money creation merely took a less visible form. If someone wanted to borrow from a bank, the bank could open an account and create a new deposit entry.15 This is “book” money, or bank money. It worked as well as gold or paper money. So even today, private banks create most of the money supply. Currently, in most countries less than 10 percent of the money supply is paper money issued by the central bank. As in the days of an advanced goldsmith credit economy, banks today create and allocate the vast majority of purchasing power in the economy.16
The classical economists thought that the way to measure this bank money creation was to count all bank deposits. This is probably due to the fact that the old bank notes were called deposit receipts. But on a net basis, the banks issued new deposit receipts only when they granted new loans. Modern M-type deposit aggregates do not measure circulating money. They measure savings. The modern equivalent of the deposit receipt issuance by banks is not the accumulation of bank deposits but the extension of loans. Bank credit measures the money that is actually circulating.17
Seeing Trees, Not the Forest
Another reason why classical and modern neoclassical theories do not usually recognize the role of banks may be their focus on microeconomics, and the static nature of the theories. Thus economists often would only analyze one single bank, or one deposit or loan transaction. Combine this with the usual textbook treatment of the credit creation in a fractional-reserve banking system, and the true money creation power of banks is obscured. This is why in most finance or money and banking textbooks, banks are today described as financial intermediaries that merely accept deposits with one hand and extend these as loans with the other. Banks are just like the stock market or other financial intermediaries, these textbooks say: institutions that transfer money from savers to investors.18
Banks’ power of credit creation should not be played down, but explained in a way that makes this enormous power obvious—such as by pointing out that a bank does not just hand out a deposit to others as a loan once—but more than ten times. If you deposit $1,000 with a bank, and if the central bank requires banks to hold reserves of 1 percent, it is tempting to assume that the bank will lend out $990 and keep $10 (1 percent of $1,000) as reserves (as most textbooks also describe it). This is not what happens. Based on your $1,000 in new deposits, the first bank can already lend $99,000 (and keep your $1,000, which is 1 percent of $100,000 as reserves). How is this possible? Where does the bank get the extra $99,000 from?
The truth is, banks don’t have money. They simply create it by granting “credit” to someone. This does not cost them anything, as loans are created out of nothing. In the 1930s, this credit creation process took the form of a manual entry into the bank’s loan book ledger. Today it is but an entry into the bank’s computer. The more loans banks give out, the more deposits will be written into existence. If one bank gets more deposits than another, the excess deposits are passed along to the other banks that have a shortage (through the interbank market).
The Life Cycle of Money
The life cycle of money begins when money is born by the extension of bank loans. It does its job while circulating as purchasing power in the economy. The more credit a bank creates, the more purchasing power is exerted in the economy and used for transactions that otherwise would not take place. When the borrower spends the money, the receiver is likely to deposit it again with a bank. This is when money is “retired” from circulation. By drawing it from a deposit account, it can be mobilized again. Newly created purchasing power is eliminated again from circulation—money “dies,” so to speak—when the loans are paid back.
The power to create money makes banks special, and quite different from stock or bond markets, which can only reallocate already existing purchasing power.19 It also makes them more fragile. Austrian school economists remain convinced that banking is founded on fraud: the banks’ promise that the money is deposited with them is not kept—nor could it be kept should everyone insist upon it.20 That is why the bankers wanted to have a central bank, to step in and print cash when necessary.
Credit Is Supply-Determined
A correct measure of the “money supply” is simply the sum of central bank credit creation (injected as a result of the net buying and selling of assets by the central bank) and private bank credit. Credit aggregates therefore have a far better correlation with economic activity than the M-measures of deposits that are emphasized in central bank publications.21 They also easily beat the information value of interest rates.
The trouble with interest rates is that they are not uniquely related to the quantity of credit. They can’t be, because banks keep interest rates artificially low, in order to ration the credit market, and select among potential loan applicants those they prefer. In rationed markets, not the price, but the quantity determines the outcome. Interest rates can be low, and credit growth very fast. But credit growth can also be slow. That depends entirely on the banks’ decisions.22
This means that the entire industry of interest rate watchers and analysts could spend their time more fruitfully in other ways. When interest rates go up, it is not clear that the economy will slow. Likewise, declining interest rates are no indication that the economy will accelerate. Economic growth is determined by the quantity of credit, not its price.
There is No “Capital Shortage”
Without an understanding of the credit creation process, economic theories also had to get other concepts wrong, such as the role of savings and the determinants of growth. Classical economics assumed that there is a given amount of savings, which pose a limit for loan extension and hence investment. In reality savings are not limited at any moment in time. They are not a constraint on loans or investment. If more money is required for investment, banks can simply create it.23
Occasionally economists worry about a “savings shortage” or “capital shortage,” which they feel is holding back growth. There is no such thing. Savings do not impose a limit on economic growth. If necessary, banks can create more money, and hence create more deposits, which are savings. This will surely raise nominal spending and investment and hence nominal growth.24
The crucial question is, of course, whether the newly created credit is used for productive purposes or not. If new money is used unproductively, it is going to drive up prices. If it is used productively, it will not result in inflation. This is easy to achieve when economic resources are idle and there is unemployment. So especially during recessions, it is easy to ensure that new credit is used productively. Hence new money creation will result in a recovery, not inflation.25
The facts about money are simple. Yet they are not well known. Introductory textbooks of economics briefly mention that banks create money. But all the theories that follow ignore this fact. It took many centuries for Europeans to rediscover the truths that had been known in China as early as the tenth century and recognize that money was intrinsically based on the laws of the state and hence could be usefully employed by the government for economic development. Many European economists did discover the truth about money and banks in the eighteenth and nineteenth centuries, such as John Law in Scotland and France, and Adam Mueller and Georg Knapp in Germany.26 However, all their theories were soon superseded and are now forgotten.
It was fortunate for the bankers that a group of economists existed, the classical and neoclassical economists, who could be relied upon to argue that money—and hence banks—did not matter. In the battle for ideas the old and new classical economists had either the better arguments or the better funding. In any case, their theories became widespread and dominate the economics profession today.27
Credit: Key Tool for a Controlled Economy
Some wartime thinkers and reform bureaucrats followed a different creed of economics. They studied their German economists well and thus came to understand the truth about money and banks. They realized that the power of banks and the central bank to create and allocate credit rendered them key levers to control the economy and allocate resources.28 Like the Chinese emperors, they wanted to control money, in order to gain control over the country.
The institutional design of the war economy system created the framework within which resources could be allocated to produce economic growth. But it was the monetary system that was used for the actual implementation of resource allocation and output creation. It is money that holds the key to understanding Japan’s success since it embarked on economic warfare in the 1930s.
Credit
The Economic High Command
Shifting from the Stock Market to Bank Funding
The paramount goal of the reform bureaucrats was to maximize economic growth—which would also maximize war production. By definition, growth is due to investment. And to invest, firms need money. External fund-raising can take the form either of bank borrowing or of issuance of debt and equity—borrowing from the securities markets. In the 1920s and early 1930s, Japanese firms mainly obtained external funding from the stock market. Similar to the United States today, between 1934 and 1936 bank borrowing in Japan accounted for an average of 18 percent of firms’ liabilities, with equity finance responsible for 81 percent. However, less than ten years later, firms had switched the source of funding radically toward bank borrowing. In the period from 1940 to 1950, on average 60 percent of firms’ liabilities consisted of bank borrowing and only 40 percent consisted of equity financing. The predominance of bank financing persisted until the late 1980s: In 1965, 89 percent of banks’ liabilities were bank borrowings; in 1970, 85 percent; and in 1980, 87 percent.1
Again, the change of a major feature of the economic system—the switch from market funding to bank funding—did not happen by coincidence or due to market forces. The visible hand of the government purposely placed bank lending at the center of the war economy. Government officials saw many advantages in bank funding and hence suppressed funding from the stock or bond markets. Instead they used bank credit as the main tool to allocate resources within the war economy system.
Bankers Have a Heart for Managers
One reason why the war economy bureaucrats preferred bank funding was that they strove to empower managers over shareholders. Equity finance would have put shareholders in charge, and that might have directed the economy toward profits, not quantitative expansion. Bank borrowing eliminated this threat.
Instead of shareholders, company management was now monitored by their bankers, who had to ensure that their loans were not wasted. But the bankers were managers themselves. The separation of ownership and control, which was engineered by the control bureaucrats, also included banks. This meant that from the late 1930s onward, individual shareholder influence over banks had been minimized. Also, the bankers were less interested in profits than in growth. Instead of charging high interest rates, they therefore wanted to boost their lending. That would be possible only if companies grew fast and hence had a further need for borrowing. Thanks to bank financing, corporate managers had found a natural ally in their bankers.
Another reason was speed. In a state of war, priority industries must raise large amounts of money quickly. Bank financing beats market financing when it comes to speed and ease of fund-raising. All that is necessary for a firm to obtain funds from a bank is the decision by the loan officer, who can make the money available at the stroke of a pen. Equity financing or even debt issuance involves many more steps and participants, from lawyers drawing up the deals to underwriting and placement in the market. This can take months of preparation and execution. War planners could not afford such a leisurely pace.
Banks Boost Savings
Providing money to key industries is only one side of the tasks authorities faced during the war effort, however. As priority industries increasingly obtained purchasing power and laid claim to the available—and limited—national output, prices would be driven up if consumption demand was not at the same time reduced. Continued strong private consumption would pit firms against consumers in the competition for scarce resources. To avoid inflation and the social instability that could follow, authorities had to ensure that consumers increasingly withheld their purchasing power. Individuals needed to be encouraged to save.
In a stock-market-based financial system, savers would have to be encouraged to buy stocks or corporate bonds. But as savings instruments for the broad masses, these involve risks and require careful research. In a state of war, individual savers could hardly be expected to put their savings in bulk into debt and equity. Losses of savings may have caused social instability.
With a bank-based economic system, the authorities could simply guarantee depositors’ money. Should a bank be allowed to fail, the central bank could bail out depositors. At least the principal of a household’s savings was thus guaranteed. In exchange for high security, however, savers had to accept lower returns. This allowed more funds to remain invested.
From about 1937 onward, government officials encouraged savings with annual savings campaigns. The media were used to spread the message that spending is bad and saving is good. Local bank, credit union, and post office branches acted as the collectors of people’s savings, ensuring that purchasing power would be withheld. Bureaucrats discouraged all other forms of saving by effectively making them equivalent to bank saving, and stocks became like bonds or deposits, yielding a fixed, administered return. That yield was pushed down so as not to compete with bank deposits.
Bankers, the Money Creators
By far the most important reason why war planners preferred bank funding as the main conduit of resource allocation was that banks create most of the money in the economy. And they make the crucial decision of who will get this money. Their actions thus have a profound impact on equity, growth, efficiency, and inflation. By withholding purchasing power from one sector and allocating newly created money to another, the entire economic landscape can be reshaped.
Given this pivotal role of the banks, it is not surprising that the reform bureaucrats and war planners had developed a strong interest in them. The German economists they read argued that banks and economic growth were crucially linked.2 Economic growth can be accelerated if the inputs used—land, labor, capital, and technology—are increased. As we saw, the war bureaucrats had already found efficient ways of organizing the labor market and firms’ management in order to ensure effective mobilization of land and human resources. The banks served as their main tool to maximize capital and technology inputs, direct resources and steer growth.
How to Fund Growth: Print Money
Technology is indeed nothing but new, more efficient ways of rearranging given resources. It is like a new recipe, which delivers a tastier and superior output that is then valued more by consumers. Innovators and creative entrepreneurs that have hit on a new recipe often have a problem, though: They have no money to found a company that could implement their idea on a large and viable scale. The entrepreneur could either get funding in the markets or borrow from a bank, and may not mind how the money is obtained. But for the whole economy there is a crucial difference. If an investor funds the entrepreneur, the investor would have to pull money out of other investments (such as bonds, stocks, bank deposits, or even other venture firms). As a result, already existing purchasing power would be diverted to a new use, and some other economic activity would have to be scaled down. Despite the innovation, there is no economic growth, as the national income pie is determined by the quantity of credit creation, which remains unchanged. By contrast, if the entrepreneur instead borrows money from the banking system, additional purchasing power would be created and no previous projects need to be stopped.
Productive and Unproductive Credit Creation
This sounds almost too good to be true. Could all new and good ideas be funded just by central bank money printing or bank loans? In principle, yes. Normally, the worry is that excessive money creation would result in inflation. However, as long as the money is used for productive projects that also increase output, there won’t be inflation; although more money has been created, the money was used so cleverly that there is now also more output. Both credit and output would rise, and prices would stay the same. What many classical and neoclassical economists failed to recognize is that credit both provides the demand for new goods and allows their creation. It therefore simultaneously brings about both the demand for and supply of new goods. If, on the other hand, extra money was created that was then used not to implement new technologies and create more output, but simply for consumption or speculation, more money would chase an unchanged number of goods and services. Prices would be driven up and inflation would ensue.3
There is a downside, though. In a free market economy, banks can create credit and allocate it to anybody they wish, even to borrowers who put it to unproductive use. Ultimately, though, this would also not be good for the banks, because lending for unproductive purposes is much riskier. Only when it is used productively is credit likely to generate the income that is necessary to pay interest and repay the principal. However, banks do not find it easy to recognize the actual risk involved in their loans. Each bank might think it will get the money back on its real estate loans. But taken together, all banks will end up lending more money to the real estate sector than can be used productively. As a result, money is created, but no new output and no new income can be derived from it. Eventually lenders will be unable to pay back the loans. As the excessive credit creation turns into bad debts, banks become more risk-averse and reduce lending. This slows economic growth.
Putting a Check on Bankers
Banks are special, since they serve the public function of creating and allocating money. But it is not clear that bankers, when left to their own devices, allocate funds such that the welfare of the entire community is enhanced. Banks may decide not to extend loans to a farmer who wants to introduce organic farming techniques, because it might consider these ventures too risky or not profitable enough, and instead allocate purchasing power to a real estate speculator who does not add to social welfare. German economists were particularly critical of the U.S. experience of the 1920s, when banks were encouraged to create money and give it to speculators, who wasted it. They argued that the crucial function of banks to create and allocate purchasing power had to be utilized for the common good of the nation.4 Even though a government may be democratically elected, the bankers are not. The bank owners often belonged to a small number of families who had wide-ranging power, sometimes over entire countries. Commentators noted that especially in a U.S.-style democracy, bank credit should be regulated by the government to maintain equity and fairness. U.S. founding father Thomas Jefferson was for this reason always opposed to the establishment of a privately owned central bank, and the U.S. Constitution was designed to grant the right to issue money specifically only to the U.S. government.5 The Japanese war economy bureaucrats agreed that they needed to monitor the activities of banks carefully. At the same time, they realized that bankers could be turned into their allies and helpers in doing their job. By “guiding” the banks, officials could direct newly created money to productive projects.6
Controlling the Controllers
Control over credit creation, however, had to include the central bank. The supply of money used in an economy is made up of the sum of the credit creation of the banks and the central bank. The latter can increase or reduce the amount of money in the economy. But it also wields enormous direct control over the credit creation of banks.7
Given their different understanding of the role of the state—namely, to serve the community—the Japanese bureaucrats could not accept that, even in supposedly democratic countries, the central banks were owned by private bankers.8 How could one expect the U.S. Federal Reserve system, the Bank of England, and the German Reichsbank to serve the public interest when in fact they were partly or wholly owned and controlled by private bankers?9 And closer to home the question was pressing: How could the Bank of Japan be left a joint-stock company, in large part in private hands?
In line with the German economists whose books they had studied, the Japanese war economy theorists believed that the central bank should be controlled by the government. And it should, in turn, exert control over banks to regulate the quantity and allocation of money creation, such that it would serve the nation’s interests.10
When the reform bureaucrats realized the importance of banking in shaping the economy, they started to study how central bankers supervised the banks.11 Some central banks claimed to use reserve requirements as a policy tool. Others said they set the official discount rate and thus encouraged or discouraged credit. In reality, neither tool was very effective. The discount rate or short-term interest rates were not necessarily related to economic activity. And the reserve requirements were too blunt a tool to be used strictly. If many banks failed to meet the reserve requirement, the central bank would be forced to lend enough money to the banks so that they would meet it, thus defeating the purpose. The alternative, though, was to watch how banks would try to borrow money from each other to meet the requirements, pushing up interest rates so sharply that it could disrupt the economy. Due to this problem, central bank officials often say that they cannot control the money supply. Yet there is a way for them to control the quantity of purchasing power created by banks—they can set loan-growth targets to banks.
The Secret Control Tool
This was a method pioneered by the German central bank, the Reichsbank. It already had gained invaluable experience during the First World War and in the 1920s in restricting overall credit growth to desirable levels and also in allocating the newly created money to preferred sectors. During the 1920s, the Reichsbank, under its president Hjalmar Schacht, also provided strict “guidance” to the banks regarding their loan extension. The discount rate—the short-term interest rate at which banks could officially borrow from the central bank—was still announced, but it had become more of a public relations tool. By 1924, inflation had been brought under control. But the Reichsbank’s “guidance” continued virtually uninterrupted for years—indeed, until 1945.12
The procedure was simple: Each bank had to apply to the central bank for its loan contingent for the coming period. The banks then proceeded to allocate their contingents among borrowers. Once the contingent was used up, the central bank would refuse to discount any further bills presented by that bank and would punish further credit expansions. Since there was no legal basis for these credit controls, the Reichsbank relied on “moral suasion,” that is, informal administrative pressure under the threat of sanctions that could be highly costly for the banks. One internal Reichsbank memo of 1924 dryly notes that the central bank wields “substantial means of exerting pressure,” which “it will not hesitate to employ.”13
Schacht, Credit Dictator
The credit control system imposed in Germany handed enormous power to the central bank. Since the Reichsbank had been made independent from the government after the hyperinflation of 1924, it could do as it wished.14 It was only a small step further to give the banks detailed instructions about the sectoral, regional, and qualitative allocation of their credits. Reichsbank president Schacht made ample use of this power. By giving instructions to banks about what type of industrial sector and even which companies to lend to—and which ones to cut off from lending—Schacht engaged in a far-reaching structural economic policy, favoring specific regions, sectors, and institutions that he considered “productive” and pushing for corporate restructuring. The latter was getting fashionable in Germany, the United States, and Japan under the label “rationalization.” Schacht argued that to advance rationalization, firms must merge and “uncompetitive” firms must be forced into bankruptcy. Schacht put such structural changes above the need to stimulate the economy. Consequently, unemployment remained a problem throughout the 1920s.15
Commentators noted that “many injustices and disagreements about the details are unavoidable.”16 Numerous observers argued that in a democracy such vital decisions could be made only by parliament and the elected government. Indeed, the Reichsbank had become the actual German government, easily superseding the fragile and short-lived Weimar governments in terms of influence on the economy. Governments fell at a hectic pace, but Schacht remained firmly enthroned from 1924 until he resigned in 1930, a period that turned out to be crucial for Germany’s later development. Contemporaries recognized in him a “credit dictator” or “economic dictator” and called the Reichsbank Germany’s “second government.”17
Introducing Credit Controls in Japan
In Japan, the reform bureaucrats had studied the Reichsbank’s methods and realized the enormous potential offered by central bank credit controls over the banking system.18 They had dispatched officials to Berlin, based in the Japanese embassy or more directly at the Reichsbank. This included Hisato Ichimada, who had been sent by the Bank of Japan, and who featured prominently as the Bank of Japan’s postwar credit dictator (see the next chapter).
The first law to start up the controlled war economy—initially called a “quasi-war economy,” since the measures were partial and the country was officially not at war—was the Capital Flight Prevention Law of 1932 and the Foreign Exchange Control Law of 1933. They were aimed at preventing money from being transferred abroad, and also served to regulate imports. The staff of the newly created foreign exchange control section inside the Ministry of Finance became an experienced core of economic controllers, adept at directing the flow of funds.19
Having come to power with the beginning of open hostilities in China in 1937, the reform bureaucrats moved to control the allocation of money through the Temporary Funds Adjustment Law of 1937. This law brought banks and their investment and loan decisions under strict control by the central bank and the Ministry of Finance. Funding through the stock market was reduced to a trickle, and the banking system was relied upon for resource allocation.
It was now time to use the central bank for the purposes of the war planners. “In the period before World War II, and particularly before 1932, the Bank of Japan did not have a close relationship with the commercial banks and the money market except in times of crisis, when it acted as lender of last resort.”20 In 1942, the war leaders brought the Bank of Japan directly under the control of the government and its finance ministry by translating Hitler’s new Reichsbank Law of 1939 and introducing it as the new Bank of Japan Law.21 Together with the capital flow and foreign exchange control laws, this completed the system of financial controls.
The 1942 law stated clearly that it was the central bank’s job to work toward the full mobilization of resources to achieve maximum output growth. Article 1 stated that “the purpose of the Bank of Japan shall be to adjust currency, to regulate financing and to develop the credit system in conformity with policies of the state so as to ensure appropriate application of the state’s total economic power.” Article 2 stated that “the Bank of Japan shall be operated exclusively with a view to accomplishing the purposes of the state.”22
To simplify the credit allocation regime, the number of banks was drastically reduced, from about fourteen hundred by the end of the 1920s to a mere sixty-four by the end of the Second World War. Similar to the control associations in various industries, the banks were organized in so-called financial control associations under the umbrella of the National Financial Control Association. As in other industries, it stayed in place in the postwar era, as the Japan Bankers’ Association.23
Bank of Japan at the Control Levers
Banks were ideal as bureaucratic tools to direct resources. All that was needed was to impose detailed guidelines on bank lending, which the banks would have to follow. In order to ensure that firms with nonpriority investment projects would not compete for scarce resources by raising funds in the stock market, various administrative measures were employed to restrict equity finance and corporate debt issuance.
The Bank of Japan acted as the control center of the creation and allocation of purchasing power. Its governor headed the National Financial Control Association, which was operated by the BoJ and implemented the resource allocation plans worked out by the Cabinet Planning Board. The plan was structured on a top-down basis: First, the needed output was decided upon. Then a hierarchy of manufacturers, subcontractors, and raw-material importers was determined. Finally, the banks were required to ensure that purchasing power was made available for all the firms involved to be able to acquire the inputs into their production process. While shareholder influence was eliminated, competition was ensured on all levels, because the employees of companies and also of the banks were made to compete in ranking hierarchies for promotion and other rewards.
Thanks to them, resources could be allocated to industries of strategic importance—during the war it was the munitions industry. Based on plans for the overall output needs, borrowers were classified into three categories: A for critical war supplies, such as munitions and raw-material companies, B for medium-priority borrowers, and C for low-priority borrowers that manufactured goods for domestic consumption and items considered “luxuries.” The allocation of loans to sectors in the B category was restricted, and lending to sectors classified as C was almost impossible. The manufacturers included in category A would be assigned a “main bank,” whose job it was to ensure that enough loans were given to the firm in order to meet its production targets. The firms were themselves part of a hierarchy of subcontractors and related firms, which were grouped so as to ensure fast and efficient production of allotted output targets.24
This system quickly reshaped the economy. It ensured that only priority manufacturers received newly created purchasing power. Low-priority firms and industries were weakened, while the strategic firms and sectors grew rapidly. Manufacturers of luxury items, if not yet transformed for war production (such as the piano maker Yamaha, which retooled to produce aircraft propellers—a wartime legacy that enabled the firm to diversify into motorbike production after the war), simply could not raise any external funds. Purchasing power was not used for unnecessary sectors or unproductive purposes. Loans were allocated to achieve the goals of the war economy: maximization of the desired type of output.
Credit Controls Maintained After War
During the war the desired type of output was munitions. In the postwar era it was manufacturing of industrial and consumer goods. The system of controls worked so efficiently that it was completely carried over into the postwar era. A large number of the postwar links between companies in the various business groups, their subcontractors, and their main banks originated in the wartime credit allocation system.25
Making sure that banks complied with the bureaucratic lending guidelines was not difficult. During the war, the mobilization laws stated plainly that the private sector had to do what it was told by the bureaucracy, with extremely heavy penalties for noncompliance. In the postwar era, this was replaced by other incentives to comply with bureaucratic wishes.26 But even without these tricks, banks had to do as they were told in the postwar era, since the vagueness of the legislation that hailed from the war era gave great power to the bureaucracy.27 On that basis, government officials could issue administrative orders or notifications (tsutatsu), similar to the wartime imperial decrees issued by the bureaucracy. Private-sector institutions were not in a position to argue with the government. Banks were just as dependent on the bureaucracy as the firms were dependent on the banks. Bankers’ resistance was further reduced by the continuation of the loan guarantee system, which minimized credit risk and ensured that banks would be bailed out if lending turned sour.
Economic growth would have been lower if Japan had followed laissez-faire policies without official intervention. Industries not crucial for investment and high growth, as well as consumers, would have competed for limited purchasing power. Indeed, given the abundance of labor in the postwar economy, a free market economic system would have tended to allocate resources toward labor-intensive industries, making it difficult for Japan to build up heavy industries. Without credit controls, too much money would also have been allocated to highly unproductive uses, such as real estate speculation or luxury consumption. Moreover, it would not have been possible to keep interest rates at artificially low levels, subsidizing the preferred industries. Finally, free capital flows would probably have created the types of problems that occurred in Thailand and Korea in the late 1990s, when fixed exchange rates encouraged large-scale borrowing from abroad (largely needlessly, since domestic banks could have created the money), which triggered a crisis when foreign investors pulled out. Given the crucial link between credit and growth, it is no exaggeration to say that a major reason for Japan’s successful postwar economic development has been the system of financial controls, which “guided” credit to high-value-added sectors and made the most of the wartime economic structure.28 The financial sector was the “general staff behind the battlefield in this total war called high economic growth.”29
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