Central banks have an array of responsibilities, the exact composition and the relative importance of which often depends on the country’s level of development. Some are tasked with ensuring a favorable market for government borrowing, others with maintaining a fixed exchange rate; some are mandated to ensure stable prices and others target low unemployment as well. In any case, the moment’s most pressing challenges are always at risk of changing and the tools available to a central bank, however powerful their potential effect in some areas, are not sufficient to tackle every challenge. The history of the Bank of Japan from the 1960s onward illustrates this well.
1960s Growth
In the 1960s, the Bank of Japan had a high degree of autonomy but was not independent; Japan’s Ministry of Finance could overrule any of its decisions. However, its freedom to act was increasing. Free from a post-war restraint, in 1965, the government of Japan began to issue bonds to fund its borrowing rather than rely on the Bank of Japan’s money creation, meaning it was less interested in controlling the central bank.
During this period, the Bank of Japan was overseeing a financial system that was heavily regulated. The bank also made it a priority to ensure the international balance of payments was kept stable; large changes in the trade balance or financial flows in or out of Japan could create instability. A sustainable balance of payments, by contrast, allowed Japan to maintain a fixed exchange rate for the Japanese yen against the U.S. dollar and other currencies and kept the credit markets steady too. So, during the 1960s, the Bank of Japan was focused on financial stability, price stability, and ensuring capital was raised for reindustrialization. It was successful; Japan achieved fast economic growth, about 10% per year from the early 1950s to the early 1970s.
In achieving this, the Bank of Japan’s principal tools were adjustments to its official discount rate, recommendations of certain behavior to private banks, and decisions on bank reserve ratios, the proportion of banks’ deposits that had to be set aside in reserves. During the 1960s, interest rates were lowered to facilitate economic growth but were not very low by historical or global norms. The official discount rate of the Bank of Japan was lowered from over 8% in 1957 to about 5.5% by the mid-1960s.
Even at these rates though, there was considerable demand for loans; so, to control credit, the Bank of Japan set unofficial loan quotas for private banks, a measure known as ‘window guidance’. Thus, credit was rationed by banks which were hesitant to expand lending too much, even if demand existed because of the low(er) interest rates. When the Bank of Japan felt it was warranted, it could restrict credit by a variety of means; it could do so by raising interest rates, by instructing banks to lend less, or by raising reserve requirements. Window guidance during the 1960s and beyond was an example of the second tool in action.
1970s Inflation
Whatever its success in the 1960s, Japan exhibited many of the same problems other countries did during the following decade. As with other countries, it abandoned a currency peg to the U.S. dollar; flexible exchange rates replaced this peg from 1973. At the same time, the oil shock hit Japan hard. Inflation in Tokyo rose to 12% in 1973 and remained high for some time. In response, the Bank of Japan increased its official discount rate from 4.25% in April 1973 to 9% at the end of the year but inflation in Tokyo still hit 23% in 1974 while GDP contracted, a rare occurrence for this fast-growing economy. It was the sort of crisis in which it was impossible to satisfy all wants.
Inflation did fall back to 4% in 1978 but rose again to 8% with the second oil crisis of 1979. In 1978, the Bank of Japan began to target changes in the money supply to control inflation, a practice then fashionable among central banks around the world but generally short-lived. Nonetheless, the Bank of Japan’s experience under this new approach seemed very successful. Inflation fell to 3% in 1982. All along, the Bank of Japan had been using its unofficial loan quotas to regulate credit as well as by adjusting its interest rates.
1980s Boom
Japan’s economy overperformed compared to its peers in the late 1970s and early 1980s. Japanese products were able to win market share abroad and a large trade surplus returned. The tight regulation of the financial system gave way to deregulation as the Bank of Japan lost the tight control of the financial system it possessed in the 1960s. During the 1980s, there was international pressure on Japan to liberalize its financial system and also to manage its exchange rate to affect a strengthening of the yen, most notably at the Plaza Accord summit in 1985.
The yen appreciated from ¥260 to the U.S. dollar to ¥150 over about a year-and-a-half period between 1985-86. The yen would strength further, reaching ¥120 to the dollar at the end of 1987. The stronger yen had mixed consequences for Japan. The strong currency held down inflation which remained at or below 3% for most of the 1980s, a lower rate of inflation than was seen in most of the developed world in these years. However, Japanese industry struggled to cope and there was an export recession caused by the strong yen making local goods uncompetitive abroad. To compensate, the Bank of Japan cut interest rates to strengthen domestic demand, enabled in doing so by the stronger yen holding down inflation. Growth strengthened but lower interest rates fed a bubble that burst in 1990.
The Nikkei 225 stock index quadrupled over the years 1984 to 1989 and land appreciated by a similar margin. Both share and land prices peaked at the end of the decade. The bubble burst in part because of interest rate increases in 1989; the Bank of Japan’s official discount rate rose from 2.5% to 4.25% that year and reached 6.0% in 1990. Bank lending was restricted in 1990 and capital gains taxes on land investment increased, further deflating the bubble. The bear market was brutal; stock prices fell 60% by the summer of 1992.
1990s Onward
The bursting bubble, a financial system hobbled by nonperforming loans, underutilized industrial capacity, and new East Asian competitors following a similar economic model slowed the Japanese economy. Japan was slow to confront its financial problems, most notably nonperforming loans which some blame for the slow recovery. The Bank of Japan cut interest rates to 0.5% in 1995 but strong growth remained elusive. Then, another financial crisis, coinciding with one that ravaged the rest of Asia, hit Japan in 1997-98. Interest rates, and specifically the ‘uncollateralized call rate’ which replaced the official discount rate as the main interest rate set by the Bank of Japan, was already near 0%. It was thought impossible to take the rate any lower.
Despite the low rates, Japanese GDP growth was just above 1% per year between 1993 and 2003. Also, in the late-1990s, negative inflation in prices, or deflation, was persistent. This meant that at the end of 2003, Japan’s consumer price index was 3% lower than it was in 1997 and land and stock prices were still considerably below their peak levels from more than a decade earlier.
The Bank of Japan resorted to unconventional monetary policy from 1999 on. One of these approaches was to provide forward guidance as to the path of future interest rates. This allowed the bank of influence longer term rates. In 2001, the global economy slowed yet again. To further stimulate it, the Bank of Japan bought bonds to reduce yields on securities and provide funding to banks from which it acquired the bonds. The pace of this buying increased from ¥400 billion per month in mid-2001 to ¥1.2 trillion in October 2002. These bonds were acquired by the Bank by crediting the deposited reserves of the banking system at the Bank of Japan beyond required levels and these ‘excess reserves’ rose from near zero to over ¥30 trillion in January 2004.
These policies drove the balance sheet assets of the Bank of Japan from about 10% of GDP in 1995 to 30% of GDP within a decade. As recently as 1994, banknotes still made up close to 70% of the Bank of Japan’s liabilities but the growth in its balance sheet thereafter was mostly applied to purchases of private sector assets funded by increases in bank reserves left with the central bank. While in the 2010s and 2020s, these policies would be resorted to by many of the central banks of developed countries, the Bank of Japan came to employ them more than a decade earlier.
Lesson
The central bank of an emerging economy has somewhat different concerns from one in a developed economy. Further, each country has its own political background that further affects the duties and freedoms of a central bank. The economic development, and sputtering, of many parts of the world and always changing political circumstances mean central banks have all evolved in the past half century. However, on account of Japan’s economic miracle, bubble, and lost decades, few central banks have had to evolve, and innovate, as quickly as the Bank of Japan.
Nonetheless, despite the respectable attempts to conform itself to the economic weather of any particular era, the Bank of Japan’s recent history is an illustration of the imperfection of monetary policy. However numerous and increasing the tools at a central bank’s disposal are, they are not always appropriate for addressing any of an array of economic or financial challenges. As some examples, central banks are often unequipped to handle supply shocks or financial bubbles, or cure economies in their aftermath.
More from the Tontine Coffee-House
Read about the Japanese banker and industrialist, Shibusawa Eiichi, and the property bubble of 1980s Japan. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.
Further Reading
1. Ito, Takatoshi, and Frederic S. Mishkin. “Two Decades of Japanese Monetary Policy and the Deflation Problem.” Monetary Policy under Very Low Inflation in the Pacific Rim, University of Chicago Press, 2006, pp. 131–93.
2. Shizume, Masato. “Historical Evolution of Monetary Policy (Goals and Instruments) in Japan: From the Central Bank of an Emerging Economy to the Central Bank of a Mature Economy.” Handbook of the History of Money and Currency, Springer Singapore, 2018.
3. Werner, Richard. Princes of the Yen: Japan’s Central Bankers and the Transformation of the Economy. M.E. Sharpe, 2003.
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