Michal Lerner

In the March issue of Labour Affairs I described the operation of the UK and US central banks.  In this article I will look at the central bank of Japan.

But first a word on terminology.  There will be many references to ‘reserves’ and ‘reserve accounts’ in the article.  Reserves is just another name for money.   Reserve account is the name given to the accounts which institutions, such as commercial banks like NatWest and Lloyds, hold at the central bank.  Although a reserve account just holds money, it is useful to distinguish accounts held at the central bank from accounts held at commercial banks, hence the habit of referring to them as reserve accounts.

The Bank of Japan (BOJ) is Japan’s central bank, responsible for issuing currency, maintaining financial system stability, and implementing monetary policy to achieve price stability.

Foundation

The Bank of Japan was established in 1882 under the Bank of Japan Act, during the modernization of Japan in the Meiji era. Its legal framework was significantly revised in 1997, granting the Bank greater independence from the government. The revised law came into effect in 1998 and strengthened the BOJ’s autonomy in conducting monetary policy. It’s hardly coincidental that this is the same year that Gordon Brown, as Chancellor in the UK, made similar changes to the Bank of England’s independence.  1998 was probably the high point of the neoliberal era before the dot com crash in 2000, the Global Financial Crisis (GFC) in 2008-2010 and the Covid Pandemic in 2020-2022.

The BoJ’s highest decision-making body is the Policy Board, which determines monetary policy. It consists of the Governor, two Deputy Governors and 6 additional members.  Members are appointed by the Cabinet and approved by the legislature, called the National Diet.

The BoJ is independent in monetary policy decisions.  This means it can take decisions about what rate of interest it will charge, how many Japanese Government Bonds (JGBs) it will buy from or sell to the private sector, etc.  However, despite being legally independent, the BOJ maintains close coordination with the Japanese government, particularly the Ministry of Finance, especially in matters related to financial stability and currency operations.

BoJ and government spending

The Japanese legislative body, the National Diet, equivalent to Parliament in the UK, authorizes all government spending.  Once authorized, the Ministry of Finance manages the payment

Suppose the government decides to fund a public project—say a rail upgrade or disaster reconstruction. The cabinet proposes the budget, and the National Diet of Japan debates and passes it.  What that law really does is authorize the government to make paymentsup to certain amounts for specific purposes.  But at this point, no money has moved yet.

Once the spending is authorized, the operational side begins.  The relevant ministry—say the transport ministry—approves a contract with a private company. When it’s time to pay an invoice, the payment request goes through the government’s accounting system run by the Ministry of Finance.  The Ministry of Finance then instructs that a payment be made from the government’s account which is held at the BoJ.

The Japanese government holds its main account at the Bank of Japan. This is often called the Treasury account or government deposit account.

When the Ministry of Finance authorizes a payment, the BoJ debits the government’s account and credits the reserve account of a commercial bank.  No cash moves physically—this is just balance sheet entries at the central bank.

The commercial bank then increases the amount in the deposit account of whoever the government is paying.

Can anything stop the payment happening?  Yes.  The payment cannot be made if the balance in the government deposit account is not greater than the amount to be paid.  In this respect the behaviour of the BoJ is more like that of the Federal Reserve than that of the BoE.

In the UK, the BoE simply makes the payment.  The government is given an automatic overdraft if the balance in its account at the BoE is insufficient.

In contrast, both the BoJ and the Federal Reserve must first check that the balance in the government’s account at the central bank is greater than any payment to be made before a payment can be made.

At this point, however, the Japanese and US systems diverge.  When the National Diet in Japan authorizes spending, it authorizes, at the same time, the issuing of Japanese Government Bonds (JGBs).

There is no concept of a debt ceiling in Japan, unlike in the US.  A debt ceiling in the US can often delay government payments because when congress authorizes spending it does not at the same time authorise the ‘financing’ of the spending.

One has to be very careful about terminology here.  For instance, when we talk about ‘financing spending’, it sounds like we are asking where does the government find the money.  But that’s not what we mean.

In the US and Japan, the acts of the legislature setting up the central banks require that when a government spends into the economy more than it taxes out (government deficit) then the government must at the same time drain an equivalent amount of reserves from the economy.  Reserves here just means the money in the accounts that financial institutions, mainly commercial banks, have at the central bank.

How can reserves be drained out of an economy?  They can be mainly drained by taxation or the selling of government bonds.  Draining reserves through taxation reduces the private sector’s wealth.  Draining reserves by issuing bonds simply changes the private sector’s portfolio of assets.  Money in reserve accounts becomes interest paying government bonds. One assumes that the private sector would only have made the switch if they thought it would increase their wealth.

The legal requirement in the US and Japan that reserves should be drained does not exist in the UK as a matter of law.  However, since 1985, it has become an agreed policy to drain an amount of reserves that matches any government deficit.

Why is it considered important to drain reserves?  A mandate of all three central banks is to control inflation.  The economic theory that the central banks follow tells them that inflation in related to the level of unemployment, that higher unemployment may be necessary to reduce inflation.  So the central banks may, however regrettable they find it, have to increase unemployment.  A tool they have for doing that is the rate of interest, often called the Bank Rate.  The economic theory they follow tells them that an increase in the Bank Rate will reduce demand in the economy and so create unemployment and thereby reduce inflation.

How does all this relate to the matter of draining reserves?  Imagine a commercial bank has more reserves than it needs, then it will happily lend them to other banks so that it can earn interest on these reserves.  It may be happy to lend them at a rate of interest that is lower than what the central bank thinks is appropriate to meet its inflation target.

So the idea of forcing governments to drain reserves through bond issuance is closely related to the need of central banks to use the interest rate to increase unemployment and so, according to the Phillips curve, reduce inflation.

Recently, since 2006-2008, all these central banks came up with a different strategy for retaining control of the rate of interest.  They opted to pay interest on the full balance of reserves in reserve accounts.  Previously, they had only paid interest on a portion of these reserves, the portion that was required so that the commercial banks met their capital requirements.

It was somewhat fortuitous that the central banks adopted this strategy in 2006-2008 since the Quantitative Easing (QE) that they engaged in during the GFC in 2008 and Covid in 2020-2021 greatly increased the amounts of money in the reserve accounts of the commercial banks.  

However, because interest is now paid on the full balance in reserve accounts, it makes little sense for a commercial bank to lend at less than the Bank rate.

Given this is the case, why is it necessary to drain reserves?  Particularly, if reserves drained through selling government bonds to the private sector are immediately replenished through the central banks buying these same government bonds from the private sector in the secondary market.

We can summarise the current situation as follows.

In the UK, US and Japan, a government deficit leads to an equivalent amount of reserves being drained from the reserve accounts of the commercial banks through the buying of government bonds.  In the US and Japan this happens because the law requires it.  In the UK it is government policy rather than a legal requirement.  The policy is referred to as the ‘full funding rule’.  It was adopted as a policy in 1985.  It could be abandoned without the approval of Parliament.  

But the purpose of the draining of reserves is to ensure that the central banks have control over the rate of interest.  The rate of interest is the main tool they have to increase unemployment and so reduce, according to the Phillips curve rule, the rate of inflation to their target level.

The Japanese National Debt

When governments spend money the wealth of the private sector goes up.  The national debt goes up, in the first instance, by the same amount.  If reserves are drained from the economy via an increase in taxation then the national debt goes down but the private sector is poorer by that amount.  If reserves are drained by selling bonds then there is no change in the national debt since the wealth of the private sector has not gone down.  They are simply rearranging their portfolio, exchanging reserves for government bonds.

In Japan the ratio of debt to GDP is very high at 270%.  Commercial bank reserves are also at an all-time high.  This is somewhat puzzling.  If the government is required by law to drain an amount of reserves broadly equivalent to its spending, how can reserves in the economy be increasing.

Here’s what is happening.  The government spends and reserves increase.  The government issues bonds and reserves decrease.  The Bank of Japan then buys JGBs in the secondary market and reserves increase.  Furthermore, when buying JGBs in the secondary market, the BoJ deliberately pays a price for the bonds which limits the yield on the JGBs to the level that the BoJ thinks is appropriate.  

What is that appropriate level of yield?  But first of all let’s clarify what exactly is the meaning of the yield on a JGB.

A JGB is a piece of paper that promises to pay the owner an annual amount of money for a number of years and then a lump sum.  For example consider a piece of paper that pays the owner £1 each year for 5 years and then a lump sum of £100 after 5 years.  This piece of paper would be called a JGB with a maturity of 5 years.  The total income for the owner will be $105.  Investors will bid for this piece of paper in an auction.  Someone might bid £95, someone else £98.  If you only pay £95 for a piece of paper that pays you £1 per year then the interest rate you achieve is 100/95 = 1.05%.  The interest rate on the piece of paper is 1%.  But because you only paid £95 for this piece of paper your effective interest rate (called the yield) is 1.05%

What determines what investors offer for this piece of paper?  Since 2016 the BoJ has been running a yield control curve policy (YCC).  This policy aims to control the yield on JGBs with different maturities. For instance the BoJ had decided that the yield on a 10 year JGB should be 0% while the yield on a 1 year JGB would be negative.  Why did the BoJ follow such a policy?  Why did it not just let the market determine the yield on government bonds, as happens in the UK and US?

Since about 1990, Japanese consumption and investment have been at a level that would have created unemployment without government intervention in the form of government running large deficits.  By keeping the yield on JGBs close to zero, the BoJ and the finance ministry have been hoping to make investment in Japanese industry attractive since it would likely have a return on investment higher than the 0% yield on 10 year JGBs.  That was the motivation for the YCC policy.  But the private sector has stubbornly remained a net saver.

Recent Developments in Japan

The central banks of the UK, US and Japan have all been preoccupied with controlling inflation, but from very different starting points. The UK and US central banks have been raising interest rates to reduce inflation, while the Bank of Japan has until recently been using ultra-low interest rates to increase it. The contrast reflects Japan’s unique economic predicament. Since the collapse of the property bubble in 1990, Japan’s private sector appears to have lost what Keynes called its “animal spirits” — its appetite for consumption and investment. Households save rather than spend, and businesses accumulate cash rather than invest it. The government has consequently had to run large and persistent deficits simply to prevent this excess private sector saving from causing unemployment. Japan’s national debt, at over 250% of GDP, is the largest in the developed world — yet for most of the past three decades the country has struggled with deflation rather than the inflation that conventional economics would predict from such borrowing.

To stimulate the economy the Bank of Japan adopted, and maintained until 2024, a policy called Yield Curve Control (YCC). Rather than merely setting short term interest rates, the BoJ targeted specific yields across the entire range of Japanese Government Bonds (JGBs) of different maturities, committing to buy as many bonds as necessary to keep yields near zero. The intention was to make borrowing as cheap as possible and discourage the hoarding of savings. At best, JGBs under this regime were simply a device allowing the private sector to preserve the nominal value of its savings — the BoJ was certainly not going to reward it with significant interest income for the very behaviour, excess saving, that was causing Japan’s economic stagnation.

This is where the interests of global financial markets came into direct conflict with Japanese policy. Financial institutions — pension funds, hedge funds, insurance companies and wealthy investors — want income from their holdings. More precisely, they want rent: a return on wealth derived not from any productive activity but simply from the act of possessing financial assets. Near-zero yields on JGBs denied them that rent. As global interest rates rose sharply from 2022 onwards, the pressure on Japan to abandon YCC and allow yields to rise intensified considerably. Eventually, believing that inflation was sustainably approaching its 2% target — supported by evidence of the strongest wage growth in Japan for thirty years — the Bank of Japan began dismantling YCC in 2024 and has subsequently raised interest rates for the first time in decades.

This shift has created a significant political tension. Japan’s recently elected Prime Minister, Sanae Takaichi, has been an outspoken critic of interest rate rises, at one point describing them as “stupid,” though she has moderated her language since taking office. A protégée of the late Shinzo Abe, she is a strong believer in using fiscal policy — government spending and tax cuts — to stimulate growth when the private sector is unwilling to spend. While she has paid lip service to managing the debt-to-GDP ratio, she has been far less constrained by it than a long succession of UK chancellors who have treated rising public debt as the central economic problem to be solved. Takaichi’s election platform included cutting Japan’s 10% consumption tax — particularly the 8% rate applied to food — to boost household spending and promote growth.

Herein lies the tension. A consumption tax cut would widen the government deficit and require the issuance of more JGBs. Under YCC the Bank of Japan would have absorbed those bonds in the secondary market, controlling the yield and keeping borrowing costs low. But now that YCC has been abandoned, the BoJ is no longer committed to doing so. If it declines to intervene, private sector investors may demand higher yields on the increased supply of bonds — raising the government’s debt servicing costs at precisely the moment Takaichi is trying to stimulate the economy. Japan’s debt servicing costs are already projected to reach around 31 trillion yen in fiscal 2026, roughly a quarter of the entire national budget — a figure that will rise further as older low-yield bonds mature and are rolled over at higher rates.  Takaichi will not willingly accept a situation in which rising bond yields choke off the private sector consumption and investment she is trying to encourage.

How the tension between Prime Minister Takaichi’s expansionary fiscal instincts and the Bank of Japan’s newfound appetite for monetary tightening will resolve itself remains one of the most interesting questions in the global economy.