Policy Responses of Japanese Authority

4.1 Early 1970s

Under the economic expansion during the late 1960s, Japan’s wholesale prices started to rise and concern about inflation emerged. In order to curb inflation, Japan enforced a tight monetary policy in 1969 and 1970. However, this measure only ended up further widening the trade imbalance. Then, from mid-1970, Japan aimed to stimulate the economy and reduce the trade surplus by adopting expansionary monetary and fiscal policies. However, these policies had no impact on the trade imbalance, which remained from the past phase of economic expansion. Despite the drastic adjustment in the exchange rate through the Nixon Shock and the Smithsonian Agreement in 1971, a loose monetary policy continued in 1972 and Japan faced serious inflation in 1973. High growth of the money supply through the BOP surplus and the first oil crisis in late 1973 aggravated the situation.

After World War II, the Japanese economy had been primarily led by exports and investments made by the exporting industry. Both political and business circles therefore had a strong allergy to the appreciation of yen, which threatened to make the traditional growth pattern totally ineffective. In the late 1960s through the early 1970s, when international transactions started to be liberalized gradually, Japan faced a dilemma between external equilibrium (i.e., BOP balance) and internal equilibrium (i.e., economic growth with full employment and no inflationary pressure). Due to the aversion to yen appreciation, Japan pursued stimulative economic measures to improve the external imbalance while trying to contain the pressure of appreciation on the yen as much as possible. In other words, what Japan pursued was traditional “adjusted inflation,” namely trying to achieve external equilibrium by raising domestic prices under a pegged exchange system, instead of moving to a floating exchange rate. Perhaps Japan should have floated its exchange rate earlier to achieve external equilibrium. Such a policy measure might have somewhat eased the subsequent inflationary pressure. We could summarize that this was an issue that economic theory later on explained as a trilemma among ensuring free international capital transactions, maintaining the independence of monetary policy, and keeping a pegged exchange regime.

4.2 Mid–late 1980s

Following the sharp appreciation of the yen after the Plaza Accord, serious concern re-emerged regarding the adverse impact of the appreciation on economic activities. To address this concern, Japan followed a loose monetary policy from late 1985 to early 1987. From mid-1987 to 1989, although policy makers seemed to be aware that the loose monetary policy might be excessive and did try to tighten the policy, the monetary policy continued to be loose until 1989. Consequently, the “economic bubble” was created in the late 1980s and after its collapse, Japan underwent a recession for quite a long period of time, so long that it is referred to as the “lost decade.” Certainly no single factor can explain the bubble’s creation. However, had monetary policy been tightened earlier, as the monetary authority perhaps originally intended to do, the bubble would have been smaller and its aftermath might have been less extensive.

Then, why did the monetary authority miss the chance to change the policy? After the Plaza Accord, the importance of policy coordination was emphasized among the G-7 countries, and the Japanese authority was also heavily influenced by the commitment to policy coordination when it worked out its economic policy. It seemed that the Japanese authority felt a strong pressure for Japan to increase domestic demand by keeping a loose monetary policy and try to reduce its current surplus. On the other hand, like the previous period when the yen had appreciated, a serious concern existed about the impact of the appreciation on the economy, and it was recognized that one of the primary goals of the monetary policy should be to stabilize the yen exchange rate. Since the consumer price index (CPI) at that time still remained stable, the public did not necessarily share the concerns about the overheating of the economy and inflationary pressure. Additionally, the prevailing argument at that time was that since IT- and R&D-related business investments accounted for the increase in business investments, much worry about the possibility of over capacity of the production lines was unnecessary.

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