The global financial crisis from 2007 to 2009 represented a crucial turning point in the history of economic development worldwide, leaving a profound and extensive impact on societies and economies across the globeAs time progresses, this crisis will indubitably remain an indelible memory, a haunting recollection for manyIt altered traditional notions held by policymakers and the academic community, shifting focus within policy sectors and reshaping research agendasIn responding to the crisis, countries deployed their policy tools with unparalleled vigor; central banks, in particular, leaned heavily on monetary policy measuresMany nations resorted to historically unprecedented levels of quantitative easing (QE), often drawing on approaches earlier pioneered by the Bank of JapanJapan, inspired by the principle of "having what others lack and doing it better," expanded the concept of QE with innovative policies like Qualitative and Quantitative Easing (QQE) and Yield Curve Control (YCC), enriching the toolkit available to central banks

It’s important to note that while some of these initiatives were launched under Governor Masaaki Shirakawa, others emerged after his term concluded with his successor.

The book "The Turbulent Era" highlights Shirakawa’s cautious stance towards aggressive monetary easing; he expressed concerns that certain issues were beyond the remit of monetary policy itselfDuring his tenure, while he did implement easing measures reflecting the economic and financial realities, there was a prevailing sentiment in Japan among businesses and the public that the Bank's actions were insufficientShirakawa acknowledged the immense pressure faced by the central bank in conducting monetary policy, originating from various sources, including social criticism, which he termed "Social Dominance." The pressure from society was palpable, compelling the central bank to sometimes adopt measures they were reluctant to implement

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Shirakawa emphasized the importance of broad national understanding and support for the central bank's policies, indicating that at times, managing monetary policy transcends mere technicalities, diving into the realms of political and social will.

Post-Crisis Measures Adopted by the Bank of Japan

The United States, being the epicenter of the financial crisis, was quick to response, with the Federal Reserve implementing substantial monetary easingInterest rates were slashed to near-zero levels, leading to the advent of quantitative easing policiesAs the world’s most influential central bank, Fed’s actions significantly affected the subsequent policy choices made by the Bank of JapanThe Fed's easing policies triggered a continued appreciation of the yen—which was not just against the dollar, but also against various emerging market currencies—leading to rising discontent among exporting firms and catalyzing criticism from lawmakers, the media, and economic analysts who accused the Japanese government and the Bank of inaction

Compounding this situation, Japan grappled with domestic economic stagnation and deflationary pressures, necessitating a shift towards looser monetary policiesIn October 2010, the Bank of Japan introduced a strengthened framework dubbed "Comprehensive Monetary Easing" aimed at lowering longer-term interest ratesThis involved the purchase of not just long-term government bonds but also higher-risk assets like exchange-traded funds (ETFs).

In the lead-up to the October 2010 monetary policy meeting, the Bank had already cut policy interest rates twice in late 2008, each time by 0.2 percentage points, bringing the overnight call rate down to 0.1%. By October 2010, 10-year government bond yields hovered around 0.9%, with average short- and long-term bank lending rates around 1.2%. Given that short-term rates were already at the zero lower bound, any further cuts necessitated a focus on long-term rates

Corporate borrowing costs can be decomposed into risk-free rates represented by government bond yields, plus a risk premiumTherefore, the strategy had to encompass both reducing the risk-free rate and compressing the risk premium.

To reduce the risk-free rate, the Bank of Japan leveraged two key measures: first, purchasing government bonds with maturities between one and two yearsThe relationship between bond prices and yields is inversely correlated, so by increasing demand for government bonds, their prices would rise, subsequently lowering yields, which reflects the actual returns from holding such securitiesIt’s crucial to differentiate between coupon rates—fixed at issuance—and yields, which fluctuate according to market conditionsTo simplify, if a person or institution buys government bonds at a price different from the initial issuance, their returns will be based on this purchase price

Previously, the Bank's bond-buying endeavored to inject liquidity into the marketplace; from October 2010 onward, the ultimate goal was to manage rates directlySecondly, the Bank employed a forward guidance policy, communicating the anticipated duration of its zero interest rate policy until the achievement of stable price levels—in effect, until clear and sustained inflation was observed.

To shrink the risk premium, the Bank of Japan initiated purchases of private financial assets, including commercial paper, corporate bonds, ETFs, and Real Estate Investment Trusts (REITs). It is common for central banks to focus on buying government bonds and high-grade securities under QE, ensuring both the safety of the central bank's capital and mitigating distortions within the financial marketsHowever, the Bank of Japan’s initiative to buy higher-risk ETFs and REITs was relatively unique

Following the collapse of the stock market bubble in the 1990s, there had been considerable public pressure for the government and the Bank to intervene in stock purchasing to stabilize pricesIn 2002, the Bank did buy stocks from financial institutions, yet that was merely to reinforce financial system stability rather than as a monetary policy toolTheir ETF purchase essentially put central bank resources into the equity market—a previously untested maneuverLegally, the Bank's purchases faced restrictions outlined in the Bank of Japan Act, as ETFs were not classified within the list of permissible financial assetsNonetheless, a loophole allowed for actions outside the list, provided the approval of the finance minister was obtained in pursuit of established goals.

In March 2013, Masaki Shirakawa stepped down as Governor of the Bank of Japan, handing the reins over to Haruhiko Kuroda, who announced an expansive monetary strategy

Starting in April 2013, the Bank adopted a more aggressive qualitative and quantitative easing approach (QQE), aiming not only to maintain zero interest rates but also to increase the monetary base, targeting an annual increase between 60 to 70 trillion yen, later raised to 80 trillion yen in October 2014. However, Japan’s economic growth and inflation rates remained sluggishIn February 2016, the Bank introduced a negative interest rate, dropping the policy target rate from 0.1% to -0.1%. Despite the short-term rates entering negative territory, the Bank felt that long-term rates were still not aligned with their targets, leading to the introduction of Yield Curve Control in September 2016, which aimed to sustain the 10-year government bond yield near zero, thereby lowering long-term financing costs.

The Pressure to Adopt Easing Monetary Policies

In recent years, Japan seems to have been edging away from a prolonged period of low inflation or even deflation

Starting in April 2022, both the Consumer Price Index (CPI) and Core CPI consistently exceeded 2%, with figures in September reaching 2.5% and 2.4%, respectivelyThis revitalization has emboldened the Bank of Japan to consider tightening monetary policiesIn March of this year, it set the policy rate between 0-0.1%, not far from zero but akin to breaching surface tension after nearly eight years of negative interest rates and yield curve controlFurthermore, in July, they increased the policy rate to 0.25%. The Bank’s March policy statement asserted that achieving the 2% price stability target sustainably and stably appeared attainableRecently, Japan's largest labor union, the Rengo, reported that average salaries for formal employees increased by 5.1% for the 2024 spring labor negotiations, marking the highest rise in 33 years, which is significant for maintaining Japan’s inflation rate at a reasonable level

This scenario stands in stark contrast to the inflationary landscape during Shirakawa’s presidency.

Since the late 1980s, Japan has grappled with persistently low inflation rates, teetering on the brink of deflation especially after the asset bubble burstA low price level represents a chronic ailment for Japan’s economy—unlike a life-threatening condition but very difficult to remedy—afflicting it for decadesFrom a monetary quantity theory perspective, it is clear that benign inflation suggests insufficient money supply in the economy—a sentiment echoed by critics who assert the Bank of Japan has not pursued sufficiently aggressive monetary policiesNotably, former Fed Chairman Ben Bernanke critiqued Japan's policy in a 1999 article, stating, "Japan is certainly not in a Great Depression, but the economy has been running below potential for over a decade

Policy options exist that could significantly mitigate these losses, yet these options have not been employedTo an outside observer, it seems the Bank of Japan's monetary policy is paralyzed, perhaps self-inducedAstonishingly, it appears the monetary authorities are reluctant to try anything that does not guarantee successIt may be time for Japan to muster some Rooseveltian resolve." Although these comments were made before Bernanke became Fed Chairman and reflected a somewhat presumptuous perspective, his later experiences with the complexities of policy implementation imbued him with a deeper understanding of Japan’s challenges.

During Shirakawa’s tenure, analogous challenges emerged, and indeed, were intensifiedIn response to the global financial crisis, the European sovereign debt crisis, and the Great East Japan Earthquake, the Bank deployed highly accommodative monetary policies; yet, Japan's inflation remained profoundly tepid, at times entering periods of negative price growth

Consequently, members of the Japanese Diet frequently queried, “Why doesn’t the Bank of Japan adopt an inflation-targeting regime?” or “Why not adopt more aggressive easing policies?” There were even proposals suggesting the revision of the Bank of Japan Act to officially incorporate an inflation target into law to compel the bank into adopting more accommodating measuresThe demands put forth by the Diet predominantly called for three things: to set a 2% inflation target; to substantially increase the monetary base in pursuit of that goal; and to clarify the timeframe for achieving these targets.

In December 2012, Shinzo Abe secured re-election as Prime Minister, and his party’s campaign platform explicitly embraced a 2% inflation target, implying that revising the Bank of Japan Act could be an optionDuring a February 2013 hearing, Abe expressed to the Diet: “We must decisively execute accommodative monetary policies; the Bank of Japan must vigorously pursue monetary easing

It is our responsibility as a central bank to ensure the 2% price stability goal is achieved.” Shortly after Abe's statements, Shirakawa unexpectedly resigned nearly a month prior to the end of his term, concluding almost five years in the roleUpon learning of Shirakawa's resignation, media inquiries about whether governmental pressure influenced his decision were met with his denial, but the underlying implications were evident.

In addition to the pressure arising from the necessity to elevate price levels, the Bank of Japan occasionally faced demands stemming from fiscal imperatives to undertake certain actionsFollowing the catastrophic earthquake in March 2011, lawmakers pushed for the Bank to directly purchase government bonds, with some claiming Japan was facing a “national crisis,” thus necessitating extraordinary measures

Nevertheless, Shirakawa withstood the pressure, categorically refuting the calls for bond purchases.

Tail Risks and Their Challenges to the Financial System

On March 11, 2011, at precisely 2:46 PM, Japan experienced an unprecedented 9.0-magnitude earthquake, which unleashed a tsunami and triggered the Fukushima Daiichi nuclear disaster—Japan's most significant crisis since World War IIAccording to data from the Japanese Ministry of Health, Labor and Welfare, the earthquake and subsequent tsunami caused nearly 19,000 fatalitiesSuch natural disasters directly threaten lives and property, and secondly, disrupt the normal functioning of societyRegardless of the magnitude of a calamity, if its repercussions are brief, human society typically reverts to its normal trajectoryHowever, how a society responds to a disaster impacts its ability to return to its original path and whether that route diverges from the pre-disaster norm.

Natural disasters are a risk that human society continually faces but cannot circumvent

Every nation grapples with various natural disaster threatsHistorically, significant calamities have even led to the downfall of entire dynastiesThe Japanese earthquake raised fundamental issues, such as how societies, businesses, or financial institutions manage risks during these catastrophesDifferent entities perceive and handle disaster risk diversely—individuals may face loss of life and property, while companies might see their operations disrupted, risking bankruptcy, and financial institutions encounter significant risksRecently, countries have begun examining how financial systems can effectively respond to challenges posed by extreme climate events, integrating natural disaster risks into the framework of macroprudential policies.

For central banks, the primary post-disaster responsibility is maintaining the orderly functioning of the financial system by providing liquidity to financial institutions and ensuring the availability of payment and clearing systems to sustain financial services

For example, after a disaster, the risk-averse sentiment among investors or financial institutions typically spikes, which can elevate risk premiums in financial markets and subsequently depress economic activityCentral banks need to implement measures to mitigate unexpected surges in risk premiumsAdditionally, in a context where cash transactions might be necessary due to power outages or system failures during disasters, banks must ensure they have an adequate supply of cash ready to deploy swiftly in affected regions.

From the perspective of market-driven financial institutions, securing the safety and resilience of assets amid the shocks of natural disasters is crucial to ensuring continuous operation and minimizing adverse externalitiesFor banks, the safety of their assets (loans) hinges upon the degree of disruption faced by the businesses they serve

If companies encounter bankruptcy risks due to disasters, the banks’ loans are likely to defaultWhen a substantial portion of a bank’s loans is concentrated in a region severely impacted by a natural disaster, the overall quality of those assets could plummetHence, banks should incorporate disaster risk management into their operational strategies and implement preventative measures such as insurance to curtail potential losses.

Critical Lessons from Japan’s Economic Development

In psychology, the term "cognitive dissonance" refers to the tendency for individuals to disregard contradictory evidence unless overwhelmingly evidentConversely, people tend to pay particular attention to data that aligns with their pre-established paradigmsThis characteristic of human nature can also be viewed as a vulnerability

Since the late 20th century, Japan’s developmental trajectory serves as an objective reality; however, different nations, alongside their unique perspectives and predetermined frameworks, might misinterpret Japan’s insights or lessonsFactors such as incomplete information often cloud the external perception of conditions in Japan, leading to missteps in summarizing experiences and lessonsShirakawa identifies several lessons or insights from Japan's experience that could be particularly beneficial for other countries and regions.

Firstly, it’s crucial to recognize that prolonged economic growth on an "unsustainable" trajectory will inevitably trigger adjustment mechanisms, leading to sluggish long-term growthThe asset bubble in Japan during the late 1980s exemplified unsustainability, with its collapse unleashing severe side effects on the economy

Preceding the global financial crisis of 2007-2009, the U.Seconomy also exhibited similar unsustainable trends, which dilutes the justifications used by bodies such as the Federal Reserve to advocate a hands-off post-crisis attitudeThus, the need to address economic or financial divergences from the conventional path is paramount to prevent further straying from the proper course.

Secondly, longer-term growth trends are driven not by nominal variables like prices or currency but by real variables such as productivity, innovation, and the working-age populationIf an economy languishes in slow growth, probing the structural factors behind that stagnation is vitalShirakawa's assertion holds merit; while economics often employs a framework differentiating short-term from long-term analysis, stark divides between these terms can be problematicEconomic discourse frequently asserts that monetary variables lack neutrality in the short-run yet trend towards neutrality over time, yet these short-term variables indeed contribute significantly to the long-run trajectory.

Thirdly, it is crucial to acknowledge the severe effects of rapid aging and declining birth rates

Human actors fundamentally underpin economic operations; changes in population size and age distribution profoundly affect all dimensions of an economyJapan's demographic shifts offer lessons worth studying deeply by other nationsHowever, as Shirakawa astutely observes, without experiencing issues first-hand, societies struggle to internalize the lessons from othersRegrettably, by the time individual nations confront similar challenges, it can often be too late to act effectively.

Fourthly, it is vital to acknowledge the limitations of self-awareness, accepting that our understanding of economic and financial systems is profoundly inadequateEconomics and society constitute a complex "adaptive system." When external shocks occur, economic participants must adapt their behaviors, but if all participants are homogeneous, outcomes might be predictable

Given the diverse nature of economic participants, the consequences of a shock become unpredictable; accordingly, this lesson calls into question the certainties often associated with economic forecasts.

An Objective Assessment of Monetary Policy

Relative to fiscal policy, monetary policy's transmission effects are prolonged and fraught with evident uncertainties and lags, particularly during economic downturnsLoose monetary policy can sometimes feel akin to trying to push an object with a rope, reflecting instances where efforts yield little tractionStill, in periods of recession, society often anticipates immediate policy effects, prompting potentially one-sided evaluations that criticize monetary policy as insufficiently expansive; this reflects the societal dominance challenge articulated by Shirakawa

He believes that due to the inherent delays in monetary policy’s effects, evaluations should account for broader temporal horizons or cross-cycle assessments of actual outcomesThe pre-and post-global financial crisis assessments of Alan Greenspan serve as a pertinent example; while Greenspan’s policies were hailed before the crisis, he found himself vilified after the upheaval, with prior strategies becoming targets of derision.

Monetary policy remains a crucial economic tuning tool, yet it’s not an unconditional panaceaAdjustments in monetary policy do not guarantee economic responses; moreover, many economic and financial dilemmas cannot be resolved solely through monetary measuresThus, casting blame for monetary policies that fall short of expectations is misplacedMilton Friedman articulated the function of monetary policy during his presidency of the American Economic Association in 1968; his insights, although decades old, retain distinct relevance today

"The first and foremost lesson history imparts about the role of monetary policy is that it can prevent currency itself from becoming a primary catalyst for economic fluctuations... To mitigate the potential for financial institutions slipping into functional decline, it’s imperative that the monetary authorities actively exercise their mandates to enhance institutional performance and efficiency... Another critical function of monetary policy is to lay a robust economic foundation... By ensuring that producers, consumers, managers, and employees can anticipate average price levels within a predictable range—ideally a stable one—the economic operational system can achieve optimum efficiency."

In this statement, Friedman delineates three levels of meaning: the first asserts that monetary policy must ensure adequate monetary supply growth—not overly expansive, yet not excessively tight—fostering a conducive monetary environment for economic activities; the second centers on the central bank's critical role in preserving financial stability, a responsibility that diminished before the global financial crisis but regains importance post-crisis; the third emphasizes maintaining price stability to enhance market participant expectations, thereby improving economic efficiency.

Ultimately, economic fundamentals drive financial realities, underscoring the necessity for central bank operations to adapt to prevailing economic contexts while not discarding foundational principles such as maintaining price and financial stability, and fulfilling lender-of-last-resort responsibilities