Home > About the Bank > Speeches and Statements > Speeches 1996–2010 > Speeches 1996 > Speech given by Yasuo Matsushita, Governor of the Bank of Japan, to the Japan National Press Club in Tokyo on June 14, 1996 (The Role of the Central Bank)

The Role of the Central Bank

This article is excerpted and translated from a speech given by Yasuo Matsushita, Governor of the Bank of Japan, to the Japan National Press Club in Tokyo on June 14, 1996.

Introduction

I am truly honored to be invited to address the Japan National Press Club.

Today, I would first like to discuss the recent economic situation and the Bank of Japan's views regarding monetary policy management. Then I would like to examine some issues concerning the institutional aspects of central banking, including the basic mission and role of the central bank and its status in a modern democratic society. As there has recently been much discussion on the revision of the Bank of Japan Law, I hope that today's talk will contribute to your understanding of central banking, which is fundamental to these discussions.

The Recent Economic Situation and Monetary Policy Management

The Domestic Economic Situation

Starting with the domestic economic situation, the Bank of Japan's current view is that a moderate economic recovery continues. I will not go into the details of the situation or the reasoning behind this view, as I spoke on these matters to your colleagues at a press conference only a few days ago. But I believe that most people will agree with the Bank's view that the recent developments in demand and production as well as the results of the Bank's May Tankan--Short-Term Economic Survey of Enterprises in Japan indicate that the Japanese economy is on a path of moderate recovery.

The question is whether this recovery trend will gather momentum and spread throughout the economy, thereby laying a firm foundation for a self-sustained economic recovery. To answer this question, I would like to discuss the major points to be considered with regard to the immediate developments in the economy.

One can think of two channels through which a self-sustained recovery led by private demand is generated. The first channel is a process in which improvements in corporate production and profits lead to a stronger and wider-ranging recovery of business fixed investment. At present, profits of large manufacturing firms are projected to increase in fiscal 1996 for the third consecutive year. Profitability itself has improved significantly, and the current profits-to-sales ratio is likely to exceed 4 percent this fiscal year. In past business cycles, this level of profits was achieved about one year after the recovery began, when the strength of the recovery was fairly well established. In the present recovery phase, however, it has taken more than two and a half years to reach that same level. This indicates how severe the difficulties accompanying the present economic recovery are, namely, the aftereffects of the bursting of the economic "bubble," and the pressures exerted on the country's industrial structure for adjustment to the new international economic environment.

It appears that these difficulties were more severe for the non-manufacturing sector and for small and medium-sized firms. In fact, the improvement in their performance lagged far behind that of the large manufacturing firms. More recently, however, economic recovery has at last started to spread to the non-manufacturing sector and to the small and medium-sized firms. For example, large non-manufacturing firms, except for those in the construction industry, expect an increase in profits this fiscal year. In addition, small and medium-sized firms project a larger growth in profits than that of last fiscal year, although their level of profits remains low.

This spread of the recovery of business performance throughout the corporate sector is typically reflected in business fixed investment. Large firms in both the manufacturing and non-manufacturing sectors plan to expand their fixed investment this fiscal year, and small and medium-sized firms are gradually starting to follow this trend.

The second channel through which a self-sustained recovery is attained is where such recovery in business activity increases employees' income, thereby stimulating the consumption and housing investment of the household sector. In this respect, however, there has not been any major change in the basic trend of recent years, which has seen firms encumbered with excess labor and continuing to implement restructuring measures, including the reduction of labor costs. Therefore, compared with the first channel, the force of this second channel to generate a recovery still seems limited.

Yet, if we sketch out the developments since 1995, it is fair to say that with the recovery of the economy, the employment situation has finally bottomed out and is starting to improve, although at a very slow pace. Macroeconomic employment indicators in general are showing some improvement, and firms’ attitude toward employment is gradually becoming positive as reflected in the Tankan. Such changes in the employment situation also seem to have contributed to the recovery in consumer confidence and to the continuing high level of housing investment.

When considering the channels through which a self-sustained recovery can be achieved, it is the Bank’s view that the process whereby strengthened business activity leads to increased business fixed investment and to greater personal consumption is beginning to come into effect, and this process is gradually spreading to a wider range of industries and to smaller firms. In this regard, there is now a greater prospect of attaining a self-sustained recovery. Yet, to date, the pace of recovery in general remains moderate, constrained by the various adjustment pressures mentioned earlier. There are also other factors that call for due attention, such as (1) the question of whether the substantial reduction in the external surplus--that is, the declining trend in net exports--will continue and how it will affect the economy; (2) the implications of the easing market conditions of semiconductors, an industry which has been one of the main driving forces of the economy; and (3) developments in fiscal expenditures.

Monetary Policy Management

The Japanese economy is thus at the critical moment when its transition to a self-sustained recovery is at stake. At this juncture, the Bank of Japan will continue, in the management of monetary policy, to monitor monetary and economic developments closely, placing an emphasis on cementing the foundation for an economic recovery.

Let me now explain the Bank's interpretation of market interest rate developments in the context of monetary policy management with an emphasis on securing an economic recovery.

Although the Bank has maintained such a policy stance, long-term market rates have fluctuated rather widely since the beginning of 1996. The interest rate on government bonds with the longest remaining maturity, which had declined to 2.8 percent in autumn 1995, rose to 3.5 percent in February1996. After declining to 3.1 percent thereafter, it rose again somewhat after the release of the May Tankan results, and is now at around 3.2 percent.

Whenever long-term interest rates fluctuate like this, various comments and arguments are made to explain the movements. However, the Bank bears the following two points in mind in observing long-term interest rate developments.

The first is that the market is constantly seeking to settle at a reasonable interest rate level while assimilating the various information contained in a vast number of diverse transactions. Thus, it is necessary to focus on the relatively long-term trend of market developments, without being preoccupied with short-term fluctuations.

The second point concerns the reasonable interest rate level--in other words, what determines long-term interest rates. The level of long-term interest rates is determined based on the market participants' projection of the rate of return on investments or of the economic growth rate--in other words, their economic outlook. Also reflected in the interest rate level is the participants' projection of the Bank's monetary policy stance based on such economic outlook.

Since the autumn of 1995, the Bank has conducted money market operations in a manner designed to develop a stable market trend and to encourage a market-led formation of interest rates. Thus, the gradual rise in long-term interest rates since last year can be construed as reflecting the market’s assimilation of various information, particularly the market participants’ view that the economy is recovering gradually.

When I express such views on long-term interest rates, the media and the markets at times read too much between the lines. However, my aim is to encourage a natural market-led formation of market interest rates based on the economic fundamentals, which in turn enables the Bank to obtain greater information for assessing the economic situation. I very much count on your understanding of the policy and intentions of the Bank, since you are one of the important conduits between the Bank of Japan and the financial markets.

Issues Facing the Financial System

Another pressing issue for the Japanese economy, alongside securing a self-sustained recovery, is to restore domestic and international confidence in the financial system and to strengthen the financial functions so as to support economic activities.

As you are fully aware, bills concerning financial reforms, including those for establishing the jusen-resolution scheme, have been passed by the House of Representatives and are currently under deliberation in the House of Councilors. In addition to the bills for solving the jusen problem are bills to establish a comprehensive framework for encouraging an early solution of the nonperforming-asset problem as a whole--such as those bills for strengthening the functions of the Deposit Insurance Corporation and those for introducing a system for taking prompt corrective actions against troubled financial institutions. All these are therefore significant in restoring the soundness of the financial system.

However, installing the above-mentioned framework will not bring an end to the problems in the financial system. In addition to the early disposal of nonperforming assets, individual financial institutions will need to make further efforts to heighten their creditworthiness domestically and internationally by recovering impaired capital, improving public disclosure of financial conditions, and promoting restructuring of their businesses. Should a financial institution face liquidity problems in the process of such efforts, the Bank of Japan, as the central bank, will take the necessary measures to maintain the stability of the overall financial system and, at the same time, will encourage the financial institutions concerned to engage in more rigorous efforts.

Alongside the endeavors of individual financial institutions is another major task of reorganizing the Japanese financial system as a whole, including the system of financial administration. Increasing attention on the revision of the Bank of Japan Law is presumably attributable to this background development.

Issues Regarding the Institutional Aspect of Central Banking

I would now like to move onto the second subject of today's speech: institutional issues regarding central banking. The ruling coalition parties' project team published a report on financial administration reform on June 13. The report included the revision of the Bank of Japan Law as one of the important pillars of the reform and laid out the basic points at issue.

In response to rising interest in the revision of the law, the Bank has on occasion explained its fundamental views on central banking in order to gain the public's understanding. In doing so, however, I always feel that there are some aspects of central banking which people find hard to understand. Therefore, I would like to take some of these up today and elaborate on our view.

There are three major points to the issue of central banking: (1) the nature of central banking and the fundamental roles of the central bank; (2) the relationship between the government and the central bank--in other words, the independence of the central bank; and (3) relating to the second point, the status of the central bank in a democratic society.

As these points constitute the basis of any debate on central banking, I believe that a common understanding on them is a prerequisite for any deliberation on the revision of the Bank of Japan Law.

Before going into the details of the discussions in Japan, I would like to briefly mention the background to the heated discussions that have recently taken place outside Japan with regard to central banking, which have in fact led to legal amendments and institutional changes in several countries.

Three factors prompted such an active debate: (1) there was a need to establish a unified central bank among the member countries of the European Union as part of the move toward an integrated Europe; (2) the establishment of a modern central bank at the core of the financial system was considered to be an important task in the transition of former centrally planned economies to market economies; and (3) the experience of stagflation in the 1970s and of the bubble economy in the 1980s--which was a global phenomenon not limited to Japan--has renewed recognition that the central bank's objective of maintaining price stability was significant.

In the debates, the basics of central banking were seriously discussed: major outcomes were the provisions for the establishment of the European Central Bank included in the Maastricht Treaty, and the ensuing amendment of the central bank law in France and Italy. The European Central Bank is to be assigned the objective of maintaining price stability and is to be granted a high level of independence from European Community institutions and governments of member countries. The creation of this central bank through a political consensus has valuable implications for Japan. I have no time to go into the details, but I wish to emphasize that serious and constructive debate regarding central banking took place and that this led to a consensus being reached in Europe on the desirable nature of the central bank.

The Role of the Central Bank

I will now go on to the first point at issue concerning central banking, namely, the fundamental roles of the central bank.

The Bank of Japan is often characterized as having three roles: (1) the issuing bank; (2) the banks' bank; and (3) the government's bank. Of these, the most fundamental is its role as the issuing bank, that is, to issue currency such as banknotes.

That this should be considered the primary role is easily understood by looking back at the historical process through which the organization and system of the central bank were established.

Some central banks were established by the government, as in the case of the Bank of Japan, whereas others evolved from a private bank which, in the course of history, came to perform the functions of a central bank, as in the case of the Bank of England. In either case, the central bank was established to stabilize the currency system by concentrating the issuing function to a sole institution and making it responsible for the control of the currency.

In the case of Japan, currency was issued not only by the government but also by private banks in the early Meiji era in the latter half of the nineteenth century, and various kinds of currency were in circulation, including those issued during the preceding Edo era, which goes as far back as the seventeenth century. The currency system was thus in a height of confusion and a fall in the value of currency, or inflation, was accelerating. To resolve that situation, the Bank of Japan was established to create a stable currency system by acting as the sole issuer and controller of the currency, and through this, to lay the foundation for economic development. As this example illustrates, the inherent role of the central bank is to issue and control the currency--or one might say, to enable the people to use money confidently.

To this end, two requirements must be satisfied: first, the value of the currency must be stabilized--that is, price stability must be maintained; and second, circulation of money and the functioning of the mechanisms through which monetary transactions are processed--in other words, the settlement and financial systems--must be stable and efficient.

The mission of the central bank, therefore, is to fulfill these two requirements in order to preserve the soundness of the currency, and to thereby provide a solid foundation for sustainable economic growth and for an improved standard of living.

To fulfill this mission, the Bank of Japan carries out diverse operations. Foremost, in order to stabilize the currency value, that is, to achieve price stability, it manages the monetary aggregates in the economy and interest rates. This is the essence of monetary policy, and I believe this point needs no further elaboration.

It is also an important task for the Bank of Japan to make the yen more convenient to use and to thereby enable firms and households to confidently engage in daily transactions and funds settlements. For example, the Bank ensures every day that adequate money is supplied smoothly throughout the nation to meet the needs arising from transactions, and it also controls the physical quality of money to ensure the supply of banknotes of a high standard. While these tasks might not stand out, they are nevertheless important in upholding people's fundamental confidence in the currency.

Alongside cash settlement, a large part of the daily transactions of households and firms are settled by means of funds transfers and remittances between banks. In turn, banks' balances are settled across their accounts held with the Bank of Japan. In other words, the majority of transactions conducted throughout the country is eventually concentrated and settled at the Bank. As a result, the amount settled across the current accounts at the Bank totals more than 300 trillion per day. This means that an amount equivalent to approximately 70percent of Japan's annual GDP is transferred each day through the accounts at the Bank.

Therefore, the Bank is constantly working to improve the settlement system so that such transfers of funds are processed smoothly. For example, the Bank of Japan Financial Network System, or the BOJ-NET, is a computer network for processing interbank settlements via accounts at the Bank of Japan, and is the product of continuous efforts made by the Bank over the years to realize a more efficient and sophisticated settlement system.

While I have used such words as "currency” and "money" to mean "cash," such terms today are not limited to cash issued by the Bank of Japan. As mentioned earlier, most of the household payments of public utility charges and settlements between firms are made by transferring funds between bank accounts rather than by cash. This signifies that bank deposits function as money based on the assumption that such deposits maybe exchanged for cash at any time at equal value.

Money held in this form is termed "deposit currency" as opposed to "cash currency," and the amount held as the former far exceeds that of the latter. The amount outstanding of monetary aggregates, as measured in Japan by M2+CDs, is approximately 550 trillion yen, of which more than500 trillion yen is in the form of deposit currency, while cash currency only accounts for about 40 trillion yen.

Such a currency system, as I have already mentioned, is built on the public's confidence that bank deposits can be exchanged for cash at any time. Japan's currency system is thus founded on two kinds of credibility: that of the cash currency issued by the central bank, and that of the deposit currency offered by private banks.

Therefore, in order for this currency system to function effectively as a whole, the stable functioning of the overall financial system is essential. As deposit currency is one of the liabilities of private banks, sound bank management established on the principle of self-responsibility is fundamental to maintaining its credibility. In addition, a safety net such as the Deposit Insurance Corporation is provided to uphold testability of the financial system by offering depositor protection. Furthermore, should a problem arise in any corner of the financial system with the risk of spreading throughout the entire system--that is, when there is a risk that erosion of confidence in the system might spread through a chain reaction--the central bank is to provide emergency liquidity assistance as deemed necessary to prevent a malfunction of the financial system and its serious negative impact on people's lives. The central bank's function to provide such liquidity is known as the "lender of last resort."

To perform this lender-of-last-resort function smoothly and expeditiously, the Bank must not only encourage the sound management of financial institutions, but must also fully recognize at all times whether there is excessive concentration of risks within the financial system, and whether the sequence of settlements between financial institutions is conducted smoothly. It is also extremely important in the context of monetary policy management to understand and predict how the Bank's policy changes will affect financial institutions' market behavior and how that influence will in turn spread through the system.

Such function of the Bank of reviewing the conditions of financial institutions is performed by means of regular on-site examinations and daily monitoring. These are also important operations for achieving the mission of the central bank.

Having outlined a few of the diverse operations of the Bank of Japan, I trust that you understand how they are all closely linked to the Bank's two objectives of maintaining price stability and ensuring financial system stability, and that these two objectives ultimately translate into the single objective of the appropriate control of the currency.

Relationship between the Central Bank and the Government

Next, I would like to explain why the authority to control the currency is assigned to the central bank in major industrialized countries.

The reason for this assignment, in short, is that the authority to control the currency, or managing monetary policy, can in the short term be used for a variety of purposes if one so intends, but if utilized inappropriately, will invariably cause pernicious problems for the country in the long term.

History abounds with instances of heedless increases in the money supply and excessive interest rate cuts aimed at securing low-cost funding for the government or at forcibly adjusting the foreign exchange rate. These instances were followed in many cases by the undermining of price stability, triggering substantial economic fluctuations, or by the impairing of fiscal prudence. Whichever was the result, the public was to pay the ultimate costs.

Such historical experiences led people to conclude that the distinct duty of maintaining the value of the currency should be entrusted to the central bank, which is impartial to the short-sighted interests of the times, and that the central bank's unbiased and professional judgment should be respected.

One of the reasons for granting independence to the central bank derives from the nature of the objective of maintaining the value of the currency, that this objective can be achieved only through detachment from short-sighted interests in order to build a foundation for people's lives and the country’s economic activity. This independence can be perceived as one of the ways devised for checking and balancing powers in a modern state.

The two basic principles governing the modern state are "democracy" and "separation of powers." These principles are equally fundamental to a presidential system and to a parliamentary system: in either system, the parliament and, in turn, the people decide on the best way to achieve separation of powers--or, the best system for checks and balances. It is not only the well-known separation of the three powers of legislation, administration, and jurisdiction which is founded on this concept of checks and balances: in modern states, the concept is reflected in various systems, such as the bicameral system of parliament or the establishment of independent administrative bodies in the executive. The granting of independence to the central bank, or having an independent central bank, is also one of the systems based upon this concept.

Independence is granted to the central bank in major industrialized countries, not only in countries having a presidential system but also in those adopting the parliamentary system. While the cabinet is held primarily accountable to the parliament on economic policies in general under the latter system, independence has nevertheless been attached to the central bank by the judgment of the parliament in such countries as Germany, Italy, and Spain.

Of course, major industrialized countries have at the same time devised measures to coordinate monetary policy and other economic policies. Under these measures, on the assumption that adequately managed monetary policy and other economic policies are unlikely to clash, and that these policies do not have widely different aims, the government and the central bank will do their utmost to fulfill their respective duties while fully embracing the concept of checks and balances. This given, a system for coordinating policy between the government and the central bank is also in place in case such coordination becomes necessary. For example, in Europe, a number of countries have recently adopted a system allowing the government to make policy requests to the decision-making body of the central bank or to attend the meetings of the central bank board to present its views.

Democracy and the Central Bank

Granting independence to the central bank, however, does not mean enabling it to manage monetary policy willfully outside the framework of modern parliamentary democracy.

Recent international debate over central banking, which I mentioned earlier, has highlighted the need to enhance public monitoring of the central bank through its reporting to the parliament together with the need to strengthen central bank independence. This is one of the basic points of central banking on which a consensus has been reached.

This view, in short, sees independence and accountability as indivisible. Since the word "accountability” is not familiar to the Japanese, allow me to take a moment to describe it in some detail. The word "accountability” is commonly translated into a Japanese word meaning "responsibility. “However, this translation does not fully reflect the true meaning of the word.

The word "accountability" derives from "account," which has such meanings as to count money or to explain. In other words, "accountability “implies not simply responsibility but "responsibility to explain properly."

Unfortunately, there is no corresponding Japanese word. This may be an indication of the fact that the concept of this word was not recognized widely in Japan. Yet, it is an indispensable concept when discussing central bank independence.

The effects of monetary policy are transmitted through extremely complicated channels and they become visible only after a substantial period of time, in certain cases after several years. This necessitates that monetary policy be managed from a long-term perspective, and also complicates the debate over the responsibility for monetary policy.

In managing monetary policy, therefore, the central bank is mindful of the need to properly explain the contents, the objectives, and the fundamental thinking regarding its policy management. This makes it possible for the bank to later review its policy stance and objectives, and to thereby learn valuable lessons.

Such an approach can be considered a mechanism for encouraging the central bank to manage monetary policy adequately and responsibly, and in a way that makes policy management clearer to the public. Furthermore, such an attitude should foster a better mutual understanding between the government, the parliament, and the central bank regarding the economic situation and their respective policy management, and it should thus also contribute to achieving a higher level of consistency in the country’s economic policies.

Some people express the concern that increased independence of the central bank might turn it into an untethered kite. However, the basic thinking today on central banking is that by adopting the above approach, the central bank will be able to manage monetary policy adequately without being bound by short-sighted interests or external pressures, and without the danger of becoming a tether less kite. Many of the major industrialized countries actually employ such a mechanism in an attempt to harmonize central bank independence and democracy.

The Bank of Japan has made various efforts to improve its accountability for monetary policy management. For example, in 1995, we began to announce all significant changes in our market operations with a view to clarifying our thinking behind such changes and our immediate policy on the direction of money market rates. In addition, when changing the official discount rate, we have tried to provide in official statements a more detailed explanation than before on the Bank's economic outlook and the reasoning behind the policy change. Furthermore, from this year, we have upgraded the contents of the Policy Board’s monthly and annual reports to include details of the policy decisions by the Board and the thinking behind those decisions.

Yet we believe much remains to be done. We will continue to study possible ways to further promote the transparency of our policy management and to improve our accountability.

Conclusion

I have discussed today the Bank's basic thoughts on central banking, making reference to the recent debate in major industrialized countries on this issue. The issue centers on the appropriate status of the central bank in a modern democratic society and on the establishment of a mechanism that will encourage the central bank to adequately perform its inherent duties.

According to a report by a project team of the ruling coalition parties, a forum is to be established under the government for transparent and fair deliberations on the revision of the Bank of Japan Law. Concrete discussions on the issue are yet to be held. When deliberations are launched, it will be required that the fundamental thinking on central banking, which I have explained, be shared broadly and that the debate be founded firmly on that common understanding.

When such a forum is established, the Bank of Japan intends to contribute constructively to the discussions, and to that end will be pleased to benefit from any constructive comments or suggestions you might care to offer.

I am most grateful for your attention today.