Monetary Policy, Deflation, and Economic History: Lessons for the Bank of Japan

The paper discusses Bank of Japan policy during the 1990s, especially the late 1990s, in the context of the historical experiences of the United States, Sweden, and Japan in the 1930s. Sharp differences exist between Japan in the 1990s and the 1930s environment; however, this paper takes the position that there are qualitative similarities which cannot be ignored in terms of financial distress, downward price trends, debate over appropriate central bank policy, and how legal independence may constrain appropriate central bank policy. The paper reviews the evolution of views about policy targets from the 1930s to the present to show how price stability reemerged as the primary policy target. Evidence on the success central banks have attained in achieving price stability is reviewed. The evidence shows that claims central banks have overemphasized controlling inflation at the expense of deflation are incorrect with the exception of Japan. The paper reviews the role of the Federal Reserve in the 1930s to show that failure to prevent deflation during the critical 1929?33 period had adverse impacts on the economy and resulted in rendering the Federal Reserve de facto dependent on the government despite its legal independence. The paper then considers the experiences of Japan and Sweden in the 1930s to provide counter-examples of how the U.S. economy might have responded to central bank policy designed to prevent deflation. In both cases, policies explicitly designed to reverse the downward movement in prices reduced the economic and financial distress in those countries compared to the United States. The paper draws implications from the historical record for Bank of Japan policy and suggests that more aggressive action would have been appropriate in the 1990s and that further institutional change toward inflation targeting should be considered.