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The Role of a Central Bank in a Bubble Economy

November 26, 1999


II. Analysis

In retrospect, the bubble economy was an economic disaster for Japan. While the adverse economic conditions during the early years of the 1990s were undoubtedly due, in part, to the natural effects of the business cycle, the downturn was certainly exacerbated by the effects of the bubble. The bubble caused many firms to over-invest in plant, equipment, and inventory. The economy took several years to adjust to the overhang once economic conditions cooled. Many real estate projects were started during the bubble period, based on economic projections which proved to be wildly optimistic once the joyride of the bubble came to an end. Tokyo, like many cities in the United States after the savings and loan debacle of the early 1980s, has its share of half-finished or abandoned projects or over-built, extravagant office buildings and hotels now no longer able to carry their financing costs. Many companies and individuals who had speculated in the equity or land markets have gone bankrupt, and the actual level of insolvency is no doubt much higher than reported figures because commercial banks and other financial institutions are working to renegotiate loans rather than casting borrowers into bankruptcy. Thus, while it cannot be said that the bubble economy is directly responsible for all the economic hardship, it clearly bears a share of the blame.

It also seems evident that the Bank of Japan might have ameliorated the problem if it had tightened monetary policy earlier -- perhaps two years earlier -- than it did. The evidence of speculative activity in the equity and asset markets was hard to miss, especially for an institution centered in Tokyo. Nor was it hard to draw the connection between the speculative price increases and the availability of credit. While the light of hindsight is always clearer than that ex ante, it is not unreasonable to conclude that the Bank could have acted earlier.

Why did the Bank wait as long as it did to pop the bubble economy? This is an important question, not only because it bears on the decision-making processes in the Bank of Japan, but also because it presents a structural question that central banks around the world may have to address within their own economies. Rapid rises in stock market or land prices have occurred in several countries; often the increase is followed by a fall, with significant consequences for the overall economy. The events in Japan were unusual because of the magnitude of the catastrophe; but similar bubbles occur on a smaller scale in other countries.

In this section, I will suggest a number of reasons why a central bank might not act swiftly to stymie a speculative bubble. I will also consider whether these reasons can help explain some of the BOJ's actions during the period in question.

Problems a central bank may face in coping with a real estate or share price bubble include the following:

1. In the case of equities, national boundaries are quite permeable to share market volatility in other countries. This means that a central bank's response to a share market bubble in its own economy may have to be modified or limited by concern for the effects in other countries.

In the case of Japan's share market bubble, there is clear evidence that the BOJ's response was affected by concern for the impact of its actions on share markets abroad, especially in the United States. The interviews conducted for this article established that the Bank was concerned about the rapid growth of the monetary aggregates as early as 1987. Initially, the concern was not so much one about asset or equity market bubbles as a more traditional focus on inflation and the business cycle. The money supply measure M2 + CDs had been growing at a rapid pace, rising 9.2 percent in 1986 and 10.8 percent in 1987, much faster than the growth in GNP which increased by 4.4 and 4.9 percent during those years. The Bank was concerned that the economy was overheating, and, according to press accounts, concluded that a hike in interest rates was indicated in order to stave off inflation. Its plans were tabled, however, as a result of the Black Monday stock market crash of October 17, 1987, which affected stock markets around the world. The Tokyo market was one of the least affected of the major world bourses, recovering nearly all the losses within a few months. If the Bank of Japan had been free to act independently, it might have raised rates as soon as it became apparent that the Tokyo Stock Exchange had overcome the problems of the share market crash. However, it turned out that the Bank was not free to act. The BOJ was effectively forced to put the emphasis of its monetary policy on short-term international coordination, including the need to stabilize the New York stock market.

The Bank had another, related set of concerns during this period. The Bundesbank was widely criticized after Black Monday, on the ground that unlike other central banks, it did not cut interest rates or intervene in European exchange markets to bolster the dollar. Although the BOJ might have been prepared to risk a crash in the Tokyo stock market as a result of raising rates, it probably not want to face criticism that its economic policy had contributed to a further crash in stockmarkets elsewhere in the world. Again, concern for other parts of the world may have inhibited the Bank's ability to control the run-up in its own land and share markets.

2. Because bubbles in a domestic economy follow rapid internal dynamic processes, it may be difficult to harmonize the slow pace of international diplomacy on economic policy with the rapid developments in a bubble economy.

The Bank of Japan's policy in responding to the bubble economy was influenced by concerns about international diplomacy on economic issues. As part of the Louvre Accord, Japan committed itself to implementing policies to strengthen domestic demand, and the Bank specifically agreed to reduce interest rates to 2.5 percent. For the Bank to turn around a raise interest rates in the Fall of the same year might have appeared as a violation of the spirit of the Louvre Accord, with potentially adverse effects on international relations. Not surprisingly, concerns about the Louvre Accord were among the major reasons advanced by opponents of a rise in short term rates at this time.

In part, the problem is one of timing. While international diplomacy on economic matters has a relatively rapid time profile, as diplomacy goes, the pace of this activity tends to be dictated by the schedule of meetings of the G-7 countries rather than by market developments. Moreover, the diplomatic understanding established within the framework of the Plaza Accord suggests the need for consultation with other major industrial democracies before any nation embarks on a fundamental change in policy. The international diplomatic process, accordingly, may put a brake on domestic initiatives to control incipient bubbles within a nation's own economic system.

3. The authority of a central bank to act to control a share price or land price bubble is likely to be quite uncertain, because the bubbles may not affect the broader economic indicators until the bubble process is already well advanced.

In the case of the Japanese bubble economy, one of the principal impediments facing the Bank was the lack of any clear responsibility for action. Like most central banks, the Bank of Japan does not have any clear-cut mandate to control asset or stock market prices. The Bank's responsibility is over monetary policy, and in that regard it was expected to look at aggregate statistics such as industrial production, unemployment, and indexes of consumer and wholesale prices. The run-up in stock and asset prices, however, showed up on none of these indexes. The broad indexes did not indicate anything unusual happening in the Japanese economy.

Even the standard inflation measures, the consumer and wholesale price indexes, failed to pick up the bubbles. This appears to be an artifact of national accounting. Neither the wholesale nor the consumer price index takes account of the prices of equity securities; and land values are factored into the consumer price index only with a lagging measure of residential rents. The huge jump in capital values, especially in commercial real estate, was simply not measured in the indices, and accordingly it was technically off the radar screen for the Bank.

There was one standard aggregate measure which did potentially support intervention -- the money supply figures, which were growing at a much faster rate than the economy as a whole. These figures might have been used as an excuse for tightening monetary policy, but had the Bank done so, it would have essentially been acting -- or could have been criticized as acting -- on the basis of monetarist economic theory. The Bank has never adhered to monetarism, and it did not want to be accused of lapsing into a monetarist stance. Accordingly, the Bank was unwilling to place too much emphasis on the money supply figures as a rationale for tightening policy.

Thus, the BOJ did not have available a clear-cut basis on which to tighten policy, and for this reason, it was inhibited about taking rapid action against the equity and land value bubbles until the effects of this activity had begun to appear in the broad statistics which central banks ordinarily use in formulating monetary policy.

4. In the case of a bubble economy, the underlying economic activity will often be within the regulatory jurisdiction of an institution other than the central bank. Thus, the central bank may face opposition from other bureaucratic departments if it wishes to act against the bubble.

In the case of Japan, it is quite clear that the BOJ has no direct jurisdiction over either equity or asset prices. Equity prices are, in theory, subject to no regulation at all, being entirely market-driven. Moreover, the Securities Bureau of the Ministry of Finance supervises the markets on which equities trade, and in this capacity, would naturally want a significant amount of input in any decision that would fundamentally affect the volume, liquidity and price levels on those markets, if any such decision were to be made.

In the case of land prices, there is no national agency in Japan with overall responsibility. However, the Municipality of Tokyo and other local jurisdictions do have an interest in land prices within their borders, and have the regulatory authority to take some actions to control price level changes. Beyond this, the Banking Bureau of the Ministry of Finance is concerned with land prices insofar as the land in question is either being used as collateral for bank loans, or is being developed with bank financing. In fact, the MOF did intervene in real estate markets in 1989, by imposing restrictions on the ability of commercial banks to finance new real estate development projects in Tokyo; one consequence was to drive the bubble into neighboring prefectures and other cities.

5. The bubble economy may be the result, in part, of financial deregulation which has the effect of directing bank credit into particular economic sectors, especially real estate. Depending on the legal powers of the central bank, it may not have the authority to deal with the underlying root causes of the credit surplus.

In the case of the Bank of Japan, financial market deregulation played a role in the development of the bubble economy. The Ministry of Finance has been steadily deregulating the financial services industry since 1984. The results have been dramatic, as banks and securities firms came into competition over product markets. Interest rates on bank deposits have been deregulated. These and other deregulatory initiatives have resulted in important changes in the Japanese financial system.

One of the most important, and probably unintended, changes, has been the gradual erosion of the Japanese "main bank" system, under which the large commercial banks maintained close, long-standing relationships with borrowers and provided the bulk of these customers' financing. As a result of deregulation, larger corporate customers found that they could finance their operations more cheaply in direct securities markets than they could with bank loans. Banks accordingly began to lose some of their traditional lending business to organized securities markets. At the same time, as interest rates were deregulated, banks found themselves in competition for deposits, and thus began to look for higher-yielding (and therefore more risky) investments.

The result of these factors was that the Japanese banks began to make increasing amounts of loans to smaller or mid-sized firms. To make up for the lack of long-standing customer relationships typical of the main banking relationship, banks began to rely increasingly on collateral as their security for repayment. A traditional and well-accepted form of collateral is real estate. For a number of reasons, therefore, Japanese banks greatly increased their real estate lending during the bubble economy. This real estate lending, in turn, accelerated the bubble process because the flood of new credit into real estate development increased the prices of the underlying assets.

The underlying causes of the increases in available real estate financing were not within the BOJ's regulatory authority, since financial market deregulation was within the MOF's power. The BOJ does examine commercial banks as an incident to its clearance function, and accordingly had some power of administrative guidance to discourage excessive reliance on real estate lending. The Bank in fact did attempt to deter real estate speculation by this means, but its effect was only marginal. In general, the Bank was not responsible for the increase in real estate lending that occurred during the late 1980s; accordingly, the Bank's policy response of tightening monetary policy was not finely crafted to deal with this aspect of the underlying problem.

6. The tools available to the central bank to act against bubbles in the economy are likely to have effects on economic activity outside the bubble economy, and accordingly a central bank is likely to use these tools with caution even if a bubble develops in a particular sector.

The power of a central bank is essentially the power to set and implement monetary policy. Because this is a power that applies to all economic activity in a country, its use to counteract a bubble in a particular area of commerce, such as equity securities or land prices, cannot be limited to these particular activities. Monetary policy is not like a "smart bullet" that kills only its intended victim; it is broad based in its approach, and even if it is effective at stopping a bubble economy, it may have other negative effects, such as inhibiting desirable economic expansion in other areas, adversely affecting exchange rates, and the like.

These considerations affected the thinking of policymakers at the Bank of Japan in 1988 and 1989. Even though some of these individuals believed that stock and land prices were too high, and were concerned about the potential negative effects of further increases, they also had to take into their calculations the fact that the underlying economic indicators did not show a significant threat of inflation; the consumer and wholesale price indices during the bubble period were remarkably stable, and the other economic measures seemed to indicate an economy which was functioning well. In these circumstances, tightening policy might have inhibited positive economic growth without any significant payoff in inflation control. For these reasons, the Bank was not inclined to tighten policy quickly in the absence of compelling reasons to do so.

7. The central bank is likely to encounter significant opposition to its actions against a bubble because powerful interest groups will attempt to block any such move. The reason behind this intuition is straightforward. Once a bubble process starts, economic interests will tend to organize in order to ensure its continuation.

Most immediately concerned are persons with a direct financial interest in the bubble itself. These include persons who facilitate transactions in the industry -- for example, real estate brokers or stock brokers who will make large profits because of rapid turnover of assets -- and persons who hold assets subject to the bubble -- for example, homeowners whose net wealth is increasing because of the run-up in real estate prices, or speculators who have purchased during the bubble period in hopes of a quick profit.

In addition to groups that profit directly from a bubble economy, others may suffer collateral harm from the monetary policies which the central bank would use against the bubble. This is a function of the fact that the central bank does not have a magic bullet to use against a bubble economy, but must respond with broadly-based policies that have effects outside the problem area. The most important of these effects is going to be in the area of exchange rate policy. If the central bank tightens monetary policy to control asset price increases, the effect may be higher domestic interest rates, which in turn is likely to increase the value of the domestic currency on world markets (because there is a higher return from holding investments in the currency). Strengthening of the currency, in turn, makes exports more expensive, and harms the interests of exporting firms (while helping importers). Exporters are likely to oppose the monetary tightening necessary if the central bank is to act against an asset bubble.

Beyond these groups which either profit directly from the bubble, or which would suffer harm if the central bank intervened, there is likely to be a third group favoring the continuation of a bubble economy, at least until the process is fairly well advanced: ordinary citizens who participate vicariously in the good times and who become swept up in the good feelings incident to a bubble economy.

This phenomenon of political support for the bubble economy was present in the Japanese real estate and share price bubbles. Interest groups that benefited from the price increases included securities firms which were experiencing huge profits from stock brokerage, insurance firms which had begun to issue a popular insurance product with returns linked to the stock market, property developers and speculators, and home owners.

Interest groups that might not have benefited directly from the equity and real estate bubbles, but which could be harmed if the BOJ moved aggressively against the bubble economy by tightening policy, included a powerful group of large exporting firms, represented in the Ministry of International Trade and Industry (MITI) and in the umbrella organization of the large firms, Kaidanren. These groups had an interest in keeping Japanese interest rates low, both to spark internal demand for Japanese products, and to keep the yen from appreciating against the dollar and other major currencies.

Added to these groups with a direct economic interest in the continuation of the bubble economy, or in the avoidance of measures that would counter-act the bubble economy, was a broader base of people who perceived the price increases as beneficial, or at least as not undesirable, given that the general price level, outside of the bubble area, was remarkably well-controlled. National pride was involved; Japanese citizens were pleased at their country's economic success. As Governor Mieno commented later, "as prices were not rising, it was difficult to obtain people's understanding for a policy aimed at achieving a sustainable growth of the economy through monetary tightening."

8. Because it may be difficult to detect the difference between a speculative price bubble and price increases based on economic fundamentals, the central bank may be uncertain about the wisdom of acting during the early stages of an event which, ex post, turns out to be a bubble economy.

This phenomenon was present at the Bank of Japan during 1988-1989. There was uncertainty as to whether the events in question were actually a bubble, or whether the simply reflected the expression of a dynamic, growing economy with potential for future growth. Had the central bank intervened during this period, it might have been making a serious mistake and cutting off a normal and desirable process of economic growth.

9. Depending on the political status of the central bank, it may need the support of politicians if it is to act decisively against a bubble economy, especially during the early stages of the bubble when the phenomenon is likely to enjoy widespread popular support.

In the case of Japan, it appears that the BOJ could not count on the clear support from the politicians in the ruling Liberal Democratic Party (LDP) during the crucial months. The LDP was in disarray as a result of factional infighting and political scandals, most notoriously, the Recruit affair in which politicians were accused of having accepted bonus stock in return for helping the issuing firm. In March, 1989, the Nihon Keizai Shinbun reported poll results finding that only 13 percent of the population supported the government. In two regional elections held that month, the LDP candidates lost one and barely held on to beat an opposition candidate backed by the Communist Party. By April, 1989, Prime Minister Takeshita resigned; his replacement Sosuke Uno also resigned in July, 1989, after the LDP suffered several electoral defeats. This was not a party in any sort of condition to provide strong support to what would no doubt be an unpopular decision on the part of the Bank to rain on the national parade by driving down land and stock prices.

10. Finally, the power of a central bank to act against an asset or equity price bubble may depend in part on the bank's own political and legal organization. Other things equal, an independent central bank is likely to have greater power to act against a bubble than a politically dependent one, since an independent central bank has a degree of ability to take action autonomously, or even against the will, of the political actors.

In the case of the Bank of Japan, this factor may have contributed to the Bank's slowness in responding to the asset and equity price bubbles. In legal form, the BOJ is essentially an arm of the Japanese Ministry of Finance. However, in practice, the Bank of Japan enjoys a significant degree of power over the formulation of monetary policy. In setting the official discount rate, the Bank appears to engage in a form of "preclearance" of its decisions with other relevant actors, but for a variety of factors, the Bank usually controls the outcome of the process. It might, accordingly, be more accurate to say that the Bank of Japan sets monetary policy through a process of consultation and preclearance than to define it as either independent or dependent. But, however its decision processes are described, it appears clear that the Bank does not have the same degree of freedom to set monetary policy as is enjoyed, for example, by the Bundesbank.

Arguably, the tradition of preclearance in monetary policy matters may have impeded the Bank of Japan's ability to respond quickly and decisively to the asset and share price bubbles. It might be that the Bank could not act entirely autonomously in setting monetary policy, but rather needed some time to consult with other parties, especially the Ministry of Finance, before acting. This process of consultation might have delayed the Bank's response, since any action against the asset and share price bubbles would have been controversial within the agency. There is some indication that the Bank of Japan encountered resistance from the Ministry of Finance after it began the process of raising interest rates and tightening monetary policy in response to the asset and share price bubbles. The actual roles of the Ministry of Finance and the Bank of Japan in formulating a response to the bubble economy are, as yet, not matters of public knowledge.

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