The Federal Reserve in the Shadow of the Bank of Japan.

Author:Cargill, Thomas F.
 
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  1. Introduction

    Since the 2000s, Federal Reserve officials have been following in the shadow of the Bank of Japan, mimicking its policies to no avail. For reasons we examine in the paper, Federal Reserve officials have largely ignored the Japanese experience. Yet the results of Federal Reserve policy have been disappointing. The bursting of the dot-com bubble was followed by a period of then-extraordinarily low interest rates. Those rates inflated a housing bubble, which also burst, resulting in the Great Recession. The Federal Reserve then engaged in rounds of large-scale asset purchases, or quantitative easing policy (QEP). That was part of a zero interest rate policy (ZIRP).

    Like the Japanese experience, the US recovery has been weak by almost any measure. To name just one, the US economy has gone a decade without one year of at least 3 percent real GDP growth. That is a historical record of economic weakness. There are proposals for institutional redesign of the central bank (e.g., Cochrane and Taylor 2016; Fed Oversight Reform and Modernization Act of 2015, H.R. 3189). These discussions and legislative proposals would benefit from considering the Federal Reserve in the shadow of the Bank of Japan. Though not well known, many fundamental issues of Federal Reserve policy and institutional redesign, as well as the political economy of constraints on central bank policy, have been experienced by the Bank of Japan well before they became issues in the United States. In fact, the policy discussion in Japan about central bank policy in the context of other policies has been far more transparent than discussion in the United States.

    The Bank of Japan was at the forefront of a strategic focus on price stability before the Federal Reserve and, as a result, avoided the Great Inflation and stagflation that characterized Federal Reserve policy in the 1970s. The Bank of Japan contradicts the "conventional wisdom" that independent central banks generate lower inflation outcomes (Alesina and Summers 1993; Carlstrom and Fuerst 2009; Yellen 2015; and especially, Lohmann 2006, p. 536). The Japanese experience reveals how flaws in financial regulation and the structure of the financial system amplify central bank policy errors when the strategic focus shifts away from price stability; that occurred in Japan almost two decades before the same occurred in the United States. The Bank of Japan experience illustrates how legal independence is a wall between government and the central bank that can be easily breached. And the Bank of Japan provides an understanding of how the political environment constrains central bank policy regardless of any reforms.

    The rise of the Japanese economy after WWII through the 1980s, and its fall into economic distress starting with the collapse of real estate and equity asset prices in 1990 and 1991, is remarkable and well documented (e.g., Cargill, Hutchison, and Ito 1997, 2000; Cargill and Sakamoto 2008). What is seldom appreciated, however, is the role of the Bank of Japan in this economic performance. Understanding that role casts light on recent Federal Reserve policy and US economic performance.

    We explore three aspects of the relationship between the Bank of Japan and the Federal Reserve. First, the asset bubbles and bursting of those bubbles in Japan (1985-1991) and in the United States (2001-2006) were both the result of central bank policy errors combined with a flawed financial structure. Second, the political economy of the operating environment of the Bank of Japan and the Federal Reserve ensures continued suboptimal monetary policy regardless of institutional redesigns of the central bank. There are flaws in the financial and real sectors supported by political considerations; politicians continue to run budget deficits, thus increasing outstanding debt; and there is an implicit crony relationship between government and the "independent" central bank in which the central bank accommodates government budget deficits. Third, the Bank of Japan and the Federal Reserve together present a serious contradiction to the conventional wisdom that legal independence is the foundation for optimal central bank policy outcomes.

  2. Monetary Policy, Financial Policy, and the Structure of the Financial System

    The ability of central bank policy to focus on long-run price stability can be constrained by the government's financial and industrial policies. That, in turn, provides a channel for the politicization of monetary policy and amplifies policy errors on the part of the central bank. The comparative records of the Bank of Japan and the Federal Reserve illustrate these points.

    Japan's economic development after 1945 is remarkable. Like the fabled phoenix, Japan emerged from the ashes of war to become the second largest and one of the richest economies in the world by the early 1970s. In terms of size, it has since moved to third or fourth place, yet Japan remains an important part of the world economy. During the first three decades of development, Japan's economy was internationally isolated; its industrial structure was dominated by a close relationship between politicians, bureaucrats, and client industries referred to as the Iron Triangle; and its financial system was rigidly controlled and regulated. In the mid-1970s, Japan commenced a financial liberalization process and began to open its economy to the rest of the world. Liberalization was successful, especially compared to the financial distress experienced in Europe and the United States during the 1970s and 1980s. It succeeded in part because the Bank of Japan, despite being de jure dependent of the government, achieved price stability and narrowed the difference between market and regulated interest rates. It avoided the stagflation that characterized European and US economies in the 1970s and early 1980s (Cargill and Royama 1988).

    Japan's impressive economic progress began to unravel in the second half of the 1980s as a result of asset bubbles in the real estate and equity markets. The country has yet to recover from the collapse of the bubbles in 1990 and 1991. Many regard Japan's bubbles and their bursting as a special case offering few lessons for the rest of the world or for the United States. Katz (2009), for example, was quick to point out that the cause of the US economic and financial distress that started with the collapse of housing prices in early 2006 and the Lehman Brothers bankruptcy in September 2008 was different than the circumstances in Japan. Further, the US response would prevent the United States from experiencing anything close to a "lost" decade.

    These predictions were overoptimistic. Not only is the Federal Reserve in the shadow of the Bank of Japan, the US economy has been in the shadow of the Japanese economy. Samuelson (2012) noted that the United States should not be so sanguine about avoiding a lost decade like Japan experienced and that both countries face similar debt problems. Parallels have also been drawn between Japan and Europe (Evans-Pritchard 2012).

    Central bank policy errors in the context of flawed financial policies and the structure of the financial system are the common link. In both Japan and the United States, monetary policy errors, combined with a flawed financial policy, generated asset bubbles. Their bursting was followed by intense economic and financial distress. These events have generated unprecedented monetary policy responses in the form of QEP and ZIRP, provided new responsibilities over the financial system to central banks, and, at least in the early part of the Great Recession, led to overoptimistic views of the power of central banks to resolve economic and financial distress. Yet central banks gain new powers and responsibilities after major policy errors. We return below to the reasons for this counterintuitive outcome.

    Japan experienced simultaneously an equity and real-estate price bubble from 1985 to 1991, the collapse of which set the stage for the "lost decades" in Japan's economic and financial development that have yet to be resolved. The United States experienced two successive asset bubbles, the first in equities (1995-2000) and the second in housing prices (2001-2006). The bursting of the equity bubble around March 2000 had a relatively minor impact on the US economy, but the bursting...

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