House of the setting sun, part 2

The Bank of Japan, credit allocation, and the battle to undervalue the Yen

Apr 24, 2024

‘Empires have no interest in operating within an international system; they aspire to be the international system’

—Henry Kissinger

Inflation arises when too much money is chasing too few goods. Some money is created through the mint, but in a modern economy the vast majority of new money comes about through banks creating money when they lend. As such, one method to reduce inflation is through clamping down on the creation of money wholesale, especially bank lending. But credit not only provides demand for new goods; it also brings about their creation. What if policy focused less on the supply of credit per se, and more on where and how this credit is allocated? After all, provided that the newly-created money is being used for productive purposes, with output increasing sufficiently (and sufficiently quickly) to absorb any new demand, both credit and output can rise together without excessive inflation — though achieving this was, of course, a delicate and administratively complex task. This was, in essence, the logic that lay behind Japanese policy in the early post-war period.

The bureaucrats who had taken charge of Japan’s peacetime war economy (see Part 1) realised that they had to carefully guide the bankers so that they would be allies rather than enemies in the difficult task of allocating credit towards productive purposes. To achieve this, Japanese economic bureaucrats believed that the central bank should be tightly controlled by the government, and that it should exert control over the banking system in order to effectively regulate the quantity and allocation of money creation such that it best served the interests of the nation as a whole.

They studied how central bankers supervised banks and the supply of money elsewhere: some claimed to use reserve requirements as their main policy tool; others interest rates. But in reality, neither tool seemed very effective. On the one hand, changes to interest rates did not necessarily seem to closely track the level of economic activity; on the other, reserve requirements (and similar tools) seemed too blunt to be useful for the enlightened central banker.

Instead of these tools, the Japanese decided that they would control credit through issuing loan growth targets for banks. This was a strategy first pioneered by the Reichsbank under Hjalmar Schacht in the 1920s. While the discount rate remained an integral part of the Reichsbank’s arsenal, and was in fact still regularly used, it was now more of a public relations tool than the centre of policy. By 1924, German inflation had been brought under control; nonetheless, the Reichbank’s guidance on loan issuance continued virtually uninterrupted until 1945.

The procedure was simple: each bank had to apply to the central bank for a loan contingent for the coming period. The banks then allocated their contingents among borrowers. Once used up, the central bank would punish those who engaged in any credit expansion beyond what had been allocated to them. Although the ‘stick’ necessary for this strategy to be effective had no basis in law, the Reichsbank made use of informal administrative pressure, threatening to impose sanctions that could be hugely costly for any banks that disobeyed. Naturally, this gave the Reichsbank enormous, and crucially, selective power over German industry. Throughout this period, Schacht was a ‘credit dictator’: governments and politicians would come and go, but Schacht remained; some even said that the Reichsbank was Germany’s ‘second government’. Japan, which had always been influenced more by German than by Anglo-American administrative practice, studied these central bank credit controls closely; it even dispatched officials to the Reichsbank for years at a time, including future Bank of Japan Governor Hisato Ichimada.

Total War and the road to a subordinate Bank of Japan, c.1932-45

Before 1932, the Bank of Japan did not have a close relationship with the banks and the money market. The only exception was in times of crisis when, entirely in line with orthodox Bagehotian central banking principles, it acted as a lender of last resort. It was only in 1942 that the Bank of Japan was formally brought under the control of the Ministry of Finance. The new legislation was entirely derivative, produced by simply translating Germany’s Reichsbank Law of 1939 and renaming it the ‘Bank of Japan Law’.

Together with the laws regulating the movement of capital and foreign exchange (as described in Part 1), this completed the Japanese system of financial controls. The new legislation stated that it was the Bank of Japan’s job to work towards the full mobilisation of resources and the achievement of maximum output growth. To assist in the implementation of these new German-style central banking principles, between 1929 and 1945 the number of private banks in Japan was reduced from well over a thousand to just sixty-four. Much like any other industry, the remaining banks had their own ‘control’ organisation. This organisation would evolve into the Japan Banker’s Association after the War.

The Bank of Japan acted as the control centre for the creation and allocation of purchasing power. The Governor of the Bank was in charge of the National Financial Control Association, which implemented the resource allocation plans that had been worked out by the Cabinet Planning Board, i.e., outside of the Bank itself. The plan was top down: first, the required output of each industry was decided upon; then a hierarchy of manufacturers, subcontractors, and raw material importers was determined; and finally, the banks were required to provide the necessary purchasing power for the achievement of the state’s output goals. Potential borrowers were placed in one of three categories: Category A for high-priority borrowers, meaning critical war supplies, such as munitions and raw materials; Category B for medium-priority borrowers; and Category C for low-priority borrowers, such as manufacturers of goods for domestic consumption and/or ‘luxury’ items. Borrowing as a Category B customer was restricted; borrowing as a Category C customer was almost impossible. Those manufacturers lucky enough to be designated as Category A borrowers were assigned a ‘main bank’. Their main bank’s job was to ensure that sufficient loans were granted to their new VIP customer so that they could meet the state’s production targets. These favoured firms were themselves part of a hierarchy of subcontractors and related firms which were grouped to try to better achieve their output targets. This system soon transformed the economy: firms in ‘low-priority’ industries were weakened, while strategically important sectors grew rapidly.

During the War, banks faced heavy legal penalties for non-compliance with bureaucratic lending guidelines. In the postwar era, these legal penalties were replaced with financial incentives. But even without the use of formal penalties and incentives, the vagueness of the legislation gave great power to the bureaucracy. Government officials could issue administrative orders to the banks — similar to wartime imperial decrees — forcing them to do as they were told, as private sector institutions were not at this time in a position to argue with the government.

In 1946, with the approval of the US occupation force (SCAP), a relatively young official named Hisato Ichimada was appointed Governor of the Bank of Japan. He had previously spent time at the crucial Banking Department (1927-37), which managed credit creation and relations with the banking sector. He regarded Schacht’s highly independent Reichsbank as a role model for the Bank of Japan. In his memoirs, Ichimada states that ‘…what left the strongest impression on me in Germany was… Schacht’. Despite his young age, Ichimada had become personally acquainted with the first great credit dictator, and after the War, Schacht would visit Ichimada in Japan.

Ichimada had also spent four years at the Bank of Japan’s Auditing Bureau, and became its chief in 1942. At the Auditing Bureau, Ichimada monitored the purposes for which credit was being used: a critical aspect of the Bank of Japan’s system. The main criterion was to decide if the loans were being used ‘productively’ in the eyes of the central bank. In 1942, Ichimada would also become the National Financial Control Association’s first Secretary General. Although the Governor and Vice Governor of the Bank were formally in charge of the Association, serving as the Association’s Chairman and Vice Chairman respectively, in practice it was Ichimada who was in charge of the Association’s affairs on a day-to-day basis. This meant that he was working at the very heart of the Japanese war economy.

Reconstruction, reflation, and inflation, c.1945-49

After the Japanese defeat in 1945, it was clear that the quality of the loan books of the private banks had badly deteriorated in the final years of the War, as lending had been diverted towards economically unproductive (i.e., military) purposes on a massive scale. The only other major assets of the banks were worthless war bonds and other wartime government debt. As a result, the banks were effectively insolvent. The asset problems of the banks were sufficiently large to create a credit crunch and a major deflationary downturn in the Japanese economy after the War.

To counteract this, it was necessary to get credit flowing around the economy once more. Firstly, the Cabinet Planning Board was reestablished in the form of the powerful (but short-lived) Economic Stabilisation Board. The Board initially used the Reconstruction Finance Department of the Industrial Bank of Japan (IBJ) to supply the economy with funding, but in 1947, the Board would become fully independent from the IBJ, establishing itself as the public Reconstruction Finance Bank (RFB), whose job it was to provide preferential loans to designated strategic industries. The Reconstruction Finance Bank was in turn funded by government bills that the Bank of Japan was forced to discount. Secondly, the Ministry of Finance reestablished a modified form of the priority production system that had been in place in wartime.

The Bank of Japan was unhappy with these activities, for they clearly encroached on what the Bank considered to be its own bureaucratic turf: namely, the creation and allocation of credit. The Bank of Japan resented the fact that the priority production categories were determined by the Board and the Ministry of Finance. In accordance with the Bank of Japan Law of 1942, the Ministry of Finance expected the Bank to merely act as its agent, faithfully acting in accordance with Ministry diktat to achieve goals set outside of the Bank. This very limited (and subordinate) role was not in line with Ichimada’s vision for the future of the Bank of Japan. The Bank of Japan also resented the activities of the Reconstruction Finance Bank, as this was an institution that the Bank of Japan did not control and that, once again, clearly challenged the Bank of Japan’s monopoly on the creation and allocation of credit. If this continued, the Bank of Japan would never regain the pivotal role in the Japanese economy that it desired.

Ichimada lost no time. Virtually simultaneously with the Ministry of Finance’s priority production system, the Bank established a separate system to direct funds to designated priority industries. Meanwhile, Ichimada sought to incapacitate the administration of the Ministry of Finance’s scheme by assigning only eight to ten staff to a highly administratively complex task that required far more manpower, while simultaneously giving this small group the equally complex task of dealing with frozen bank accounts from wartime.

The Bank of Japan also issued instructions that, in principle, banks were not allowed to increase their outstanding loan balance after 20 March 1946 unless they received a permit from the Bank of Japan and the government. This prevented ‘low-priority’ industries and consumers from laying claim to scarce resources.

Ichimada adopted a two-pronged reflation policy. First, while the banks were severely wounded from bad wartime debts, Ichimada borrowed a trick from Schacht: he turned the Bank of Japan into the banker for the nation. In the early postwar years, he made use of the ‘Stamped Bill System’. Firms in specific sectors were invited to apply for funding, either directly or through their banks. The Bank of Japan discounted bills of exchange from firms in the coal, fertiliser, and textile industries, as well as certain major exporters. Retail, agriculture, education, and construction were then considered to be of somewhat lower priority. Most domestically-oriented consumer industries fell into the ‘low-priority’ category: loans for real estate, department stores, hotels, restaurants, entertainment, publishers, and brewers were not forthcoming, not to mention that consumers themselves had little hope of obtaining funds, for Ichimada felt that Japan could not afford such luxuries. All of this discrimination took place in the Loan Coordination Division of the Bank of Japan’s Banking Department.

Second, banks were brought back into the process, with the Bank of Japan providing assistance in improving their balance sheets and offering guidance on their discounting of bills. Improving bank balance sheets was easy; at least in theory, no more than an accounting problem: all Ichimada needed to do was have the Bank of Japan buy their worthless wartime bonds for good money, for when a central bank uses its own currency, it does not need to worry about bad debts. All that would happen was that the Bank would print the necessary money to purchase the bonds, and then keep the purchased assets on its balance sheet in perpetuity, never forcing it to recognise a loss unless it chose to do so. Simultaneously, this made the banks dependent on the goodwill of the Bank of Japan and more willing to cooperate with the Bank’s informal guidance. If the central bank wished, it could extend unlimited credit funding to them. The Bank of Japan knew that, in theory, so long as any newly-created money was used productively, it would result in an increase in output, and not just prices.

In the end, Ichimada had reinstated the Bank of Japan’s full control over both the quantity and sectoral allocation of new bank loans in a mechanism that later became known as ‘window guidance’.

The battle of the Bank and the Ministry, c.1949-1971

These programs were highly successful at achieving their short-term aims, and a severe postwar credit crunch was averted. But as already mentioned, far from all of the expansion of credit was due to the activities of the Bank of Japan: the ESB’s activities, including lending by the Reconstruction Finance Bank, also had a lot to do with it, as did a sizeable budget deficit. Both were funded through the issuance of short-term financing bills or bonds that the central bank had to discount.

Demand soon picked up, but it turned out that demand was being stimulated well beyond what the limited capacity of the Japanese economy — which still suffered from supply bottlenecks, partly caused by damage from wartime bombing raids — could bear. As a result, inflation began to rise. Rising inflation was the perfect opportunity for the Bank of Japan to damage its bureaucratic rivals. The Bank blamed the inflation on the lending of the Reconstruction Finance Bank and the budget deficit, both of which the Bank of Japan was forced to finance despite being out of the Bank’s control. In 1948, Ichimada’s claims were endorsed by Washington, with SCAP issuing a widely-publicised Nine Point Economic Stabilisation Programme in December 1948, recommending tighter fiscal and monetary policies. The following year, Washington sent Joseph Dodge, President of the Detroit Bank, to Japan to advise SCAP on fiscal and monetary problems. Dodge put an end to deficit spending and the bulk of the central bank underwriting of government bills. The Reconstruction Finance Bank was prohibited from making any further loans, and was to be slowly wound up.

This established the principle that henceforth, government banks, such as the Japan Export Bank (est. 1950) and the Japan Development Bank (est. 1951) would have to be funded from postal savings, and that government banks had no power to create credit or to influence the money supply. The Bank of Japan and its client banks thus established a monopoly over the creation and allocation of new money — a major victory for the previously totally subordinate Bank of Japan.

Governor Ichimada’s powers were now far-reaching. He personally decided whether a project would go ahead or not. As a result, leaders of industry, commerce, and finance felt obliged to visit him frequently at the Bank of Japan to try to gain his approval for their investment plans, which he was known to frequently refuse. For many business leaders, this was a humbling experience. Credit allocation was extralegal and informal, but they had to follow every whim of Ichimada and his lieutenants. There was no committee, not much discussion, and no right to appeal, despite the Bank’s decision being one of life or death for a business project. This led to Ichimada being nicknamed ‘the Pope’. He would remain in the job for eight-and-a-half years, a record for a Bank of Japan Governor. After stepping down, he became Minister of Finance — a rare move for a Bank of Japan man, and one that would not be repeated in the postwar era.

Despite Ichimada’s victory in 1948/9, from the beginning of the 1950s until the end of the 1970s, there was a continuous struggle for full independence by the Bank of Japan. The Bank of Japan found it relatively easy to outmanoeuvre the Econimic Planning Agency and MITI, but it could only partially neutralise the Ministry of Finance. This was because the Bank of Japan was de jure in the same subordinate position outlined in the Bank of Japan Law of 1942. SCAP did not seek to repeal this law, as they thought it a good thing that the Bank of Japan remained accountable to the now-democratic government and its bureaucracy.

One method to obtain greater independence was to obscure the Bank’s policies. In public, the Bank of Japan always downplayed the importance of ‘window guidance’. Simultaneously, the Bank made it appear as if interest rates were central to its policy, despite not believing them to be of much importance internally. This obfuscation continued even with the rest of the bureaucracy: whenever the Ministry of Finance inquired about the Bank of Japan’s quantitative or allocative policy, or about bond market transactions, Ichimada and his staff would engage in complex discussions full of technical jargon to make the process appear impenetrable to non-experts, and even to many Bank of Japan staff.

When Ichimada became Minister of Finance in 1954, he soon lobbied for greater Bank of Japan independence — curiously, he desired a reduction in the powers of his own ministry, the Ministry of Finance. He argued that, short of full independence, the goal of Bank of Japan policy should be changed from ‘supporting government policies’ and ‘maintaining economic growth’, as outlined in the 1942 Law, to the now-common mandate of ‘maintaining price stability’. The Bank of Japan calculated that this change would result in de facto independence, for it could then refuse to implement policies that it disliked on the grounds that they endangered price stability. Ichimada was, however, defeated by his political and bureaucratic opponents, and was replaced as Minister of Finance in a reshuffle in June 1958.

The Ministry of Finance had won this battle, but it was a hollow victory, partly because of the liberalisation that was required for Japan to join in OECD in 1963. External researchers concluded that the Ministry of Finance stayed out of discussions between the Bank of Japan and MITI about which sectors should receive credit. The Bank of Japan kept the details of ‘window guidance‘ secret, and presented it as highly technical. To further convince the world — both at home and abroad — that ‘window guidance’ was not the main policy mechanism of the Bank of Japan, the Bank stepped up its ‘research’ publications, which claimed that it followed orthodox central banking policies. The Bank gradually sought to move interest rates to centre stage; in 1978, it even officially introduced monetary targeting as a smokescreen for its activities. During this period, ‘window guidance’ was repeatedly abolished and reintroduced, as the Bank of Japan wanted to be perceived at home and abroad as a champion of free markets, and credit controls were perceived as an embarrassment.

Asset price inflation and fighting to depreciate the Yen, c.1971-76

In the 1960s, the success of Japanese exporters led to growing frictions with the United States over textile imports; in the 1970s, these frictions spread to automobiles and consumer electronics. The United States had consented to the maintenance of Japan’s war economy in peacetime because of the exigencies of Cold War, but the price had been high — for some, such as Nixon, too high.

Various remedies were discussed. The Ministry of Finance looked into a revaluation of the Yen, but a group of internationally-minded officials and intellectuals realised that the Japanese economic system as a whole would have to be changed in order to reduce Japan’s enormous trade surpluses, as the United States was demanding. They were, however, in a minority, given the prosperity and growth that the system had delivered in the previous decades. The first doubts as to whether this was a viable course of action were sown in the mid-1970s. In many ways, this period represented a test run of the much bigger and more far-reaching events of the 1980s and 1990s.

Until the collapse of the Bretton Woods system in 1971, all the major world currencies were pegged to the dollar. For Japan, the exchange rate was fixed at 360¥/$. In turn, the dollar was pegged to a certain quantity of gold, though only central banks could make use of the gold window, and most central banks (with the important exception of the Banque de France) generally did not do so. Gradually, over the course of the 1950s and 1960s, a dollar shortage became a dollar glut, and the United States began to record large current account deficits. This meant that many began to wonder whether the Dollar was overvalued. At first, currency speculation centred on Sterling, which was more clearly overvalued. But after Sterling’s 1967 devaluation, speculative attacks soon shifted to the Dollar, and foreign central banks eventually began redeeming dollars for gold.

In August 1971, the United States suspended the convertibility of the dollar to gold. This effectively ended the Bretton Woods system, and the dollar fell sharply on world markets. This took the Bank of Japan by surprise, and the Bank’s foreign exchange reserves jumped by $5bn in the month of August alone. The Bank of Japan began aggressively stimulating domestic demand in an attempt to keep the Yen relatively weak, so that Japanese exports would remain competitive.

In the end, the strengthening of the Yen to 308¥/$ by December 1971 proved to be significantly less than expected, given that the Yen had been deliberately undervalued for the entirety of the postwar period. However, the stimulation of domestic demand in order to avoid excessive currency appreciation caused an explosion in asset prices, with the Nikkei 225 rising from ¥3000 in March 1972 to ¥5000 by the end of 1972. In 1972 alone, gains from the appreciation of land amounted to ¥15tn, and stock gains to ¥5tn.

This led to extreme speculation and credit misallocation which, since the money lent against these assets cannot be paid back when asset prices fall, harms banks. This pre-Oil Shock asset price inflation was put to an end by a tightening of ‘window guidance’ in early 1973 for a full two years. Bad debts began to pile up in the banking system. Industrial production dropped a massive 19% between late 1973 and early 1975; unemployment rose to a post-war record by the late 1970s; and GDP growth sank to virtually nil in 1974.

This recession lasted longer and was more severe than most had anticipated. Despite a string of fiscal packages and interest rate cuts, both the private and public sectors were looking shaky. Nonetheless, in late 1976, industrial production finally recovered to the October 1973 peak. The reason for this had been the Bank of Japan quietly increasing its ‘window guidance’ quotas in late 1975 and early 1976, thus once again allowing for the expansion of credit.

Nonetheless, a sudden shift from twenty years of almost continuous double-digit (or close) real GDP growth to a lengthy recession followed by a fragile recovery led to a general questioning of the Japanese economic system. Discussion of ‘structural problems’ in the Japanese economy was thrust to the centre of political debate. In particular, there were growing calls for a reorientation of the Japanese economy away from exports, and towards domestic consumption. This led to criticisms of the more visible elites, such as politicians and Ministry of Finance bureaucrats. The Bank of Japan took note: they knew that they were the only major player who could have created the recovery, and had mostly hidden ‘window guidance’ for a decade. Whether by accident or not, the Bank of Japan had scored a big victory over its rival, the Ministry of Finance. These events would serve as a test run for the much bigger, and much more famous, bubble in the following decade.

To be continued…