Publication Type: Conference Paper/Unpublished Manuscript
Review Method: Peer Reviewed
Abstract: The bubble economy of the late 1980’s is generally thought to be a main cause of the stagnation of Japanese economy in the 1990’s. Many economists, political scientists, and journalists insist that the Bank of Japan’s extremely low level of independence was the main reason behind the inflation of the bubble economy. Their explanation goes as follows. The US administration demanded that the Japanese government expand domestic demand to reduce its huge current account surplus with the US. However, the Ministry of Finance resisted increases in fiscal expenditures, instead prioritizing fiscal reconstruction. So, the Ministry demanded that the Bank of Japan loosen monetary policy. The Bank of Japan complied, unable to reject the Finance Ministry’s demand due to its lack of independence from the Ministry. In February 1987, the Bank of Japan lowered the official discount rate to 2.5 0x1.e115d00000001p-895nd kept it at that level until May 1989. This excessively loose monetary policy drastically increased financial liquidity, stimulating a rapid increase in the price of land and stocks.
I argue, however, that the independence of Japan’s central bank was much higher than such explanations suggest. Central bank independence is generally judged by reference to the legal provisions concerning the relationship between the government and the central bank. But, I argue that this method of assessment of independence is sometimes misleading. I argue that the Bank of Japan was able to decide monetary policy by itself to some extent against the pressures from the Prime Minister and the Ministry of Finance. In fact, the Bank of Japan tightened monetary policy in an earlier period, against Ministry of Finance wishes, and in doing so succeeded in controlling inflation after the second oil shock.
Why then did the Bank of Japan loosen monetary policy from January 1986 to February 1987 and keep an easy money policy in place until May 1989? I argue that there were three reasons. First, the Bank of Japan worried excessively about a possible recession caused by the appreciation of the yen. Second, the central bank was concerned about a sudden depreciation of the dollar. Because it was thought that one of the causes of Black Monday was the raising of the short-term interest rate by West Germany, the central bank could not help but to adopt a prudent stance toward raising the interest rate. Third, and most critically, I argue that there were no signs of an increase in inflationary pressures. To be sure, the value of assets continued to rise extraordinarily. But, it was common knowledge that central banks should not use monetary policy to deal with asset price inflation. Therefore, the Bank of Japan had no positive reasons to tighten monetary policy.
The paper traces the process through which monetary policy was formulated and demonstrates that the Bank of Japan was independent from the Prime Minister and the Ministry of Finance to an extent that was important and that it ultimately decided to loosen monetary policy on its own volition.