Japanese monetary policy

The rather poor economic performance of Japan since the early 1990s provided inspiration to US and UK policy makers in how they addressed the 2007 financial crisis. How did US and UK policy makers respond to the 2007 financial crisis in a way that was different to the response in Japan? This part of the question would benefit from quantitative evidence.

There are several similarities between the Japanese financial crisis of the 1990s and the global financial crisis that started in 2008. Countries like the US and the UK realized this and have studied the measures that were taken by the Japanese central bank (Bank of Japan) at the time in order to learn from it. Measures that proved to be effective have been taken into account and are currently being applied in adapted forms by the Federal Reserve (the US central bank) and the Bank of England (the British central bank). In order to understand these measures, a brief recapitulation of Japan’s crisis will be given first in this paper. Subsequently, a comparison will be made with US and UK policies in order to analyze the differences and similarities.

In the three decades following 1960 Japan achieved a rapid economic growth. Euphoria about the economic prospects started to break out due to the long period of excellent economic growth rates, which is referred to as the Japanese post-war economic miracle. In the 1980s overconfident institutions, firms and citizens started massive borrowing and aggressive speculation, which caused the economy to overheat. A bubble was created in the stock exchange and in the real estate market, which came to burst at the beginning of the 1990s. The resulting negative wealth effect caused the Japanese people to cut their expenditure and increase savings. People had no trust anymore in the banks, which had turned into zombie banks due to the large amount of non-performing assets on their balance sheets (toxic debt), and therefore they kept their savings outside the banking system. Dropping sales (due to increased saving) resulted in job losses, which in turn led to even more saving and less spending. By this way the Japan provisionally “saved” itself into a recession.

The Bank of Japan first reacted to the recession with conventional monetary policy. They reduced interest rates in order to stimulate the economy. However, due to the collapse of asset prices, the insolvency of banks and firms and the refusal of Japanese consumers to spend their income, the Japanese economy slipped into deflation from 1998. The deflation worked as an incentive for the Japanese people to save even more and spend even less, since saving yields a positive return when there is deflation. The Bank of Japan responded by further lowering the interest rate to (close to) 0%. Because of the deflation however, the real interest rate was still positive and people continued to save. Since the interest rate could not be dropped below 0% the Bank of Japan reached a state of monetary policy impotence, see figure 4.
FIGURE 4
Janese Interest Rate（Benchmark Interest Rate)

Source from: http://www.tradingeconomics.com

Japan also suffered from fiscal policy impotence. Neither significantly increasing government expenditure nor dropping taxes was possible to stimulate the economy. The first because Japan did not have the funds (they were in debt) and the latter because the conservative and risk averse Japanese citizens were very likely to save tax cuts instead of spending them.

For a long time, the Bank of Japan believed that economic growth and recovery of asset prices would bring things back to normal over time. Their efforts were focused on prevention of bank failures and collapse of the financial system and not on active recovery. The zombie banks, which were for a large part responsible for all the misery, were implicitly protected. Accounting rules were relaxed, so that banks got the opportunity to conceal their financial trouble. There was no public support for any form of financial bailout that would solve problems on a more structural basis and throughout the 90s the financial institutions continued to muddle along. This period is known as the lost decade (Vollmer & Bebenroth，2012).

In the early 2000’s the Bank of Japan tried a different approach. They came with an important policy innovation, called quantitative easing. Under the quantitative easing program the Bank of Japan started to increase the monetary base, in order to flood the banks with liquidity. The idea was that the banks could lend this newly created money to households and firms and that this would lead to an increase in consumption expenditure and investments.

In addition to the quantitative easing, the bank of Japan also broke with their previous policy of regulatory forbearance. They implemented a series of accounting reforms that made it more difficult for banks to conceal their bad loans. By making the financial sector balance sheets more transparent the bad debt problem was emphasized and it became clear that the accumulation of non-performing loans had to be curbed. A certain degree of public support for recapitalization was secured, which made it politically possible to inject public money in the financial sector (Lipscy & Takinami, 2013).

These unconventional policy measures seemed to assort effect. After a long period of trial and error and policy experimentation, the Japanese managed to turn the tide and modest economic growth was recorded until the global financial crisis kicked in in 2008. Although the growth figures had not been fantastic, the Japanese gain and loss during anti-crisis were noticed by UK and US policymakers. In their view, the Japanese experience had highlighted what policy actions should be taken or avoided to deal with a financial crisis.

Basically, the reaction that followed from the UK and the US to the 2008 financial crisis is fourfold: interest rate cuts, quantitative easing, bank bailouts and change of regulations (Parkin, Powell & Matthews, 2012c). Due to lessons learnt they executed these actions much faster and more determined than Japan however. For the interest rate cuts and the quantitative easing, this is greatly illustrated in the figures below(See figure 5 and 6).

FIGURE 5
United States Interest Rate 2007-2012（Benchmark Interest Rate)

Source from: http://www.tradingeconomics.com

FIGURE 6
United Kingdom Interest Rate （Benchmark Interest Rate)

Source from: http://www.tradingeconomics.com

Where Japan had reduced interest rates gradually, the US and the UK took relative much sharper cuts. Also, they introduced quantitative easing on a much larger scale. As can be seen from the expansion in outstanding balances at the central bank, the monetary base was increased to a much larger extent (See Figure 7).

FIGURE 7
Central Bank Balance Sheets (US, UK AND JAPAN)

Source from: (Philips, 2013 )

Another lesson learnt from Japan was that you should not let toxic debt create zombie banks. Both the US and the UK immediately injected massive amounts of public funds into large commercial banks when they ran the risk to fail. To justify these bail outs to the public, great transparency of the financial sector balance sheets was sought after, for instance by doing stress tests. Also, the Japanese case was frequently referenced to in order to secure public support.

The public resentment against the irresponsible and risky behavior of financial institutions that caused the financial crisis, has contributed to a change in regulations. These will continue to change, since the debate about acceptable risks, supervisory authorities and banks that are ‘too big to fail’ is still ongoing. If the evolving regulations, combined with the measures that were first introduced in Japan’s financial crisis of the 1990s, will be the way out of the crisis remains to be seen (See Figure 8).

FIGURE 8 Monetary policy in Japan and the United States

Source from: (Lipscy & Takinami, 2013)