Japan's Central Bank Dilemma: Navigating Independence in Turbulent Times
When did BOJ become independent and why did CBI matter?
In April 2023, Kazuo Ueda was appointed as the new governor at the Bank of Japan (BOJ), marking a notable change after the previous governor's decade-long tenure. This event has reignited international interest in BOJ, particularly focusing on its ultra-loose monetary policies and its independence.
BOJ’s independence can be traced back to 1998 when it underwent a legal transformation, emerging as an independent central bank. This transformation mirrored a broader global trend in the late 20th century towards granting central banks greater independence.
The impetus behind the global adoption of central bank independence (CBI) can be dated back to the 1970s when governments globally faced a pressing need to combat rising inflation. The prevailing theories suggest that embracing CBI can effectively mitigate inflationary pressures. According to this framework, a credible independent central bank divorced from political influences is capable of controlling inflation to achieve price stability. By contrast, when under political influence, central banks may succumb to short-term monetary stimulus aimed at gaining electoral favour, resulting in artificial economic booms and subsequent harmful inflationary spirals.
However, Japan's experience diverged from this narrative. Despite heightened concerns about inflation due to the 1970s oil shocks, the motivation behind BOJ's independence was not primarily focused on curbing inflation. Data indicates that Japan had been facing low inflation since the mid-1980s, preceding BOJ’s reform. Instead, it was the voter's preferences that drove the establishment of an independent central bank, detached from the Ministry of Finance and other political forces. This move was a response to the cumbersome economic bureaucracy that had led to prolonged policy failures and corruption scandals.
As BOJ also struggled to effectively address deflation, scepticism arose regarding the effectiveness of CBI. Therefore, the support for BOJ’s independence gradually diminished. Despite the legal framework preserving BOJ's independence, interventions in its autonomy increased within Japan's unique political landscape, characterised by the single-party dominance of its Liberal Democratic Party (LDP) and Shinzo Abe’s extended tenure.
Why BOJ’s CBI has been low, especially under Abe’s government?
Data suggests that BOJ lacks independence when compared to other developed economies. Two pivotal yet closely intertwined criteria for evaluating CBI are "political independence" and "economic independence."
In the realm of political independence, the degree to which central banks are permitted to uphold their primary objective, particularly maintaining price stability, comes into focus for most independent central banks. Notably, Article 2 of the Bank of Japan Act explicitly outlines that BOJ is directed at achieving price stability, seemingly indicating a robust political independence. However, it is accompanied by the additional responsibility, as stated in the same article, of "contributing to the sound development of the national economy". This broader obligation suggests a potential need for collaboration with the government to pursue other macroeconomic objectives. Such collaboration may inadvertently provide politicians with justifications to encroach upon the independence of BOJ.
Direct intervention in BOJ’s political independence unfolded with Abe’s return as the prime minister for the second time in December 2012. The notable political pressure exerted on the BOJ explicitly laid out the objective of swiftly achieving a 2% inflation target. While framed as a decisive measure to lift Japan's economy from the deflationary trap, this overly ambitious short-term goal could also be viewed as Abe's strategic move to garner political support and solidify LDP’s position after its rare electoral loss from 2009 to 2012. This political action carries the risk of straying from the primary focus of BOJ's Act, which is maintaining long-term price stability.
Abe's formidable political influence also encroached on economic independence to a certain extent, where economic independence refers to the central bank's ability to freely determine the monetary policy instruments it deems suitable. Upon commencing Abe’s second term in March 2013, he appointed Haruhiko Kuroda as the new governor of BOJ, who then remained in this position throughout Abe’s tenure. While Abe's direct appointment of Kuroda initially raised concerns about BOJ’s political independence, the subsequent implementation of unconventional monetary policies under Kuroda's leadership was viewed as a violation of economic independence. Before Kuroda's appointment, the BOJ's Policy Board had rejected unconventional monetary policy proposals due to concerns about price instability. However, with Kuroda at the helm, these policies were soon implemented, reflecting a shift in the BOJ's stance under his leadership. This indicated that Abe had indirectly intervened in the BOJ's control over monetary policy instruments through the appointment of a governor aligned with his objectives.
The unfortunate irony lies in Kuroda's former position as a Ministry of Finance official—the institution that directly encouraged BOJ's independence due to its historical entanglement with political power.
Is a high-level BOJ independence necessary?
As the low independence of BOJ becomes increasingly evident, a crucial question emerges: What degree of CBI would best serve Japan's economy? The main rationale supporting the Japan's eroding CBI is grounded in the argument that a robust level of independence cannot be assured in an economy struggling persistently with deflationary pressures, as is the case with Japan's economic landscape.
Prevailing literature advocating for robust CBI tends to hinge on the central bank's role in curbing inflation. In the context of Japan’s persistent deflation, however, the conventional tools may turn out to be ineffective. It is further suggested that without a coordinated effort with the government, unconventional measures employed by highly independent central banks could result in unintended negative social and political consequences.
In the context of Japan, there is a growing concern that unconventional monetary policies aimed at stimulating investment may lead to an overheating demand in the economy in the short term. This potential outcome raises worries about the widening wealth gap, as it is anticipated that affluent individuals, primarily involved in significant investments and real estate holdings, would reap the benefits. Meanwhile, citizens facing credit constraints and those who did not invest may not witness much improvement in their asset values but would experience an increase in overall price levels. To address these concerns stemming from the side effects of loose monetary policies, the Abe government devised structural reforms. These supply-side reforms were strategically planned to counterbalance potential disparities. One key focus was on aiding workers, a demographic that typically invests less and holds fewer assets, through labour market reforms aimed at enhancing job security and fostering wage growth. Additionally, acknowledging that the elderly relying mainly on indexed pensions could be adversely affected, the government addressed pension and healthcare issues as part of its comprehensive approach.
Nonetheless, the significance of an independent central bank in achieving the desired price level persists in the long run, relying on the maintenance of credibility, irrespective of whether the economic challenge involves inflation or deflation. Despite implementing aggressive monetary easing measures with the aim of achieving the 2% inflation target, the Japanese economy has failed to meet this objective. This unfavourable outcome is in line with the anticipated results of theories advocating for central bank independence. Such theories propose that a central bank must build sufficient credibility to shape people's inflation expectations and effectively reach its inflation target, otherwise monetary policies geared toward achieving the inflation target will prove ineffective. In the case of BOJ, there seems to be a decline in its credibility, largely attributed to its entanglement with political power and the consequent overly ambitious inflation target. The decline in credibility poses a potential threat to Japan's long-term battle with deflation, as it undermines BOJ's ability to effectively manage price levels.
Overall, in assessing the intensified collaboration between BOJ and the Japanese government, noteworthy achievements were observed in curbing deflationary pressures initially, particularly evident in the positive inflation rates recorded between 2012 and 2015. However, the longer-term perspective unveils a discernible drawback as the BOJ experiences a loss of credibility, reflected in the inflation rate's drop to just above 0 percent from 2016 onward. Several factors may contribute to this decline, including the perceived ineffectiveness of structural reform policies eroding confidence in coordinated economic strategies, potentially setting the stage for a return to deflation. Alternatively, this trend could stem from a growing preference among economic agents for an independent central bank, learned from historical experiences. Therefore, advocating for a more independent central bank emerges as a potentially judicious decision for the Japanese economy.
It is worth noting that absolute political independence is an unattainable goal, even for the most autonomous central banks. The necessity arises for regular meetings between central banks and governments to synchronise monetary and fiscal policies effectively. While central banks have the legal authority to reject the government's preferred macroeconomic goals, the practical dynamics occasionally deviate from this ideal scenario. This ambiguity opens avenues for politicians to exert pressure on central banks, blurring the lines between collaboration and interference.