A success in the conduct of conventional monetary policy can defeat itself. Shirakawa’s Monetary Policy Paradox demonstrates how monetary policy, in its very pursuit for creating economic stability, can create new incentives among economic agents to engender economic imbalance and economic instability.
Monetary policy’s success in containing inflation feeds very causes of financial crisis—an extension of leverage and its consequence, asset bubble. It is so effective in causing economic instability. Once its consequential financial crisis unfolds, monetary policy loses its effectiveness. It creates a self-defeating cycle.
The previous reading, Shirakawa's Monetary Policy Paradox—Part 1, mainly outlined the general architecture of Shirakawa’s Monetary Policy Paradox. It provides us with a general framework of monetary policy paradox, focusing on general economic factors. However, in reality, a particular set of conditions could alter the course of economic events and create a particular path for an unfolding financial crisis in the aftermath of a bubble burst. Particularity is always present in economic condition or social and political conditions. For example. foreign demand can alter the domestic economic conditions. As another example, policy responses are influenced and constrained by particular social and political conditions, which could significantly differ from one country to another. In order to better analyse each case of financial crisis, it is imperative for us to distinguish between the general architecture of Shirakawa’s Monetary Policy Paradox and a particular set of relevant conditions that each case imposes.
Empirical study on specific historical experiences can provide materials for us to understand how particular conditions can shape the course of events along the general architecture of monetary policy paradox. This reading explores Shirakawa’s Paradox from an empirical point of view and projects it over the chronology of a specific historical experience of Japan during the period between the 1980s and the 2000s. (Click here to Particularities in Empirical Monetary Policy Paradox)
Hyman Minsky exposed that modern money is not neutral at all, but it interacts with real economic activities. In his exposition, Minsky elucidated the paradoxical structure of modern money, encapsulating the mechanism in his remark, "the creation of money is the first step in a process, in which money is to be destroyed.” (Minsky, 1985, p. 13). In other words, uncertain unwarranted lending creates money, while borrowers’ credible act of repayment destroys the money created. Therefore, a pair of these two economic events forms an inevitable “feed-in feed-back” cycle.
A period of economic euphoria produces excess money through excess financing that cannot be fully honoured in the future. Excess money would be destined to lead to its own feedback, evaporation of money. This is another inevitable “feed-in feed-back” cycle. Evaporation of money leads to a deleveraging process and would impair the real economic system. Accordingly, money affects our real economic activities even in the long term. In short, modern money is not neutral at all.
Does a successful monetary policy guarantee the stability of the economy? Monetary policy has to face a dilemma in dealing with differences in the behaviours among price categories. For example, general price (CPI, PCE, etc.), real asset price (productive assets, real estate, land, etc.), commodities prices, and equity prices, all those three demonstrate different price behaviour and cannot be managed at the same time by the conventional monetary policy alone.
Japan’s lost decades revealed an anecdote of paradoxical nature of successful monetary policy. In his speech Shirakawa, the ex-governor of Bank of Japan, outlined the mechanism how successful monetary policy actions that contained CPI inflation can lead to an unintended consequence, asset bubble and its inevitable collapse. Koo’s “Balance -Sheet Recession” stylized the mechanism of detrimental consequences of the combination of “high indebtedness” and “(asset) deflation.” The victory on resolving the old problem could brew the foundation of the next problem, inflation in other price categories.
Putting those two views together now reveals the self-defeating nature of monetary policy.