Japanese debt monetization before zero interest rate policy: Intent, extent, and method

This paper investigates three empirical issues involving the monetization of Japanese government debt in the period 1962-97.  This is an interesting period in the political economy of Japan’s monetary policy since it precedes the April 1998 implementation of the new Bank of Japan (BOJ) Law which granted the BOJ de jureautonomy from the Ministry of Finance (MOF) and Japanese politicians.  This period includes several instances of dramatic increases in government debt, but excludes the post-1997 period of the Zero Interest Rate Policy (ZIRP). 

Three questions are addressed in this paper.  The first question involves the intentions of the monetary authorities.  Was it the intentof the BOJ to monetize deficits in spite of legal (balanced budget) constraints and claims to the contrary?  To the extent monetary policy responded to budget deficits, was the policy action a direct result of exogenous political pressures or was it an indirect and unintended consequence of macroeconomic stabilization efforts?

The second question is the extent to which government bonds have been monetized in the postwar period.  Was the conservative rhetoric of Japan’s pre-1998 monetary authorities reflected in actual monetary experience? 

A third question is the methodby which budget deficits are monetized.  It is generally presumed that monetization results from open market operations by the central bank.  Another possibility in the Japan of this period, however, is that monetization occurs as a result of the absorption of government debt by private banks, perhaps at the prodding of the monetary authorities.  This later case was a distinct possibility during this “convoy period” since Japanese banks and the BOJ were subjected to administrative guidance by the powerful MOF.

Reactions functions for the call rate, the monetary base, and money supply were estimated to elucidate the behavior of the BOJ.  No convincing support was found for direct monetization in any of the sub-periods examined.  The behavior of the call rate the BOJ’s operating target, suggests that monetization was most likely an indirect byproduct of macroeconomic stabilization rather than the intent to monetize government debt.  Concerning the extent of monetization, a statistically significant, but economically modest, correlation was found between the growth rates of debt and money in the post-1975 period.  The methodof monetization, however, was through bond absorption by private banks and the non-bank public, rather than expansion of the BOJ balance sheet. 

Key words:  Monetization, government debt, Bank of Japan, macroeconomic stabilization