While much of the world’s attention has been focused on the U.S. Federal Reserve’s attempts to rescue the credit markets, a drama involving the Bank of Japan is also playing out. A contentious battle between the two major political parties has left the BoJ without a leader. Toshihiko Fukui’s five year term as governor of the Bank of Japan ended on March 19th with no replacement in sight — and unlike the recent appointments in the UK and Canada where leaders of the Banks were announced many months in advance.

A brief summary of current events

Prime Minister Yasuo Fukuda has been unable, after two tries, to name a new governor for the Bank of Japan. The opposition Democratic Party of Japan (DPJ), which controls the upper house of the Diet, has said that the primary reason for their opposition was the candidates’ backgrounds at the Ministry of Finance which they feel, would hurt the BoJ’s independence. The upper house rejected Fukuda’s proposal to promote outgoing deputy governor Toshiro Muto as governor and to appoint economics professor Takatoshi Ito because of their MoF experience. Fukuda stunned analysts when he again nominated a former Finance Ministry official, Koji Tanami, to be BoJ governor. As widely expected, he too was rejected.

A political debate about Japan’s monetary policy is also growing. After years of interest rates at zero to counter deflation, Mr. Fukui had hoped to leave office having “normalized” monetary policy — that is he had hoped to bring rates up to Japan's nominal growth rate of 1.5 percent to 2 percent. But he managed to boost rates to only 0.5 percent before the U.S. credit crises and signs of a cyclical slowdown in Japan made further increases politically objectionable. Now, most analysts assume that the BoJ will not be able to raise rates again until the Federal Reserve does so — whenever that might be. Some economists say that Japan's low interest rates have not boosted the economy. For example savers, earning poor returns, have depressed consumption. Higher interest rates would have put money in people's pockets while also breaking Japan's deflationary mindset.

Pressure for BoJ nomination

On March 21, Masaaki Shirakawa, a deputy governor of the Bank, assumed the role of acting governor and said the central bank’s priority would be to tackle unstable global financial markets. Mr. Shirakawa now faces a worsening global credit crisis, a sharply appreciating yen and a slowing economy. These factors could raise pressure on the BoJ to consider a cut in interest rates, currently at 0.5 percent. As one of the board members who played a key role in the central bank’s departure from its super-easy monetary policy, Mr. Shirakawa’s views are believed to be close to the mainstream and observers do not expect him to lower interest rates soon. He also pledged to steer monetary policy flexibly to help a slowing Japanese economy but gave no clear hints on whether the banks would cut rates anytime soon.

About the BoJ

Like other central banks, the Bank of Japan’s primary objective is to maintain price stability, even though it has no official inflation target, and to provide the foundations for sound economic growth. Unlike other central banks, the Bank has been fighting deflation or falling prices rather than keeping a lid on price increases or inflation. About five years ago, the BoJ launched a monetary experiment — a so-called “quantitative easing” policy, which basically meant that they printed lots of money in an unorthodox approach to ridding the economy of deflation.

Although the Bank has been around since the end of the 19th century, it initially fulfilled a very limited role as the government’s banker and currency issuer. It has only been “independent” since 1997, with most of the ensuing years spent trying to squirm out from under the Ministry of Finance’s thumb. The Bank is zealous in protecting its independence, which was gained at the time of Japan's big bang — a major overhaul of the financial markets and the institutions that oversee them.

There has been the inevitable friction between the Bank and the MoF — they have differed on what policies were needed to tackle deflation as the BoJ tried to invoke its independence. The Bank maintained a zero interest rate policy because of poor Japanese economic performance that was exacerbated by deflation. Furthermore, it swore that it would not increase rates until its inflation measure (year-on-year percent change in the core measure of consumer prices that excludes perishable foods) was positive for a considerable period of time.

But as the economy finally began to grow and price declines diminished, a major difference of opinion emerged. Politicians led by the then prime minister Junichiro Koizumi were concerned that an interest rate of any sort would stifle Japan’s economic expansion. Government officials were also worried that any increase in borrowing costs would escalate the cost of servicing its huge fiscal deficit. They suggested that the GDP deflator rather than the CPI should be used as the measure of deflation — and on that score, Japan is still very much ensnarled in deflation. Financing costs alone absorbed over 22 percent of Japan’s budget in 2005, while the nation’s budget deficit swelled to an estimated 151 percent of gross domestic product for the fiscal year that ended on March 31, 2007.

Japanese asset bubble explodes

During the 1980s, people around the world were amazed by the inflated value of Japanese financial assets. Current account surpluses soared, the yen was strong and asset values (land and stocks) skyrocketed. Japan became the world’s largest creditor nation as they invested worldwide in virtually anything, including (and especially) golf courses. Japanese banks and securities companies expanded worldwide, and Japanese banks monopolized the upper end of the world rankings in terms of assets. Stock trading and other financial businesses were very active, and foreign banks and securities companies all wanted to do business in Japan. At that time, Tokyo became the biggest financial center in Asia and was expected to become one of the world’s three major financial centers, together with New York and London. But when the asset price bubble burst, asset prices spiraled downward and brought new woes to Japanese banks that were unlike anything they faced in the post-war growth era. In the 1990s Japanese banks, beset and overwhelmed by bad loans, were forced to undergo cataclysmic changes. Many observers have suggested that the U.S. has a lot to learn from the Japanese experience.

Many banks collapsed under the weight of their bad loans, even though massive amounts of public funds were injected into the banking system. Capital bank management was drastically streamlined and businesses were shed, while others merged or consolidated. And red ink ruled year-end financial results. Needless to say, these events transformed the banking industry, as did the liberalization and globalization that characterized Japanese banks in the 1980s. It eventually culminated in the Financial System Reform Law of 1992, the unveiling of the 1996 Japanese Big Bang and the ongoing reshuffling of the industry. At the same time, the Ministry of Finance was completely reorganized and the way it was supervised was drastically changed. The economic collapse and the ensuing financial industry reforms were pivotal to the Bank of Japan. In the process of the reforms leading to the Big Bang, the Bank also gained more independence from the finance ministry.

Bottom line

Last week the Japanese Upper House of the Diet — led by the DPJ and other opposition parties — rejected the Fukuda government’s second candidate to become BoJ governor, creating a vacancy that will be filled temporarily by new Board member Masaaki Shirakawa. Although this may have little impact on monetary policy decisions and daily operations, the perception of political paralysis contributes to the prevailing mood of uncertainty about the Japanese economy. Another proposed candidate, Kiyohiko Nishimura (a current BoJ board member and former University of Tokyo professor), was accepted as a deputy governor. This leaves two vacancies on the nine member policy board, including the governor. In the meantime, Masaaki Shirakawa (an ex-BoJ official), who was already approved by both Houses as deputy governor, has been appointed as the acting governor.

The Bank of Japan is not the only major central bank operating with fewer monetary policy committee members than authorized. The Federal Reserve is currently down two governors while a third remains on the Board of Governors even though his term has expired. Rules allow the board member to remain until a replacement has been nominated. And the likelihood of the nominees being approved appears to be slim to non-existent until a new U.S. president is elected. Regardless of staff, this leaves the Board short of expertise in a critical time. And like Japan, the appointment of Fed officials has been politicized and not for the first time.

Anne D Picker is the author of International Economic Indicators and Central Banks.