Shirakawa's Monetary Policy Paradox Part I

Shirakawa’s
Monetary Policy Paradox (Part I)

General Perspective:
Architecture of Monetary Policy Paradox

Originally published August 28, 2017
Edited August 30, 2017
By Michio Suginoo

A success in the conduct of conventional monetary policy can defeat itself. Masaaki Shirakawa, who served the governor of the Bank of Japan from April 2008 to March 2013, expressed his insight of the paradox in the conduct of monetary policy, reflecting Japan’s experience of asset bubble during the 80s, its bust in 1991, and its aftermath.

Monetary policy’s success in restoring price and economic stabilities could feed the very causes of financial crisis: an extension of leverage and its consequence, asset bubble. It is so effective in causing the economic instability. Once its consequential financial crisis unfolds, monetary policy loses its effectiveness in containing new problems. It creates a self-defeating cycle. In the long-run, monetary policy could end up transferring economic imbalance from one area to another in the economy.

This reading, the Part I, revisits Shirakawa’s past statements and attempts to capture the general framework of his monetary policy paradox. Let us call it Shirakawa’s Monetary Policy Paradox, or Shirakawa’s Paradox.

[1] Paradox of Price Stability

(1) The Architecture of Shirakawa’s Monetary Policy Paradox:

Monetary policy, while having an intensive focus on the stability of general price (CPI), has to face a dilemma in dealing with differences in the behaviours among price categories. For example, general price (CPI, PCE, etc.), asset price (productive assets, real estate, land, etc.), commodities price, and equity price—all those four demonstrate different price behaviour in response to interest rate dynamics and cannot be managed at the same time by conventional monetary policy alone.

Shirakawa presents one of foundations of the architecture of the paradox:

“The goal of monetary policy is to achieve sustainable growth with price stability. This is a well-established principle that is shared in Japan, the United Kingdom and globally, regardless of whether an inflation targeting framework is adopted. (…) Focusing obsessively on the short-term stability of the consumer price index as a way to ensure economic stability will actually have the opposite effect of increasing instability.” (Shirakwa, January 10, 2010, p. 12)

“When price stability is achieved, many economic entities gain the confidence to take more risk. And, as a result, the stability of the financial system is compromised. This paradox of price stability is a good example of the need for the central banks to stay vigilant and keep learning in a changing environment.” (Shirakawa, October 9, 2012, p. 7)

(2) Victory creates New Problem, shifting Economic Imbalance:

Shirakawa’s paradox starts with a victory of monetary policy over general price inflation, which is proxied by CPI. The victory, once stabilising CPI inflation, brings down the short-term interest rates and stabilises economy. It gradually transforms the psychology of the market participants, which yields new economic imbalances—excess credit expansion and its consequence asset inflation:

“The success in attaining price stability lent support to public conﬁdence in the central bank’s conduct of monetary policy. As a result, inﬂation expectations of private-sector economic entities became well anchored to a low-target inﬂation rate. Thus, imbalances in the economy began to appear in forms other than inﬂation of goods and services. Imbalances materialized in different forms such as increases in asset prices and growth of credit extension.” (Shirakawa, April 22, 2010, pp. 488-489)

” (…) during this period, (…) the subtle role of interest rates to dynamically allocate resources tended to be disregarded. And it was exactly during this period that the seeds of the crisis were sown in the form of the expansion of credit and leverage, and the increase in maturity mismatches.” (Shirakawa, April 22, 2010, p. 490)

“Needless to say, bubbles are not caused by low interest rates alone. However, when the expectation prevails that low interest rates will continue for a long period of time, it is likely to encourage leverage and maturity mismatching between the assets and liabilities of financial institutions.” In that sense, I believe that in the conduct of monetary policy central banks also need to be attentive to the accumulation of financial imbalances. (Shirakwa, January 10, 2010, p. 12)

(3) Cycle of Confidence: Interaction between psychology and incentives

The caveat of Shirakawa’s Monetary Policy Paradox can be encapsulated into a simple phrase: the victory of monetary policy defeats itself. What drives Shirakawa’s paradox?

Two factors play significant roles in the architecture of the paradox:

psychology of economic agents;
incentives created by governments.

Shirakawa explains what drive financial institutions’ activities:

“Financial institutions’ activities are influenced not only by the expectation that a stable environment will continue but also by incentives created by the regulatory and supervisory framework.” (Shirakwa, January 10, 2010, p. 12)

Policy makers have a critical role in creating incentives; and the private sector might have no other choice than respond to them. Once incentive, policy maker’s creation, compels the private sector’s economic actors to react, the resulting new chain reaction can be one directional and become the source of economic imbalance. The interaction between policy incentive and economic agents’ psychology is a driving force in creating economic imbalance in the architecture of Shirakawa’s Paradox.

The victory of monetary policy embodies central bank’s commitment on price stability. Once the victory brings down the interest rates, it shapes a new expectation among economic agents, the confidence in economic stability. And the expectation for sustainable growth and low interest rates also creates an incentive for economic agents to take more risk. As a result, economic imbalance starts shifting from CPI inflation to credit expansion and asset inflation.

Shirakawa characterises the chain of these behavioural reactions as the cycle of confidence.

“Success breeds conﬁdence which unfortunately turns into over-conﬁdence or even arrogance. Complacency also sets in. The collapse of the bubble based on this over-conﬁdence leads now to under-conﬁdence, which is followed by rebuilding efforts. Then the cycle begins once again.”(Shirakawa, April 22, 2010, p. 486)

(4) Diminishing effectiveness of Monetary Policy:

Shirakawa also points out diminishing effectiveness of monetary policy in the post-asset-bubble economy. Here also, Shirakawa reveals a self-defeating characteristic of successful monetary policy. At an early stage of pre-bubble economy, after containing CPI inflation, monetary policy is highly effective in restoring confidence. That very effectiveness, ironically, shapes the foundation of a bubble economy--excess debt and asset price inflation. Once bubble bursts, however, the effectiveness of monetary policy diminishes.

Shirakawa contrasts the effectiveness of monetary policy between before and after the bubble burst. First, he describes the effectiveness of monetary policy during the recovery prior to the bubble formation:

“When it comes to the transmission mechanism of monetary policy, in Japan, lower interest rates had previously induced an increase in banks' lending to small- and medium-sized firms. This in turn increased business fixed investment by such firms, which drove economic recovery.”

This mechanism did not work, however, after the bubble burst. Similarly, in the United States, a decline in long-term government bond yields has not been fully transmitted to a decline in the effective rates of mortgage loans because borrowers with low credit scores have not refinanced at lower interest rates. In Europe -- Spain is a prime example -- bank lending rates have risen due to higher interest rates for covered bonds, reflecting a deterioration in the quality of real estate collateral.

(Shirakwa, January 10, 2010, p. 4)

Here, Shirakawa is talking about credit spread widening. After a bubble burst collateral value would plunge dramatically. Accordingly, risk spread would widen for commercial lending. Despite the decline in risk-free interest rates, the increasing risk premium would make the net effect unfavourable to borrowers, especially those with lower credit ratings. In this setting, monetary easing would not work effectively. This is one aspect of asset price deflation in the post-bubble economy.

As monetary easing continues, the short term interest rates approach zero rate. Shirakawa points out diminishing effectiveness of conventional monetary policy under a near zero interest rates environment.

In his remark below, Shirakawa presents one of the reasons for the diminishing effectiveness of monetary policy in the post-bubble deleveraging paradigm from a demand perspective—diminishing return characteristics:

“Monetary easing can affect the economy either through bringing forward future demand or bringing in overseas demand. In the former case, available future demand gradually decreases as monetary easing is prolonged. In the latter case, when economic growth in developed countries is generally weak, monetary easing in individual countries aiming at bringing in overseas demand may increasingly lead to a zero-sum game, which is not desirable for the sustainable growth of the global economy as a whole.” (Shirakwa, January 10, 2010, p. 11)

What is the “zero-sum game” in bringing overseas demand? Also, is there any other cause for diminishing effectiveness of monetary policy? These points regarding diminishing effectiveness of monetary policy are to be discussed in a separate material.

(5) Limited role of Monetary Policy in a Post-Bubble deleveraging paradigm:

In Shirakawa’s view, monetary policy, once losing its effectiveness in a deleveraging economy, is merely an instrument to buy time to allow legislators to deliver necessary structural reforms.

we need to bear in mind that providing liquidity as "a lender of last resort" is, in essence, a policy to "buy time." It is essential that the necessary structural reforms take place while time is being bought, as the time that we can buy becomes progressively more expensive. (Shirakwa, January 10, 2010, p. 11)

In reality, however, legislators would face political barriers—principal agent problem, regulatory captures, conflict of interest—and could compromise the political process in pursuing structural reforms.

(6) Summary

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 restoring price and economic stability can feed 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. In the long-run, monetary policy could end up transferring economic imbalance from one area to another in the economy.

Shirakawa’s paradox reminds us of Hyman Minsky’s emblematic phrase “Stability is Destabilising” that encapsulates his Financial Instability Hypothesis. Both Minsky’s Financial Instability Hypothesis and Shirakawa’s Monetary Paradox analyse the same topic—causes and consequences of finance-fed financial crises. While Minsky’s Financial Instability Hypothesis has intense focus on the private sector’s money creation mechanism, Shirakawa’s Monetary Policy Paradox has a wider framework to examine and question the effectiveness of central banks’ monetary policy actions. And both articulate that policy incentives and behaviours of economic agents play significant roles in altering economic reality.

Shirakawa’s remarks below reminds us of the very cause of the paradox embedded in the architecture of monetary policy.

After the end of World War II, until relatively recently, a stable ﬁnancial environment was almost synonymous with price stability.Also, we were quite used to a ﬁnancial system structure where the health of commercial banks was almost synonymous with ﬁnancial system stability. However, having experienced the current crisis, we have come to realize that such understandings are now outdated. (Shirakawa, April 22, 2010, p. 492)

The experience of the bubble shows that even when prices are stable, the economy can experience huge swings. What is expected of central banks is the attainment of a stable ﬁnancial environment, that is, a ﬁnancial environment that is consistent with, and contributes to, sustainable economic growth. Price stability is certainly one important element of the stability of monetary conditions. However, it is not conﬁned to this. Rather, when a central bank feels constrained by short-term price stability, this may complicate the attainment of the ultimate objective of sustainable growth. (Shirakawa, April 22, 2010, p. 491)

When central banks are celebrating success, new problems may be beginning to emerge in the private sector quietly. (Shirakawa, April 22, 2010, p. 493)

[2] Primary Determinants for the Aftermath Time Line of an Asset Bubble

Now imagine that we were standing somewhere close to the culmination of an asset bubble prior to its bust. A question should arise how devastating its consequence would be to the entire economy; how long it would take to complete the deleveraging process before the recovery.

Shirakawa stresses, the consequence of a bubble bust to an entire economy depends not only on economic factors but also social and political conditions that constrain the policy response. Social and political variables could significantly differ from one society to another. For now, let us focus on more common factors within economic dynamism.

Shirakawa lists up primary factors that affect the timeline of aftermath events in a post asset-bubble economy. He contemplated the following three primary economic variables.

The Cumulative Size of Excess Debt;
Growth of Domestic Economy in the Post-Bubble Economy;
Growth of Global Economy in the Post-Bubble Economy;

(Shirakwa, January 10, 2010, pp. 8-10)

(1) Debt Level:

Naturally, the more the cumulative size of excess debt is, the longer it would take for an economy to recover from the consequence of financial crisis. Needless to say, in order to assess its impact to an entire economy, it needs to be scaled against the size of the economy, or GDP. Beyond that, this factor further needs to be assessed relative to two other metrics.

(2) Growth Potential of the Domestic Economy:

The negative impact of a forthcoming financial crisis needs to be assessed relative to the growth potential of the domestic economy in the post bubble economy. Shirakawa goes:

For two economies with the same amount of debt, the one with higher growth potential can lighten the burden of excess debt faster. Having said that, growth potential is not fixed and can change as a result of policy measures and the response of the society after a bubble bursts. (Shirakwa, January 10, 2010, p. 8)

In a sense, for a high growth economy, the growth might exceed the negative impact of financial crisis and prevent the net effect from causing a catastrophic economic crisis as a whole.

On the other hand, for a low growth economy, the negative impact of financial crisis not only might exceed the growth, but also might reduce the potential growth, causing collateral damage. In this respect, Shirakawa raises three points below.

a) Collateral Damage:
Collateral damage could materialize in various ways. For example, in a low-growth economy that is in the process of deleveraging, social stress tends to intensify and is more likely to result in a rise in protectionism and excessive government intervention.When lending to non-viable firms continues for political or social reasons, the resultant decline in productivity growth will lower growth potential. (Shirakwa, January 10, 2010, p. 9)

b) Distortion of Economic Incentive by Monetary Policy:
Low interest rates and abundant liquidity are necessary but if they continue for a long time, they may lower productivity by keeping inefficient firms alive.Necessary adjustment will also be delayed if low interest rates discourage the government from making efforts to restore fiscal balance. (Shirakwa, January 10, 2010, p. 9)

c) Demographic:
Population decline will also prolong the adjustment of excess debt by lowering growth potential. … The contribution to population growth from immigration is significant in the United States and many European countries. However, this contribution from immigration could diminish if the stagnation of economic activity is prolonged. (Shirakwa, January 10, 2010, p. 9)

(3) Global Growth

The third factor, the global growth momentum, if substantially high, not only might absorb the shock of a local systemic financial crisis and avoid its ripple effect, but also might help the country in crisis maintain or even strengthen its trade surplus--for example via a trade off with its depreciated currency. The net effect would help the impaired economy restore itself.

(4) Overall Assessment:

Shirakawa argues, among three economic factors, we can influence these two growth factors—domestic and global—in order to mitigate the negative consequence.

Of these three factors that define the length of time needed for deleveraging, the first one—the initial size of excess debt—is a given over a bubble bursts, but we can still influence the remaining two factors: the growth potential of individual economies and growth momentum in the global economy as a whole. (Shirakwa, January 10, 2010, p. 10)

In the above, Shirakawa only delineates a blue print to grasp the scale of post-bubble systemic financial crisis. Nevertheless, this blue print gives us a starting point to further develop a model in anticipating the scale of coming crises in the future.

The reading made a brief overview of the architecture of Shirakawa’s Monetary Policy Paradox. It presented a general framework of the paradox. The following reading reviews a historical experience of Japan’s asset bubble and its bust and examines particular conditions that affected the historical experience.

References:

Shirakawa, M. (2002). One Year Under Quantitative Easing. Tokyo: INSTITUTE FOR MONETARY AND ECONOMIC STUDIES, Bank of Japan.
Shirakawa, M. (April 22, 2010, 3 13). Revisiting the Philosophy behind Central Bank Policy. International Finance, 485-493. doi:10.1111/j.1468-2362.2010.01271.x
Shirakawa, M. (October 9, 2012). Evolution of the Bank of Japan's Policies and Operations: Looking Back on Fifty Years of History. 2012 Annual Meetings of the IMF/World Bank Group. Tokyo: Bank of Japan.
Shirakwa, M. (January 10, 2010). Deleveraging and Growth: Is the Developed World Following Japan's Long and Winding Road? Lecture at the London School of Economics and Political Science. Tokyo: Bank of Japan.