Boriana Handjiyska

Money and Banking

Prof. Jamee Moudud

Spring 2000

The two leading economies of the world – the U.S. and the Japanese – are regulated by central banks of different organization. And yet both of them rely on similar monetary policies, based on similar macroeconomic theory, implemented through similar tools, at similar times of the business cycle. In this paper I am going to contrast the two systems showing that there are more similarities than differences between them, and that those differences are merely procedural and the outcome for the economy is essentially the same. This is not to belittle or ignore the differences between the two systems, they are important, however the purpose of this paper is to show that they are often times regionally or culturally determined and are not due to differences in strategy. Also, there are differences in how the two central banks handle financial bubbles. The Japanese Central Bank went through it in 1989, while the Federal Reserve is in the process of dealing with it now. The Federal Reserve should learn from the experience of the Bank of Japan, not necessarily because of its strategy, but rather from its mistakes.

Since the end of World War II the Japanese economy has been growing with an extraordinary growth rate, to which no other country can compare. Initially, the cause for this rate was the fact that the economy was recovering from a recession; however, it was sustained in the years after. Japan’s annual growth rate for the past ten years has been more than 9% until 1989. This high rate was caused by several factors: high levels of private investment, technological innovations, eager competition among enterprises, expansionary government activities, a large increase in export, high rate of capital accumulation, and abundant and skilled labor force. However, in 1989 the Japanese economy underwent a severe recession – its most severe recession since World War II. The financial instability and recessions in the rest of Asia contributed to its severity. Currently the Japanese economy is recovering; and for this some credit should be given to the Bank of Japan, which plays important role in stimulating and synchronizing the Japanese economy.

The U.S. economy on the other hand has been in an expansion for the past several years. The last recession in the U.S. was in the beginning of the 1990’s with inflation rate of 7% and unemployment rate of 9%. The period since then has been characterized with low unemployment rate and low inflation, contrary to the short-run Phillips curve, while growth rate has been accelerating. Part of those conditions should be accredited to the Federal Reserve System.

The national banking system in Japan was created in 1872 and was modeled by the example of the U.S. banking system. By the 1880 the over-issuance of currency and the following inflation made it to fail and there appeared the need for a central bank. The Bank of Japan was established in 1882 with the mission to withdraw inconvertible currency from the economy and reduce inflation. The preceding years were marked with a high growth of industries, which lead to the creation of an abundance of inconvertible currency and rising prices. The Bank of Japan was created to solve this problem. The retirement of the inconvertible money was the immediate but not the only reason for the establishment of the bank. It was the basis for the following economic growth in Japan. In 1942 it went through some modifications because of the wartime situation. After the war the Bank of Japan attempted to increase its independence from the Ministry of Finance but the Committee on Financial System Research was not able to define what the relationship between the Bank of Japan and the government should be.

The Federal Reserve System was created in 1913 as a result of the failure of the previous banking system. There were four flaws in the preceding banking systems, as identified by the International Monetary Commission, that the Federal Reserve was established to eliminate. First, there was decentralization of bank reserves. Bank reserves were scattered through the country and unevenly distributed among the different banks. Second, the inelasticity of the American bank credit was a problem because it acted pro-cyclically: it expanded the money supply in booms and contracted it during recessions. Third, the defects of the transfer-and-exchange system consisted in the fact that shipments of currency within the country were expensive and exchange of currency was complicated and costly because it happened through London. Fourth, the defects of the banking machinery of the federal government consisted in the unnecessary keeping of excess currency in the Treasury vaults, which lead to losses of interest and administrative costs.

The immediate cause of the creation of the Japanese and U.S. central banks was to correct the failures of the previous banking systems. However, the underlying reason for their existence is to serve the needs of their respective economies.

In the 1970’s the main two objectives of the Bank of Japan were attaining a high rate of growth and maintaining monetary stability in the economy. Thus, it aimed to achieve high level of employment and high standard of living. A high rate of growth in Japan was not hard to attain given price stability, so the emphasis of monetary policy was shifted to price stability. This is not to say that growth rate was belittled or ignored, rather it was left to fiscal policy and was supported by sound monetary conditions in the economy, pursued through appropriate monetary policies. The Bank of Japan’s present mission statement asserts, "The Bank of Japan’s missions are to maintain price stability and to ensure stability of the financial system, thereby laying the foundations for sound economic development".

The objectives of the Federal Reserve System are somewhat similar: Conducting the nation’s monetary policy by influencing the money and credit conditions in the economy in pursuit of full employment and stable prices; maintaining the stability of the financial system and containing systematic risk that may arise in financial markets.

Tools:

Both the Japanese and the U.S. Central banks use as their main tools for monetary policy open-market-operations, changes in the reserve requirement, and changes in the discount window rate.

The Bank of Japan is a government institution with 55% of its shares held by the government and 45% held by private individuals, institutions, and local governments. The main policy-making organ is the Policy Board, which is internal to the Bank of Japan. Its major duties are to regulate credit and money, and to operate monetary policy. The other important organ is the Executive Committee, which is comparable to the U.S. Federal Open Market Committee.

The policy-makers of the Federal Reserve System are the Board of Governors, which is also an organ internal to the central bank and the FOMC. Their duties are divided so that FOMC regulates the open market operations’ tool of the bank. The Board of Governors decides upon the reserve requirement and must approve any changes in the discount rate made by a Federal Reserve banks.

According to the Japanese Law the Bank of Japan is said to be dependent on government. There have been attempts to reduce this dependence but unsuccessfully so far. The Bank of Japan is subject to the supervision of the Minister of Finance. Every decision that is made goes first through the Ministry. The Minister of Finance therefore, may if necessary, order the Bank of Japan to undertake particular policies or order alterations in its By-Laws, it also can request reports on the financial conditions of the Bank as well as reports about any of the actions of the bank.

The U.S. Federal Reserve System is considered to be an independent central bank, meaning that its decisions do not have to be ratified by the President or anyone else from the executive branch of the government. The entire System is subject to oversight by the U.S. Congress because the Constitution gives to Congress the power to coin money and set its value. Congress passed this power on to the Federal Reserve in 1913. The Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government, and thus the description of the System as "independent within the government" is more accurate.

Independence is by far the major difference between the two central banks. According to economic theory there is a relationship between independence of the central bank of a particular country and its inflation rate. The theory states that the more independent from the government a central bank is the less inflation it generates. The Federal Reserve is one of the most independent central banks in the world. The Central bank of Japan is considerably less independent. However, the empirical data show that the Japanese Central Bank keeps inflation lower than the U.S. one. The Bank of Japan is viewed as a model central bank in terms of preservation of price stability. In the case of Japan and U.S. there is more than just the magnitude of independence that determines the rate of inflation.

The Japanese culture is generally more conservative than the experimental American mentality. The Japanese are innovative, but in the sense that they create innovations (in terms of technology for example), which they sell on the American market so that Americans first experiment with them, and then if successful the innovation invades the Japanese market. In the same way, the idea of independence of the central bank is a relatively new idea (1935 the Federal Reserve gained its present independence). While some Japanese economists are already ready to embrace the idea of central bank independence, others need more time to swallow the concept and support it. This difference between the two central banks could be marked as due to cultural characteristics.

There are two major differences between the decision-making process of the two systems: centralization/regionalism and decision-making units within the central bank. The Bank of Japan is entirely centralized – the Tokyo headquarters are the ones responsible for making all major decisions. The Fed, on the other hand, is largely decentralized – there are 12 Federal Reserve Banks and 24 branches in different states and all of them take active part in the decision-making process. This distribution of decision-making powers can be accredited to the fact that while the U.S. Central bank makes decisions about the whole U.S. economy and about the sub-economies of every state or region, with their particularities, but the Bank of Japan’s main, and by far most important financial center is Tokyo, and it is logical to locate the decision-making powers in that financial center. The difference of decentralized versus centralized can be marked as due to regional characteristics.

The second difference is in how decisions are made. In Japan for that is the Policy Board of the Bank of Japan is responsible. In U.S. – it is the Board of Governors. Both of those administrative units are at the top of the administrative ladder. However, while in U.S. the Board of Governors has a significant freedom to make decisions, the Japanese Policy Board is highly influenced by the Executive Board, in which are included the Governor, the vice-Governor, and some executive directors of the Bank of Japan. Put in contemporary words the monetary policy in U.S. adopts a "top-down" management style, while the Japanese style is "bottom-up". As a result in U.S. often the Federal Reserve is identified with one person – the Chair of the Board governors (currently Alan Greenspan), while in Japan there is no one individual to be accredited with the monetary policy decisions. The Japanese culture is more stimulating of "team-work", while the American culture supports individuality and personal expression. While this might not be the main reason for the different approaches of making decisions in the two central banks, this is a revealing factor, from which the difference in the approaches follows logically, and could be marked as due to cultural characteristics.

In terms of monetary policy operations the two banks used to differ drastically. The Japanese Bank operated in an internationally isolated environment, while the Federal Reserve functioned in a more open and competitive environment. In the 1970’s both banks adopted the "interest-rate focused" policy, which brought the two banks closer in terms of operation.

In Japan there are three identifiable periods: the High Growth Period from 1955 to the late 1960’s; the late 1960’s to 1975; and the post 1975 period. During the first period inflation was higher than in U.S. but it was also accompanied with 10% annual growth. Also at the time there was an emphasis on keeping the exchange rate fixed (at ¥360=$1), rather than keeping prices stable. During the second period there were pressures on the Bank of Japan to ensure growth of 10% for the next decade, which lead to increase in inflation, which climbed up to 30%. Since 1973 the Bank of Japan has dedicated its time and efforts into keeping prices stable through tight monetary policies. It has succeeded. Even the first and second oil shocks did not affect the price stability in Japan.

In U.S. there are also three identifiable periods: 1950’s to mid-1960’s; mid-1960’s to early 1980’s; and early 1980’s to present. During the first period inflation was low. During the second period inflation increased and climbed up to 20%. During the third period price-stability was established as a goal in itself and inflation was kept low. Nevertheless Japan’s price stability record was better.

Both central banks achieved periods of very low inflation rates, which was the banks’ main objective. The other goal of the central banks is to ensure stability in the financial markets. The question that John Makin poses in this situation is: "What if stock prices or other asset prices keep going up without any inflation? If [the central banker’s] main goal is to keep inflation low and stable, then low and stable inflation shouldn’t trigger any response from the central bank. But if financial market bubbles, or suspected bubbles, can be followed by financial panics, shouldn’t the central bank do something to deflate a bubble, even if there is no inflation?"

The Bank of Japan dealt for a first time with a major postwar equity market and real estate bubble in 1989, when there was no inflation in Japan. The consequential crash of equity and real estate values has deleted about $18 trillion of Japanese wealth, or about four years of national income. Japan’s problem in the aftermath of this catastrophe, which is not to be blamed on monetary policy alone, is now a tendency toward deflation—and the danger that monetary policy, thanks to a liquidity trap, cannot control it. Japan now confronts the reality that central banks are better at eliminating inflation than they are at removing deflation, though the latter might be more harmful to the real and financial sectors of the economy.

With inflation low and stable, or absent, the major central banks are left with new problems. The Fed has little inflation to fight, yet stock prices are 40 percent above what they should be. The interest rates that the Bank of Japan has set are equal to zero, nevertheless there is no increase in prices, which should have followed through increase of investment, leading to increase of aggregate demand and shift of the demand curve to the right. How did the central banks achieve their goal of largely eliminating inflation? The usual target is the interest rate, usually a short-term interest rate that the central bank manages by raising and lowering the discount window rate – the rate at which it lends overnight to commercial banks in the system. If the inflation rate (or the expected inflation rate) is above the target level, the central bank raises interest rates, in order to decrease demand, and thus prevent rising of prices.

At the same time, so far, the problem of inflation that is too low—deflation, has been put on second place. Part of the reason is because the process of bringing the inflation rate down from a high level, say 10 percent or more, to 1 or 2 percent can take a long time. When inflation had reached double-digit levels in the United States by the end of the 1970s, the Federal Reserve raised interest rates sharply, thus lowering the money supply. By the end of 1982 inflation fell from 13.3 percent at the end of 1979 to 3.8 percent. There was no stock market crash because the stock market had already been depressed by the disruptions associated with rising and more volatile inflation. After 1982, CPI inflation in the United States drifted irregularly around 4 percent throughout the 1980s; it jumped briefly to 6 percent with the disruptions from the Gulf War in 1990 and then fell gradually from 3.1 percent at the end of 1991 to 1.6 percent at the end of 1998. In 1999, inflation has risen to 2.3 percent (in August).

In general, the Japanese and U.S. central banks have been quite successful at restricting double-digit inflation and holding it under 5%, without bursting financial bubbles or causing financial panics. The problems arise after the banks have achieved the low-zero inflation target. At the 1999 annual meeting of the central banks despite the great proximate success in bringing down inflation rates, the persistent dilemma at the conference was how responsive the Federal Reserve should be to the behavior of the U.S. stock market. The formal papers argued that the Fed should concentrate on targeting expected inflation, not on responding directly to movements in the stock market. But two questions remained: "Is the U.S. stock market a bubble?" and "What should the Fed do if the bubble bursts and stock prices drop sharply?"

The experience of the Bank of Japan in this field is worth mentioning. The conditions in Japan during the late 1980s, just before the bursting of the Japanese equity and real estate bubbles that began in 1990 such as zero inflation, rapid investment growth, and talk of a new era of unlimited prosperity, strongly resemble the current conditions in the U.S. economy.

One of the papers at the 1999 annual meeting suggested that, by 1989 to 1990, the Bank of Japan ought to have raised interest rates to 8 percent—well above the 4 to 6 percent rates that existed then. But Mr. Yamaguchi reminded that it would have been difficult for the Bank of Japan to set short-term rates at 8 percent, given the zero inflation at the time and the primary stated goal of achieving low inflation.

So the next question posed by John Makin is "What, then, should central banks do, now that inflation is low but the United States may be facing a stock market bubble and Japan may be facing more deflation?" His suggestion is that the Fed should keep inflation low by responding to the recent modest surge in inflation with appropriate modest tightening. The Bank of Japan, on the other hand, needs an expansionary policy such as increasing money supply by printing more money. That would stop the recent deflationary appreciation of the yen. His advice, as he himself summarizes it, is that "the Fed should tighten a little, and the Bank of Japan should ease a lot".

Despite the procedural differences between the Japanese and the U.S. central banks, the events in their respective economies very much resemble each other. The crisis in the Japanese economy of 1989 could be explained through Minsky's instability theorem. The recession was largely caused by bad loans that Asian, and in this case Japanese, banks made. The long-lasting expansion, or more accurate, the lack of severe recessions in the Japanese economy since World War II had made both consumers, borrowers, and lenders confident in the prosperity of their economy. Business finance became more and more risky, and the financial conditions in Japan became ever more fragile. In terms of Minsky's theorem - businesses switched from hedge to speculative and from speculative to ponzi finance.

Similar analysis can be made of the current situation in the U.S. economy. Savings rate is falling while business indebtedness to banks keeps rising. The U.S. economy could already be very fragile, and one of the things that the Federal Reserve should do is try to discourage additional risky – speculative and ponzi – investment through tightening of monetary policies.

The differences between the Japanese and U.S. central banks, thus, do not affect the monetary policies applicable to their respective economies, nor do they lead to different implementation of those policies. The two banks have a lot to learn from each other in terms of experience, but both central banking systems have adapted each other to their particular regional and cultural characteristics and this is from where their differences stem. The Bank of Japan has a way to go towards further independence, while the Federal Reserve might consider adopting some of the frames of the bottom-up approach of decision-making.