Reform of the Bank of Japan and Ministry of Finance

Abstract

The central bank, that is, the Bank of Japan, is the focus of this chapter. Although its reform was based on academic works emphasizing the significance of the central bank’s independence, the main political concern was how the power of the Ministry of Finance should be reduced.

1 The Background of Reform

1.1 The Role of the Central Bank

Central banks are said to have two major roles, which most standard macroeconomics textbooks explain as follows. One role is to “oversee the banking system,” and the other is to “regulate the quantity of money.”¹

The central bank is often referred to in Japanese public commentary as the “bank of banks,” reflecting its mission of maintaining the stability of the financial system. It supervises the management of private banks, operates the settlement system among financial institutions, and acts as a “lender of last resort” to financial institutions for the maintenance of an orderly credit system. In the latter role the central bank is sometimes called the “bank that issues currency (issuing bank),” but the bank’s lending activities effectively amount to monetary policy. Historically, it was not uncommon for states to have multiple issuing banks that supplied banknotes; the value of the notes was maintained through their exchangeability (convertibility) with gold and silver. However, today securing a currency’s value depends on the credibility of the government and the issuing bank. The issuance of banknotes has become a monopoly of the central bank, and monetary policy has come to have great significance in maintaining banknotes’ value.

In addition to these two roles, the central bank is also described as “the government’s bank,” tasked with the acceptance of deposits from the government or the disbursement of funds necessary to enact policies.

Through these basic functions, the central bank contributes to economic growth by maintaining price and exchange rate stability, employment, and the macroeconomic stability on which both of these are based. Its primary tool is its ability to adjust the supply of currency (money) through monetary policy. The bank does this using methods including “open-market operations,” through which it regulates the supply of currency circulating in the market (society) by purchasing and releasing bonds and other securities; and the raising and lowering of the “basic loan rate” (also called the official discount rate), which is the interest rate at which the central bank lends to private banks. To simplify somewhat, purchases of bonds, real estate, and other assets (purchase operations) and lowering the basic loan rate increase the supply of currency to the market. When the money supply increases, it stimulates investment and consumption, which in turn stimulates the broader economy, including employment. On the other hand, it can also lead to an increase in prices, since the relative value of money falls. Conversely, if the money supply is reduced, it results in a cooling of the economy and the stabilization of prices.

Since an aim of monetary policy is to contribute to macroeconomic stability, consistency with fiscal policy and the other macroeconomic policies for which the government is responsible can be an issue. For example, if fiscal policy aims to stimulate the economy by expanding public investment, and monetary policy maintains the base lending rate at a high level, the effects of these policies will be offset. However, if there is too much alignment of economic stimulus measures, the currency could depreciate and prices could rise, which could be a blow to people’s livelihoods and external creditworthiness. There has been a long-running debate over what kind of relationship between the government and the central bank is desirable to achieve monetary policy’s goal of macroeconomic stability.

As the fiscal conditions of advanced industrial countries worsened across the board from the 1970s onwards, and the effectiveness of fiscal policy to counteract the business cycle came into doubt, this relationship again came to be recognized as a problem in various countries. This is because there has been a growing movement towards the use of monetary policy to fulfill the government’s responsibility for macroeconomic conditions. This movement was also supported by the idea of monetarism, which was advocated by economist Milton Friedman. Monetarism argued that monetary policy—centered on controlling the money supply—was more effective than fiscal policy in dealing with macroeconomic change, and provided theoretical legitimacy to the use of monetary policy.

1.2 The Bank of Japan Act as Wartime Legislation

The central bank of Japan is the Bank of Japan (BOJ). The BOJ was established in 1882 on the initiative of Matsukata Masayoshi, one of the Meiji government’s leading financial experts. Thereafter, with the Convertible Banknote Act of 1884, the BOJ gained monopoly power over issuing banknotes, thereby establishing itself as the central bank. Prior to the enactment of the Convertible Bank Note Act, many national banks licensed under the National Bank Act issued banknotes, and the government also issued banknotes to finance war expenditures during the Seinan War (also known as the Satsuma Rebellion). However, since many of these banknotes and government notes were fiat money that could not be converted into gold or silver, the value of money was not stable and the credit system was shaky. The BOJ’s monopoly on the issuance of banknotes led to the collection or withdrawal of these fiat currencies and was of great significance for the establishment of a credit system.

Even so, the BOJ’s function at the time centered on serving as the “government’s bank” and an “issuing bank” in the narrow sense. The Meiji state strove to “enrich the country, strengthen the military” (fukoku kyōhei) and “encourage new industry” (shokusan kōgyō) in the process of catch-up modernization. However, this was “small government” by modern standards, with limited responsibility for responding to macroeconomic fluctuations, including the business cycle. As a result, occasions where the consistency of fiscal and monetary policies became a problem were also limited.

The situation changed dramatically during World War II. The Bank of Japan Act was promulgated on February 23, 1942, shortly after the attack on Pearl Harbor and the outbreak of war between Japan and the United States. On May 1, 1942, the BOJ became a corporation on the basis of the new law. The law, which today is often called the Former Bank of Japan Act or simply the Old Act, had the characteristics of wartime legislation. Namely, Article 1 of the Old Act stipulated that the purpose of the BOJ was “to be responsible for the adjustment of the currency, the regulation of finance, and the maintenance and development of the credit system in accordance with the policies of the nation for the proper exercise of the nation’s general economic power.” Article 2 stipulated that “the Bank of Japan shall be operated exclusively for the purpose of achieving the objectives of the nation.” Of course, the BOJ was hardly an independent central bank in the contemporary sense before that time. For example, even with regard to ensuring the convertibility of banknotes, the most important issue for monetary policy at that time—whether to establish a gold or silver standard, or whether to implement convertibility at all—was decided by the government. The Old Act confirmed this when it designated the finance minister as the BOJ’s competent minister and stipulated in Article 30 that “the competent minister … shall determine the limit of banknotes to be issued.” However, the fact that the Old Act stipulated that the BOJ’s functions were to be “in accordance with the policies of the nation” and for “achieving the objectives of the nation” could only mean that it stipulated the central bank’s subordination or submission to the government.

Defeat in World War II was also the beginning of the battle against hyperinflation. A trend had already emerged during the war whereby an increase in government debt, resulting primarily from military spending, was covered by excessive issuance of currency. This could not be cut off after Japan’s defeat, and in the months immediately after the war’s end, the money supply increased dramatically. The BOJ, which since shortly before Japan’s defeat had been engaged in research on inflation in European countries after World War I, attempted to reduce the money supply by freezing bank deposits and switching to a new yen. These measures failed to control inflation, as commodity shortages and an expansionary fiscal policy—necessary for economic reconstruction—undermined the stability of the currency. In the end, tamping down inflation had to wait until the strict austerity measures of the so-called “Dodge Line” were adopted.²

This experience led the BOJ to place greater importance on price stability, particularly on curbing inflation, but calls to revise the former Bank of Japan Act remained limited. There are likely several reasons for this.

First, the BOJ had powerful executives like Ichimada Hisato and Sasaki Tadashi who had subordinated the Policy Board, which had been established by a partial revision of the Old Act in 1949. The BOJ could maintain its effective independence since it could, while using the Policy Board as a shield, make monetary policy decisions internally (at executive board meetings). Regarding the governors, with the exception of Yamagiwa Masamichi from 1956 to 1964, no one from the Ministry of Finance (MOF) was appointed as governor until 1974. Ichimada, Sasaki, and others were appointed from the ranks of the BOJ. Relatedly, the MOF and some politicians sought to revise the Old Act to reduce the BOJ’s independence, which made it difficult to seek reforms that would further strengthen its autonomy. For the BOJ, the priority was protecting the results of the 1949 revision.

Another reason is that this was the period of high-speed growth. Although fiscal deficits emerged in the latter half of the 1960s, their scale was still small and financial resources were relatively abundant. There was also a general sense that public investment by the central and local governments was producing positive results, such as the creation of “new towns” in various areas, the construction of the Tōkaidō Shinkansen and Tōmei Expressway, and urban infrastructure for the Tokyo Olympics and Osaka Expo. Fiscal policy was emphasized as a means of macroeconomic policy, and there were few occasions where linkages or inconsistencies with monetary policy were subjected to strict scrutiny. Supported also by the fixed exchange rate system in international finance, the BOJ did not need to confront the government or the MOF directly, and it was able to conduct monetary policy with an eye solely on domestic price stability.

From the mid-1970s onward, the relationship between the BOJ and the government entered a new phase. As budget deficits became entrenched and their scale expanded, the government began to struggle to manage the national debt. The MOF, responsible for the supervision of private banks, used this influence to make financial institutions form a syndicate to underwrite government bonds, so the outward appearance of the principle of market absorption of Japanese Government Bonds (JGBs) was maintained. However, a scheme in which the BOJ purchased bonds underwritten by the syndicate before maturity through open-market operations had already been established in the mid-1960s. Under this scheme, the increase in the volume of JGBs spilled over into the money supply, leading to rising inflation. A proposal to raise the official discount rate to check inflation is said to have been blocked by Prime Minister Tanaka Kakuei, who called for the “restructuring of the Japanese archipelago” (Nihon Rettō Kaizō) and wanted to deploy expansionary fiscal policy. This inability to pursue anti-inflationary policies due to the government’s own goals recurred during the Bubble Economy of the late 1980s. In the case of the Bubble, the government’s policy of pursuing fiscal retrenchment without tax hikes produced the need for expansionary monetary policy, which led to severe asset-price inflation. This was a bitter situation for the BOJ.³

1.3 Scandals in the Ministry of Finance and the Financial Sector

Although the BOJ is responsible for monetary policy, it is deeply connected to the financial industry—that is, private banks, insurance companies, and the like. The industry, in turn, became closely tied to the MOF in the postwar era. This was because the government approved and registered the establishment of corporations, including those in the financial sector such as banks and securities firms, as well as life insurance and casualty insurance companies. Product development and daily operations also required exchanges of opinion and negotiations with the government. There also existed a supervisory relationship between the MOF and financial institutions, as the MOF regularly inspected the operations of financial institutions for the maintenance of an orderly financial system. The BOJ also conducted similar inspections, but its influence was weaker than the MOF’s. The role of the central bank as the “bank of banks,” as well the stability of the financial system overall, were largely borne by the MOF rather than the BOJ.

From the financial sector’s perspective, building a good relationship with the MOF, the “Ministry Above All Ministries,” had great operational significance. Until the 1970s, financial institutions were still far from the era of global capital mobility, and there was not much room for overseas activities. Companies focused on the domestic market, and there was no choice but to accept the so-called “convoy system”—regulations that greatly restricted competition—and burden-sharing among companies known as the hōgachō system.⁴ These decisions by financial institutions were also based on the belief that these choices could be beneficial in the long run. When the government decided to issue bonds in the late 1960s, it formed a syndicate to underwrite the bonds for the same reason. Additionally, each company assigned a “MOF officer” (MOF-tan or Mofu-tan) to gather information from the MOF and to lobby for policies and regulations that would be favorable to the company. These MOF-tan were elite employees who were often university classmates of career bureaucrats, and becoming a MOF-tan meant being on the professional fast track.⁵

As the 1980s began, the financial sector, which until then had been uniformly in line with tough administrative regulations, began to undergo gradual changes. With the internationalization of corporate activity, private companies that had traditionally raised capital through loans from banks began to raise a greater proportion of their capital through overseas bond issuance and other means. At home, the large volume of JGBs issued from the latter half of the 1970s onward was too much for private financial institutions (which purchased them via the syndicate) to hold, so the MOF permitted the bonds to be sold in the market before maturity, in addition to the BOJ’s open-market operations. As a result, a bond market that was not subject to interest rate regulations was born, but the spread between market and regulated deposit rates was a threat to banks. At the time, these trends—internationalization and bond marketization, referred to as the two kokusai-ka, since the Japanese words for “international” and “government bond” are homophones (both are pronounced kokusai)—gradually led to interest rate liberalization and other forms of deregulation.⁶

The monetary easing that created the Bubble economy proceeded at a time when deregulation was giving birth to competition in the industry. With the abundance of low-interest-rate funds and increased competition, financial institutions developed new products and made huge loans to the real estate and construction industries. In the process, the relationship between the MOF and the financial sector deepened. The highly profitable financial institutions used their ample entertainment funds to wine and dine MOF bureaucrats. There was also a growth in activities that could lead to obviously illegal or fraudulent behavior, such as asking the MOF to adjust its financial inspections or to overlook the fact that loans had become unrecoverable (bad debt). This was behavior that could undermine the stability of the financial system.

The bureaucrats of the time were not subject to an actionable code of ethics, due to a way of thinking akin to Mencius’s theory of innate human goodness. The wining and dining spread not only to the MOF-tan at major banks and securities firms, but also to the real estate industry and non-bank financial institutions, even as the Bubble passed its peak and headed for a dead end. Non-banks are companies that do not accept deposits themselves, but specialize in lending funds procured from banks and other financial institutions. During the Bubble period, loans from banks to non-banks were used to manage funds, and the two were closely intertwined. On the one hand, from March 1990, the MOF had been regulating the total amount of real estate loans through administrative guidance to financial institutions. On the other hand, there is no doubt that its sensitivity to the ill effects of the Bubble was lacking. In 1995, the concealment of large losses by Daiwa Bank’s New York branch, as well as the opaque handling of large amounts of bad debt by non-bank home mortgage lending companies (Jūsen), came to light in rapid succession. This was a sign that the MOF had lost its organizational discipline during the Bubble era, and strong criticism of the MOF spread among the mass media and the electorate.⁷

2 Two Directions

2.1 Global Trends

As we have already discussed, although both the BOJ and the MOF reforms were triggered by the failure of the Bubble economy, they contained two different orientations.

The first was based on the recognition that the excessively loose monetary policy (low interest rate policy) that fueled the Bubble was due to the BOJ’s insufficient independence in setting monetary policy. This orientation led to an emphasis on reforming the central bank system, centered on revising the Bank of Japan Act. The second reform orientation was based on the conclusion that the relationship between the MOF and the financial sector had become too close, and that this had led to delays and inappropriate actions in the disposal of non-performing loans after the collapse of the Bubble economy, and ultimately to a decline in the stability of the financial system. This position emphasized changing the relationship with the financial sector through reforms of the MOF. The difference between the two orientations was whether they considered reforming the BOJ or reforming the MOF as the “core.”

Movements to reform the relationship between the government and the central bank by increasing the latter’s independence were becoming common among advanced industrialized countries in the 1990s.⁸ After the oil shocks of the 1970s, many advanced industrialized countries experienced stagflation, or inflation without economic growth, and the subordination of central banks to governments was seen as a contributing factor.

We have already seen that the central bank is essentially given two goals: price (currency value) stability and macroeconomic stability. However, if the bank is subordinate to a government stressing the macroeconomy, it is easy for price stability to be pushed to the side and monetary easing to be brought into line with government attempts at economic stimulus through fiscal policy. If the effectiveness of fiscal policy is declining, as it was in the 1970s, excessive monetary easing will either lead to a general increase in prices that invites stagflation, or a flow of capital into specific sectors, such as real estate, leading to a bubble. One or the other is unavoidable. As a result of this growing awareness, by the end of the 1980s, a growing number of countries were undertaking reforms to increase the independence of their central banks. Concrete examples started with New Zealand and Ireland in 1989, Portugal in 1990, Italy in 1992, France and Belgium in 1993, and Canada and Spain in 1994.⁹

The Central Bank Study Group, established by Prime Minister Hashimoto Ryūtarō as a private advisory group, advocated revising the Bank of Japan Act in response to this global trend. The decision to establish the study group was made at a June 1996 meeting of the governing party (LDP, SDP, and New Party Sakigake) project team on MOF reform. This project team had already raised the issue of revising the Bank of Japan Act in late March of the same year. However, as of March, the discussion was limited to revitalizing the Policy Board and putting BOJ inspections of financial institutions on a statutory basis.¹⁰ Perhaps because of the highly specialized nature of the central banking system, it was necessary for researchers to study it, and the role played by the governing party project team was smaller than in the case of the MOF reform, a matter which will be discussed later.

2.2 The Central Bank Study Group

The Central Bank Study Group was chaired by Torii Yasuhiko, professor and president of Keio University. Although it was called a “study group,” it was in effect an advisory council tasked with examining the basic direction regarding the revision of the Bank of Japan Act and making recommendations to the government. Other members included Kanda Hideki, a scholar of commercial law; Satō Kōji, a scholar of constitutional law; Tachi Ryūichirō, an expert on public finance who was the chairman of the MOF’s Financial System Research Council; Suda Miyako, an economist specializing in monetary theory; and Fukukawa Shinji and Imai Takashi, from the business world. Additionally, Yoshino Naoyuki, who specialized in monetary theory and was a Keio University colleague of Torii’s (albeit with a different specialty), assisted the team as an expert committee member. Tanami Kōji, who was seconded from the MOF, took charge of the secretariat as head of the Cabinet Councillors’ Office on Internal Affairs (now known as the Assistant Chief Cabinet Secretary). Tanami later returned to the MOF and became the administrative vice minister. After the study group convened for the first time at the end of July 1996, it met two to three times a month—an unusually high frequency for a study group—and complied its final report as early as November 12.¹¹

The final report of the Central Bank Study Group is titled “Reforming the Central Banking System: Toward An Open Independence.” Although not especially long, the report is clear in its recognition of the issues and the measures to be taken.

Namely, it cited the linkages between the collapse of the Bubble economy and the bad debt problem, financial globalization, economic structural reform and administrative reform as issues surrounding the central banking system. On that, the starting point for the study group was, “Amidst these circumstances, doubts have been raised about the state of the Bank of Japan, which is responsible for our country’s monetary policy, and how it has responded to recent changes in domestic and international economic and financial conditions. Even the ruling parties have proposed to review the status of the Bank of Japan.” Its role would be “to conduct an investigation of the most appropriate way for a central bank to be at the core of a twenty-first-century financial system.” As for the specific institutional problems facing the BOJ, the objectives and operating principles of the BOJ as stipulated in the Bank of Japan Act, as well as the lack of clarity in ensuring the independence of the BOJ, “have become out of step with the times.” Not only that, it also noted the problem that “with regard to the monetary policy decision-making process of the Bank of Japan at the present time, it is difficult for the public in general and financial experts in the market to understand what was discussed and how policies were chosen.”

As a response to these challenges and institutional problems, the study group’s final report proposed that the BOJ should ensure two things: its independence and transparency in policy management. These elements together were called “open independence.” The Bank of Japan Act should be revised, the study group said, to clarify that the most important goal of monetary policy is price stability, and to achieve this goal, “the government’s broad authority to issue operational orders should be abolished, and, when making monetary policy decisions, the Policy Board should make the final decision after clarifying its relationship with the government.” It added, “The Bank’s independence should be ensured through a transparent monetary policy making process … As a means of ensuring the transparency of the monetary policy decision-making process, it would appropriate to release to the public a summary of the Policy Board’s proceedings promptly after a fixed period has passed. Furthermore, it is desirable to release to the public the minutes themselves after a suitable period of time.”

Regarding the membership of the Policy Board, which has great influence on monetary policy, the report said that in addition to BOJ officials, the Board should be composed of “persons with a high degree of insight into the economy and finance, rather than industry representatives as is currently the case.” It added:

With regard to monetary policy management, it is necessary to prepare a clear structure to ensure consistency between the Bank of Japan’s monetary policy and the government’s economic policy. To this end, in the event of a difference of opinion regarding monetary policy, a system should be prepared to ensure that the government submits its views to the Policy Board, including requests from the government to the Policy Board to withhold its decision on monetary policy for a certain period of time.

Thus, there was nuance of leaving a certain degree of room for government involvement in the process.

The basic plan of action underlying the Central Bank Study Group’s final report was to revise the Bank of Japan Act, under which the BOJ was strongly subordinated to the government, and to change the relationship between the government and central bank to one that was then becoming the standard in advanced industrialized countries. Although there was some ambiguity regarding the degree of government involvement, the overall direction was clear. In other words, the way that postwar Japan decided monetary policy would be fundamentally changed from opaque decision-making at the behest of the government and “industry representatives” to rational decision-making based on theoretical and systematic knowledge that could be understood by internationalized market participants. It appears that the study group members led the discussions in accordance with their own areas of expertise, and there is a strong sense that they emphasized theoretical or ideological validity. The internationalism and rationalism underlying the agreed-upon term “open independence” can be said to be an expression of modernist ideals, as described in this book.

2.3 Putting Ministry of Finance Reform on the Agenda

The formation and collapse of the Bubble economy was a consequence of monetary policy, attributable to problems with the BOJ, whose independence was not sufficiently guaranteed. However, the attention of voters and the mass media on financial matters was more strongly focused on the close ties between the MOF and the financial sector.¹²

There are several possible reasons for this. First, in 1995 and 1996, it was still not fully understood how serious the bursting of the Bubble and the resulting non-performing loan problem were, or how large the long-term damage to Japan’s economy would be. There was a rampant sense in Japanese society that the financial institutions and “Gentlemen of the Bubble” who profited from soaring real estate prices deserved to suffer. Mieno Yasushi, who served as BOJ governor from 1989 to 1994 and tightened monetary policy by raising the official discount rate and other measures, was hailed as the “Onihei of the Heisei Era” for eliminating the Bubble (referring to a long-running novel series about an Edo-period crimefighter that concluded the year that Mieno became BOJ governor).¹³ In fact, the BOJ was not disconnected from the problems of the Bubble, as evinced by the fact that BOJ officers were arrested in the MOF corruption prosecutions. However, the BOJ at the time was clearly seen as a “good guy,” a brave hero who persevered even though he was not given adequate power.

Another factor is that the scandals led to the eruption of simmering negative feelings towards the MOF, which had attracted the very best of career bureaucrats as the “Ministry Above All Ministries.” A career bureaucrat is a bureaucrat who has passed the National Public Service Type I Examination (as it was called at the time) and is employed by a government ministry or agency. The exam itself is highly competitive, but not all who pass are hired. At most twenty people per ministry per year can find employment as a generalist (law, administration, economics, etc.) career bureaucrat, and almost all are graduates of the social science faculties of the most competitive universities, beginning with the University of Tokyo’s Faculty of Law. In the case of the MOF, career bureaucrats are treated as elites. They become district directors of the tax office while still in their twenties, within a few years of being hired, and almost all are promoted to at least the level of section chief at the Ministry in their forties, with the best of their class rising to the position of administrative vice minister. Thereafter, they are guaranteed comfort through old age via amakudari (“descent from heaven”) appointments to government-affiliated special public corporations and related industries.

This kind of privileged treatment—notwithstanding the tough work conditions endured by civil servants, including intense intra-ministerial competition and health-destroying long hours—had been permitted because career bureaucrats were esteemed as highly competent and extremely capable. They had a clean image of working earnestly for the national interest for lower pay than in the private sector. However, the series of scandals revealed that, at the height of the Bubble, when money worship was at its strongest, or even before, bureaucrats were pursuing their own interests behind the scenes. The MOF, which had restricted the BOJ’s independence and delayed the post-Bubble clean-up, was seen as a villain or even the ringleader of a financial mafia. Of course, a gradual, soft landing for the non-performing loan problem would be beneficial for the economy, and the MOF was probably searching for a way to achieve one. However, this type of argument was almost entirely absent from the mass media at the time, and it was nearly impossible to gain the electorate’s understanding.

Thus, reform of the MOF appeared on the political agenda. For the LDP, there was a reason other than public opinion to take on MOF reform. Namely, when the non-LDP Hosokawa administration was formed in 1993, many LDP leaders had a clear memory of the MOF working closely with Hosokawa and Ozawa Ichirō to raise the consumption tax (by introducing a national welfare tax). The fact that these actions disregarded their longstanding intimate relationship—even though the LDP was out of power at the time—strengthened the mood within the LDP that it was unnecessary to protect the MOF. Mabuchi Masaru, a scholar of public administration, argued that the change in government in 1993 shifted the relationship between the LDP and the MOF from “partner” to “neighbor.”¹⁴

2.4 Formation of a Reform Proposal

In a document released on June 13, 1996, a governing party project team floated the idea of institutionally separating financial administration from inspection and supervision, “in order to conduct strict inspection and supervision of financial institutions.” The MOF, in order to shrink the institutional partition as much as possible and effectively forestall genuine change, appealed to the LDP to separate out only the inspection department, and move only inspection and supervision to an external bureau.¹⁵ However, Kan Naoto and Igarashi Fumihiko, who were the project team’s representatives from the New Party Sakigake, which was part of the coalition government, called for the dismantling of the MOF—including placing the budgetary process directly under the prime minister’s control—and also advocated the complete separation of inspection and supervision. The Social Democratic Party’s Itō Shigeru, who served as the chairman of the governing party project team, also backed the complete separation of inspection and supervision, seeing it as the most feasible substantive plan. Even within the LDP, with Secretary-General Katō Kōichi at the head, there was a view that the financial affairs division (comprised of the three financial bureaus for Banking, Securities, and International Finance) should be completely separated.¹⁶

Competition among political parties was also an important factor. In the 1996 general election, the first under the parallel SMD-PR system, administrative reform was one of the main issues.¹⁷ As we saw in Chap. 4, the New Frontier Party (NFP), which was seeking to win power as the leading opposition party, argued that the LDP was incapable of undertaking administrative reform due to its ties to vested interests. In political science, this pattern, in which a particular party stresses that it alone can address a problem or issue, is called “issue ownership.”¹⁸

The MOF, which was renowned and highly visible but also epitomized the negative aspects of the Bubble economy, was a suitable issue-ownership target for the NFP. The injection of public funds into Jūsen (housing loan or mortgage) companies to dispose of non-performing loans was also strongly criticized in light of the revelation that opaque promises had been exchanged between the ministry and the Ministry of Agriculture, as well as being a waste of taxpayers’ money. The Ministry of Agriculture absolutely wanted to avoid the bankruptcy of the Jūsen, which would be a direct blow to agricultural cooperatives and their members (farmers), as many Jūsen companies had been loaned money by agricultural cooperatives but could not repay it in full. At a symposium held by the Keidanren’s “Business People’s Political Forum” prior to the October general election, the NFP’s Kano Michihiko declared, “As for the administrative reform project team, we would like to start by reforming the Ministry of Finance, which is at the pinnacle of the bureaucracy.”¹⁹

Naturally, the LDP had no choice but to be even more enthusiastic about reforming the MOF. At the same time that the NFP was advocating MOF reform, the LDP was compiling its argument for complete separation of inspection and supervision. Moreover, this separation was to be promoted through the establishment of a highly independent administrative commission akin to the Fair Trade Commission, an “Article 3 Commission” based on the eponymous article of the National Government Organization Act. The term “separation of fiscal and financial affairs” was used at that time. Although the MOF was to retain policy planning functions related to financial administration, the intention was clearly to punish the ministry. The rationality of institutional design was of secondary importance. Journalist Shimizu Masato notes that the LDP’s theory of financial-oversight reform was similar to its approach to administrative reform, in that it focused less on “what kind of financial administration are we aiming for?” than on reorganizing the MOF as a political goal.²⁰

3 Which Was the “Core”?

3.1 Localization as Administrative Reform

As is clear from the previous section, central bank reform in the 1990s featured a twin bill of complete revision of the Bank of Japan Act and reform of the MOF. The next section examines how these two different reforms were carried out.

Even during the process of enacting and implementing the proposed reforms, the focus was on reforming the MOF. After the October 1996 general election, the Social Democratic Party and the New Party Sakigake shifted to extra-cabinet cooperation, but the drafting of legislation took, as its starting point, the reform proposals in the final report of the ruling party project team, which had been compiled before the election. This process can be summarized as the MOF making an all-out effort to roll it back. It did not go well.

The ministry aimed to keep the reform as small as possible and either avoid the separation of inspection and supervision functions or, if separation was unavoidable, place those functions in an agency established within the MOF like the National Tax Agency. In response, the SDP and the New Party Sakigake took separation for granted, and wanted to form a new institution as a highly independent Article 3 commission. The timing of the partition and how to proceed were also points of contention, and the MOF wanted the timing to be as late as possible, or have only the financial inspection function separated in advance. Since it could not of course take the initiative itself, it attempted to exert its influence by having the finance minister and parliamentary vice ministers speak within the ruling party. There were likely countless informal “explanations” by senior officials to relevant members of the Diet.

However, it had become too difficult for a change of course through private discussions between ruling party lawmakers and MOF officials, as MOF reform had become an issue in the general election and was attracting increasing attention and scrutiny from the mass media. From the perspective of LDP Secretary-General Katō Kōichi and others who had been grappling with this issue since before the general election, they could not give the impression of backtracking on an issue of great interest to voters and the media, in the face of a political situation in which two-party competition with the NFP had intensified even as the LDP had retained power.

Katō proposed establishing an agency in the Prime Minister’s Office that would be less independent than an Article 3 commission but completely separate from the MOF. Rather than being a compromise plan, this was based on the fact that, in the case of financial administration, where quick decision-making may be necessary, an independent commission with a collegial system would not work well. As for the separation of inspection capabilities, Katō’s close ally Yamazaki Taku had proposed it, but Mitsuzuka Hiroshi, then serving as finance minister, did not embrace it, and ultimately it did not become a major influence within the party. Above all, Hashimoto Ryūtarō, the prime minister, was committed to the basic direction of reform of the MOF as set forth in the final report of the ruling party project team, which called for an early and complete separation of inspection and supervision functions into a single entity. Hashimoto’s reiteration of this policy on December 2, 1996, largely solidified the direction of reform of the MOF.

Thereafter, discussions were held with the SDP and New Party Sakigake regarding the relationship between the MOF and the Financial Inspection and Supervision Agency, which was to be newly established in the Prime Minister’s Office, as well as how decision-making would work in the event of a financial crisis. There were also calls for discussions with the DPJ, which had emerged as a third party in the October general election, but ultimately the ruling parties reached an agreement on December 24. The agreement included that personnel exchanges between the new agency and the MOF would, in principle, not be allowed, and that the planning function for financial administration, which would remain at the ministry for the time being, would eventually be transferred to the new agency. From the MOF’s perspective, these details were nothing other than a complete failure at defending the institution.²¹

The process of reforming the MOF was similar to the process of reorganizing ministries in administrative reform. Both issues became important points of contention among parties in the October 1996 general election, the first lower house election after the reform of the electoral system, and the promises made at that time continued to bind the Hashimoto administration and the LDP after the election, resulting in a large-scale reorganization that would have been difficult to imagine before. In this sense, a more accurate view is that the reform of the MOF was not part of a set of reforms with reforms of the BOJ, but rather, as Shimizu Masato points out, part of administrative reform. Thus, it may have been a reform without principles, strongly colored by the punishment of the MOF, and insufficient in that it was not accompanied by a debate about what form financial administration should take.²²

However, there is a strong possibility that unless it had been treated as part of the administrative reforms that included other ministries and agencies, the overall reform of the BOJ and MOF described in this book would have ended up extremely close to the status quo. Central banking and financial administration are highly specialized fields, which makes it difficult to attract the attention of voters and the mass media. If the reform policy had been drawn up by a small elite, the MOF would have used its influence to undermine the arguments of the experts, intimidate the BOJ, and would have persuaded LDP politicians to squeeze reform to the smallest possible extent. By being thrown into the middle of inter-party competition as a major part of administrative reform, MOF reform attracted the attention of the public and the mass media and ended up localizing the whole process, including BOJ reform.

3.2 The Idea of “Open Independence” Survives

Compared to the MOF reform, which was conspicuous for the tug-of-war between the ruling party project team and the MOF, the most notable characteristic of central bank reform—centered on the revision of the Bank of Japan Act—was that although there were some twists and turns, it adhered to the professional perspective set out by the Central Bank Study Group.

Following the final report of the study group, revision of the Bank of Japan Act was further studied by the Financial System Research Council. The research council established a subcommittee on the revision of the BOJ Act to deal with this issue in particular. The chairman of the council was Tachi Ryūichirō, a specialist on monetary policy theory and public finance, who also chaired the subcommittee. Although Tachi was also a member of the Central Bank Study Group, the Financial System Research Council itself was an advisory body to the Minister of Finance, and, since the ministry’s Banking Bureau served as its secretariat, it was basically understood to be a venue where the wishes of the MOF could be easily reflected.²³

One focus of investigation became the composition of the policy board and its relationship with the government. It may be natural that senior BOJ officials should be on the policy board, but how many, and what percentage of the total? Should government representatives be allowed to attend as observers, and if so, how many? And can the government, in expressing an opinion on the policy board, also delay a vote by invoking a “right of postponement”? Or can it only request a postponement? In this case, the government effectively means the MOF. Although both of these issues were left ambiguous in the final report of the Central Bank Study Group, what manner of influence the BOJ and the MOF could exercise on the policy board would have great significance for the realization of the BOJ’s independence in monetary policymaking.

Another focal point was the Minister of Finance’s authority to supervise the BOJ and approve its budget. The former Bank of Japan Act stipulated that the Minister of Finance had general supervisory authority over the BOJ, the power to request tasks, the power of on-site inspection, and the power of supervision through the BOJ’s supervisory officer. Thus, it was envisioned that the BOJ would operate as part of the government while being subordinate to the MOF. The right to approve the budget should be considered a natural provision if we think about this kind of relationship between the government and the BOJ, insofar as the fundamental nature of a budget is that of a planning document for an organization’s activities. At the same time, one of the reasons why these provisions that were enacted during the war continued to exist after the war is that if the government were not given the powers of supervision and budget approval, it would mean that the BOJ, which would be responsible for administrative activities such as determining and implementing monetary policy, would not be subject to any kind of democratic control, a situation which would be constitutionally questionable. The BOJ later added a rebuttal to this position, in the report of a study group established at the Bank of Japan’s Institute for Monetary and Economic Studies called the “Study Group on the Central Bank from a Public Law Perspective,” in which administrative law scholar Shiono Hiroshi, commercial law scholar Kanda Hideki, and others participated.²⁴

The initial direction of the Financial System Research Council on each of these points was to preserve a high degree of government involvement. In other words, the basic policy was to give the government the right to defer voting in the policy board, and to large extent maintain general supervisory and budgetary approval powers.

This policy strongly reflected Chairman Tachi’s thinking, which was in accordance with the MOF’s wishes, and the BOJ was greatly dissatisfied. The mass media was also generally critical, noting that the substance of the study group’s investigation was a retreat from reform. Perhaps in response to such criticism in the media, some members of the ruling parties complained that the matter could not simply be entrusted to the Financial System Research Council, which would end up endorsing the small-scale reforms desired by the MOF. The SDP and New Party Sakigake took an especially firm position. This led to an interview by the ruling parties with participants in the Financial System Research Council following a general meeting of the council on December 24, 1997. At that meeting, council members were told in no uncertain terms not to deviate from the final report of the Central Bank Study Group and the agreement of the ruling party project team that was based upon it. ²⁵

The effect of the criticism from the mass media and the ruling parties was significant. Deliberations gradually changed course, as some members of the Financial System Research Council and its subcommittee also took the position that small-bore reforms that reflected the wishes of the MOF were undesirable. The government would have only the right to request the postponement of a policy board decision, and while the right to approve the budget would remain with the finance minister, the minister would have to provide a reason for any rejection, and the scope of the minister’s jurisdiction would be limited. As for supervisory authority, it was decided that only the supervision of legality would remain and that the rest would be abolished. This process was a setback for the MOF’s bid to regain control of its home ground.

However, two points should be noted. First, even if there remained some ambiguity on specific points, the Central Bank Study Group had presented its idea of “open independence” on clear theoretical grounds and in line with international trends, so there always existed a philosophy to which critics of the MOF and its research council could turn. From this came the basic assessment that it was desirable to secure independence for the BOJ. Additionally, because the reform of the MOF—the focus of substantial public attention—proceeded at the same time, the media and ruling party lawmakers did not lose interest in the revision of the Bank of Japan Act. As mentioned previously, although the reform of the MOF was similar to the reorganization of ministries and agencies in the administrative reform, in that it aimed to reduce the power and influence of the MOF, the same choice was made in the revision of the Bank of Japan Act. The retention of power and influence by the MOF was in and of itself considered to be a negative and seen as an obstacle to reform.

In a choice between securing the BOJ’s independence and preserving the MOF’s influence, once there was widespread agreement that the latter was a negative and the former a positive, it was virtually impossible for the MOF to regain its strength no matter what it did. The decisive turning point was that MOF reform became positioned as part of administrative reform—in other words, that it became localized as administrative reform—rather than as reform of the institutions of monetary policy. From the BOJ’s perspective, paradoxically it can be said that it was the depth of its relationship with the MOF, which was its greatest reason for seeking independence, that established a linkage between MOF reform and the revision of the Bank of Japan Act, and allowed the latter idea to survive.

4 What Happened?

4.1 The Bank of Japan Strengthens Its Independence

The reform of the BOJ and the MOF, which began with criticism of, and reflection upon, the scandals and the collapse of the Bubble economy, resulted in far more extensive institutional reform than many parties and observers had initially anticipated. Let us review again.

The revision of the Bank of Japan Act was submitted on March 11, 1997, passed by the House of Councillors on June 11, 1997, and promulgated on June 18, 1997. It came into effect on April 1, 1998. The content of the bill was in line with the conclusions of the Financial System Research Council, its main point being the “open independence” that had been advocated since the Central Bank Study Group in 1996—or, as the BOJ itself explains today, the securing of “independence and transparency.”²⁶ For the BOJ “independence” means monetary policy independence and managerial autonomy. The former refers to the fact that decision-making by the policy board, especially at monetary policy meetings, is not influenced by the government. The latter refers to the fact that the minister of finance’s supervisory and budgetary approval powers have been greatly reduced. Both of these issues were important points for the Financial System Research Council. The substance of “transparency” includes the immediate release of the summary of monetary policy meetings soon after they are held and the release of detailed minutes after 10 years, and the submission of a report on monetary policy to the Diet once every 6 months.

Of course independence remained a focal point even after reform. The appointment of the BOJ governor was a particularly salient issue. Under the Old Act, a custom existed whereby the BOJ governorship alternated between former administrative vice ministers at the MOF and deputy governors at the BOJ. The custom lasted from 1974, when former MOF administrative vice minister Morinaga Teiichirō took office, until the resignation of Matsushita Yasuo in March 1998. With the reforms, a general view emerged that if the new BOJ Act had increased the bank’s independence, it was undesirable to accept a person from the MOF as governor, and that accepting such a person would be a return to “MOF rule.” In particular, the Democratic Party of Japan, which strongly criticized “bureaucratic rule,” continued to thoroughly reject the appointment of an official from the MOF as BOJ governor.

The new BOJ Act stipulates that “the consent of both Houses of the Diet” is necessary for the appointment of the governor, deputy governors, and members of the policy board (Article 23). After the 2007 House of Councillors election resulted in a “twisted Diet,” the appointment of the BOJ governor became an entirely political issue. The term of Fukui Toshihiko, a former deputy governor who became governor in 2003, ended on March 19, 2008, and, as that date approached, the question of who should be the next governor and deputy governor was raised. The House of Councillors was then under the leadership of the DPJ, with the then-ruling LDP and Komeito coalition in the minority, and the chamber rejected several personnel proposals submitted by the Fukuda Yasuo cabinet. In these cases, the reason was that the candidates presented for the governorship—Mutō Toshirō and Tanami Kōji—were former MOF officials. As a result, from March 20 until April 9 the governorship was vacant, creating a situation in which Shirakawa Masaaki, a former BOJ official, stepped in as acting governor. Ultimately, this problem was resolved when Shirakawa was elevated to the full governorship in April by parliamentary consent. Considering the extremely important role that the governor plays in a central bank that has become more independent, it must be said that this was a serious situation.

The BOJ also became more independent in monetary policy. In Articles 1 and 2, the new BOJ Act mandated that the two objectives of the BOJ were “price stability” and “financial system stability.” As we have seen earlier, the stagflation of the 1970s had strengthened the view that central banks needed independence to ensure price stability. The European Monetary Union and the creation of the European Central Bank were also driven by a recognition that inflation depreciated currencies and destabilized the financial system. The experiences of the immediate postwar period and the Bubble period meant that the BOJ shared the view that price stability meant avoiding inflation and stagflation, and that it could choose a desirable monetary policy if it secured its independence. However, since the 1990s, the Japanese economy faced different policy challenges, beginning with prolonged deflation. To address these challenges, a new and non-traditional monetary policy was necessary, but at the time monetary policy was limited to traditional monetary easing, which was inadequate and insufficiently flexible.²⁷

Greater independence meant that the BOJ would also bear more responsibility for monetary policy. While this is only natural since the BOJ is making policy decisions autonomously, there is a clear sense that the bank’s monetary responsibilities have grown excessive relative to the role of fiscal policy. During periods such as the Koizumi and DPJ administrations, which prioritized fiscal discipline and did not pursue aggressive fiscal policy, there was a strong desire to use monetary policy to stimulate the economy. Conversely, when fiscal and other policy measures have been used to support economic recovery, as during the Obuchi administration and the second Abe administration, monetary policy has been criticized for not working in tandem with fiscal policy. The BOJ has fallen into a situation where it is criticized no matter what it does because of its enhanced independence.

Doubts remain as to the extent to which this dilemma was anticipated at the time of the revision of the Bank of Japan Act. The Old Act may have produced MOF “rule” over the BOJ, but it also made things simpler for the central bank: if BOJ officials wished to take the lead in monetary policy, they needed to persuade the MOF and no one else. The BOJ was not adequately prepared to respond to the media, voters, and politicians, who had become sensitive to the economic policy “failures” of the “lost two decades.”

4.2 The Declining Influence of the Ministry of Finance

Reform of the MOF became a policy issue as part of administrative reform and, as such, a major institutional change. The Act establishing the Financial Supervisionary Agency was enacted at about the same time that the Bank of Japan Act was entirely revised.

The Financial Supervisory Agency, which had been established in June 1998 as an external bureau of the prime minister’s office, was cut off from the MOF in terms of both organization and personnel. Subsequently, planning functions related to financial administration were also transferred to the new agency, which became the Financial Services Agency (FSA) in July 2000. Since the Prime Minister’s Office was folded into the newly created Cabinet Office in the reorganization of ministries and agencies in 2001, the current FSA is now an external agency of the Cabinet Office. Since Mori Shōji, the second head of the FSA (counting from its predecessor the Financial Supervisory Agency), there have been officials seconded from the MOF, but directors have transferred fully to the agency before taking up the post and none has returned to the MOF after retirement. Since the reorganization of the ministries, the Minister of State for Financial Services has been placed as the Minister of State for Special Missions in the Cabinet Office, and there are also deputy ministers and parliamentary secretaries in charge of financial affairs in the Cabinet Office, making the FSA effectively akin to an administrative ministry with its own minister.

Significant changes also occurred in the relationship with the financial industry. In 1996, when reform of the MOF was proceeding, another important proposal concerning financial administration was made. This was a document called “For the Revitalization of Japan’s Financial System” by the Action Plan Committee of the Economic Policy Advisory Council in the Prime Minister’s Office. The proposal, dated October 17, 1996, and prepared by the committee’s financial working group (chaired by Ikeo Kazuhito, an economist specializing in monetary theory) took as its starting point, the following position: “Despite the significant changes in the economic and technological environment surrounding Japan’s financial system, it cannot be said that sufficient progress has been made in reviewing systems and practices to respond to these changes.” It argued that Japan should aim to “build a ‘sound and stable financial system’ at the same time as an ‘efficient and innovative financial system.’” As concrete measures, it advocated for greater competition among financial institutions, capital and foreign exchange market liberalization, and a departure from the “administrative guidance in advance” and convoy styles of financial administration. Prime Minister Hashimoto issued a prime ministerial directive on “financial system reform” immediately after the October 1996 general election, and in response, the MOF presented the “Financial Big Bang Plan” in June 1997.²⁸

The Financial Big Bang aimed to increase Tokyo’s presence as a global financial center by reducing government intervention and creating free and competitive markets. The extent to which this was successful is doubtful, as above all else, the issue from the 1990s until the first half of the 2000s was cleaning up the aftermath of the Bubble economy by disposing of non-performing loans. However, there is no doubt that the relationship between the financial sector and the government began to change. The failure of industry giants such as Hokkaidō Takushoku Bank and Yamaichi Securities and the consolidation of financial institutions beyond the boundaries of the former zaibatsu (financial conglomerate) were clear consequences of this change.

Today, it is not at all uncommon to hear criticism that the FSA is returning to its former discretionary powers or that excessive regulations remain.²⁹ However, there is no discussion whatsoever of the influence of the MOF or the “subordination” of finance to public finance. Economic policy, once single-handedly influenced by the MOF, is now clearly divided into fiscal policy, monetary policy, and financial administration, and each should be seen as involving different actors.

4.3 A New Coordination System?

When we consider the BOJ and MOF reforms as part of political reform since the 1990s, how should we understand the separation between actors and the strengthening of autonomy that resulted from the revision of the BOJ Act and the reform of the MOF? It should be noticed that the BOJ and MOF reforms took a different direction from the centralization of power within the central government, which was the aim of the electoral and administrative reforms. Electoral and administrative reforms aimed to limit the number of actors with influence in the policymaking process, thereby realizing faster decision-making and clearer accountability. In contrast, the BOJ and MOF reforms advocated increasing the number of actors involved in economic policy and distributing their influence and responsibility in a more decentralized fashion.

There are two main reasons for this difference. One is that financial-oversight reform became tied up with administrative reform, which had as its two pillars the strengthening of cabinet capabilities and the reorganization of central government ministries and agencies. The aim of administrative reform was to reduce the influence of the ministries and centralize power in the cabinet (prime minister’s office). In the case of the MOF, however, the MOF’s influence was redistributed to the BOJ and the FSA. After the ministry’s influence was reduced, there was insufficient awareness that the BOJ and the FSA should bear responsibility for monetary policy and financial administration, and of what linkages with fiscal policy should be established.

Additionally, a second, related reason can be pointed out: the strong theoretical basis of the BOJ’s increased independence. Namely, envisioning the BOJ as responsible for monetary policy instead of the MOF was consistent with global theoretical trends and was the global standard in the context of the rapidly advancing internationalization of finance. Making institutions conform to international standards was one of the elements that this book’s liberal modernists emphasized in political reform, and so the argument was not in itself out of place.

But the new system has its critics. Fiscal and monetary policy, the two wheels of economic policy, are managed by different actors; the BOJ has increasingly widened this separation by protecting its independence; and a third actor, the FSA, has been entrusted with the task of ensuring the stability of the financial system. The result, some say, is that proper linkages between fiscal and monetary policy have atrophied, contributing to the Japanese economy’s “lost two decades.”³⁰ Many critics have negative views of the BOJ and the FSA. Some even hold the opinion that the BOJ has been the most reluctant of the major central banks when it comes to monetary easing and that it has neglected the yen’s appreciation in foreign exchange markets.³¹ Of course, there are also objections to these views. For example, Okina Kunio, who for a long time played an active role as an economist representing the BOJ, observes that under the Old Act, excessive government influence prevented the adoption of appropriate monetary policy, but the new Bank of Japan Act goes too far in the other direction, focusing too much on the BOJ’s independence and making it difficult to coordinate policy with the government.³² Perhaps the problem is not the BOJ’s policy position but rather its institutional status.

Judging which side of the monetary policy debate is right is not the subject of this book, and should be left to experts. From the standpoint of this book, which attempts to consider political reform as a whole, it is clear that the BOJ and MOF reforms lacked consistency with electoral reform and the strengthening of cabinet functions, and that this inconsistency has reverberated ever since. Reducing the influence of the MOF and attempting the so-called separation of fiscal and financial affairs would have conformed with global trends regarding the institutional arrangement of economic policy. However, at the same time, in the case of broader political reforms that moved towards greater centralization, it also seems to have been necessary to recognize that this produces a serious exception. Even if it is true that the specialist position within the field achieved superiority because it was localized as part of administrative reform and because it was a highly specialized domain, there was not sufficient awareness that this would lead to a mismatch with other domains.

On March 20, 2013, Kuroda Haruhiko succeeded Shirakawa as governor of the BOJ. Kuroda had long been active in the field of international finance in the MOF, and his last post before retirement was vice minister of finance for international affairs. He is the first governor from the MOF in 15 years, since Matsushita resigned in March 1998. On the same day, Iwata Kikuo, a professor at Gakushuin University who had long been one of the harshest critics of the BOJ’s monetary policies, became deputy governor. The other deputy governor was Nakaso Hiroshi, from the BOJ. Although opposition parties still held a majority in the upper house of the Diet, the DPJ, after losing power in an overwhelming defeat in the general election of December 2012, no longer had the strength to rally other parties to oppose the appointment of the BOJ governor and deputy governors.

Led by Kuroda and Iwata, the BOJ laid out a proactively cooperative stance towards correcting the strong yen, the introduction of an inflation target, and making monetary policy one of the “three arrows” of the economic policies proposed by the second Abe administration (Abenomics), which had come to power the previous year. The BOJ also responded positively to the idea of purchasing government bonds to support fiscal policy. Kuroda was reappointed in March 2018, increasing the likelihood that he will remain as BOJ governor until the end of the Abe administration.

At this point, it remains to be seen what Abenomics has brought about and whether the BOJ’s choices in response to Abenomics were appropriate in policy terms. However, there is no doubt that it was a response to the misalignment that existed between reform of the BOJ and the MOF, electoral reform, and the strengthening of the cabinet. The significance of the BOJ and MOF reforms as exceptional decentralization in the midst of centralization is being lost. But this is of course not a return to “Ministry of Finance rule” as in the past. What has emerged is Kantei leadership as a consequence of political reform.