The Alchemists: Three Central Bankers and a World on Fire (11 page)

The United States is a big country that has had its own challenges achieving a unified political system. But consider some of the ways “asymmetric shocks” are handled in a place where the Federal Reserve has to set a single monetary policy for a nation of 300 million people.

When unemployment and poverty are high in one place, the U.S. government funnels money there from more prosperous places. And it’s not just in times of unique economic distress. Some states persistently receive more money from the government than they pay in taxes—particularly those with higher concentrations of people who receive food stamps or unemployment benefits.
In 2005, Alabama paid
, on average, $5,434 in taxes per resident to Washington. But Washington sent back to Alabama $9,263 per person. Much richer New Jersey paid $9,902 per person to the federal government but received only $6,740 in return. Yet American political unity is such that one never sees politicians or newspapers in New Jersey complaining about lazy Alabamans taking New Jerseyans’ money.

The same applies with the United States’ banking system. The agencies that guarantee the nation’s banks—most prominently the Federal Deposit Insurance Corporation—are arms of the U.S. government, not of any given state. So if banks start to fail in one geographical area, the entire country stands behind them.
The bailout of savings and loans
nationwide cost U.S. taxpayers an estimated $123.8 billion between 1986 and 1995 and the private sector another $29.1 billion.
Losses in Texas
—where in the late 1980s savings and loans failed in massive numbers amid a real estate bust and falling oil prices—accounted for about 62 percent of that, according to one estimate. Imagine what would have happened if the federal government hadn’t been in place to rescue the state’s banks. The Texas government would have faced a dire choice: Either let the banks fail, in which case its citizens would lose their savings and the economy would collapse, or bail them out, in which case the state would have been thrown into a fiscal crisis. Texas’s total state tax collections in 1986 were only $10.2 billion. With only those funds available, it would have taken more than nine years for the state to pay for its bank bailout, even if it stopped paying for anything else—schools, roads, public safety. But again, when the rest of the country bailed out Texas banks in the late 1980s, there wasn’t much grumbling among residents of, say, Connecticut.

And when the economy is terrible in one part of the United States, Americans are able to pick up and move to where conditions are better.
In 2007
, for example, 787,000 more Americans relocated from the Northeast to the South than the other way around. That reflects the brighter economic prospects in Sun Belt metropolises like Houston and Atlanta than in fading northern industrial centers like Buffalo and Providence. The Maastricht Treaty ensured that Europeans would have the legal right to relocate in a similar fashion. But moving within the United States is a different thing entirely from, say, emigrating from Portugal to Germany, as much as one might joke about how New Yorkers and Texans speak a different language.

It all boils down to this: Economic unity isn’t just about having the same currency. It’s about having unified political institutions and, more broadly, a sense of cultural togetherness. Europe, argued the Brits and Americans, lacked this. It wasn’t, to use the technical term, an “optimal currency area.”
Barry Eichengreen
of the University of California at Berkeley showed how the economies of different parts of Europe have more variances in their growth patterns than those in different parts of the United States—implying the need for more integration of fiscal policy, not less. In a much-cited 1997 essay, Martin Feldstein of Harvard raised the idea that being yoked to the same currency would actually increase the likelihood of conflict between European nations. “
In the beginning there would be important disagreements
among the EMU member countries about the goals and methods of monetary policy,” wrote Feldstein in
Foreign Affairs.
“These would be exacerbated whenever the business cycle raised unemployment in a particular country or group of countries. These economic disagreements could contribute to a more general distrust among the European nations.” Summing up the conventional wisdom of the Euroskeptics was Paul Krugman, then of MIT, writing in
Fortune:

Here’s how the story has been told
: a year or two or three after the introduction of the euro, a recession develops in part—but only part—of Europe. This creates a conflict of interest between countries with weak economies and populist governments—read Italy, or Spain, or anyway someone from Europe’s slovenly south—and those with strong economies and a steely-eyed commitment to disciplined economic policy—read Germany. The weak economies want low interest rates, and wouldn’t mind a bit of inflation; but Germany is dead set on maintaining price stability at all cost. Nor can Europe deal with “asymmetric shocks” the way the United States does, by transferring workers from depressed areas to prosperous ones. . . . The result is a ferocious political argument, and perhaps a financial crisis, as markets start to discount the bonds of weaker European governments.

European economists were well aware of this sort of commentary. What the Americans didn’t understand, they said, was that the common currency was only part of the story. Europe might not be an optimal currency area
yet.
But the monetary union was one of the steps necessary to make it one; once the euro was in place, all the other forms of integration would follow. As for those European economists who had their own doubts—well, political leaders had a strategy for dealing with them. As Belgian economist Paul De Grauwe explained to the
New York Times
years later, “
The European Commission did invite economists
to present their views. It was a Darwinian process. I was invited, but when I expressed my doubts I wasn’t invited anymore. In the end only the enthusiasts were left.”

With euro enthusiasts in charge, monetary union was on an irreversible course. There were things to negotiate, of course. The new central bank would, at German insistence, be located in Frankfurt rather than in Brussels, where most pan-European institutions are headquartered. It would have a single mandate, to maintain stable prices. (The Fed, by contrast, is charged with maintaining both stable prices and maximum employment.) It would be strictly forbidden from using its ability to print money to fund governments; any hint of Weimar Republic–style monetizing of government debt was
verboten
.

But as that crucial deadline of January 1, 1999, approached, there remained the question of who would run such an institution. And the battle over that answer was characterized by the sorts of nationalistic outbursts, hardball negotiations, and ugly compromises that would haunt the euro many years later. In 1997, the consensus had been that Wim Duisenberg, the head of the Dutch central bank, would become the first president of the European Central Bank. Duisenberg had the particular advantage of being viewed by Germany as sufficiently committed to hard money and monetary independence while also being regarded by the rest of Europe as being sufficiently non-German to be someone it could support. Germany had, after all, gotten most of what it wanted in the structure and location of the ECB. If the first president of the bank had been a German as well, it might as well be called the Neue Bundesbank.

On November 3, 1997
, French president Jacques Chirac made a phone call that threw Duisenberg’s candidacy into doubt. He had decided to nominate Jean-Claude Trichet, Chirac told the prime minister of Luxembourg. With Germany getting a central bank of its own design on its own soil, Chirac demanded that the French get the first presidency, for a single eight-year term. Trichet was hardly ideal from a domestic perspective; his German-style emphasis on low inflation had alienated French politicians on both the left and right. But Chirac was determined to put him forward, for a variety of reasons, ranging from the symbolic (his desire to have a Frenchman in charge) to the cynical (his desire to put his domestic political opponents in an uncomfortable position) to the seemingly irrelevant (his annoyance at liberal Dutch drug laws).

At the start of May 1998, European leaders gathered in Brussels for a crucial final round of negotiations in advance of the launch of the common currency eight months later. Ironically, the man chairing the weekend discussion was one whose government had elected not to take on the euro at all. British prime minister Tony Blair was an enthusiast of forging closer connections with Europe, but his own chancellor of the exchequer, Gordon Brown, had repeatedly found reasons to forestall any commitment.

The compromise that started to emerge seemed promising: Duisenberg would take the ECB presidency for some short length of time before handing it off to Trichet for a full eight-year term. Chirac suggested that Duisenberg retire on his sixty-fifth birthday, in June 2000. But the Dutch were angered at the idea of having their man forced out after a short period. So were the Germans, who saw it as an affront to the idea of central bank independence—after all, the whole purpose of giving the ECB president an eight-year nonrenewable term was so that politicians like Chirac couldn’t micromanage when a new leader takes over.

“
Who is this man
who says we must waste all this time talking about a few weeks longer he stays in the job?” Chirac reportedly said at one tense point in the talks.

“You say, ‘Who is this man?’ He is not someone who just turned up off the street, you know,” retorted Dutch prime minister Wim Kok.

“
Bof!
” snorted Chirac, adding a moment later, “We have already accepted the bank would be in Frankfurt.”

With the French threatening to veto Duisenberg, and the Dutch and Germans threatening to veto Trichet, Blair proposed a compromise: Duisenberg would make a personal and voluntary announcement that he would retire before his full term was out. (As it turned out, he stepped down and was replaced by Trichet in 2003.) The French would get their president within a reasonable time frame, and the Dutch and Germans would get at least the appearance of a central bank independent from politics. As he left the negotiations in Brussels that weekend, Helmut Kohl, among the great statesmen of the postwar period, looked bedraggled, and described the concluded talks as “
the most difficult hours I have experienced in Europe
.”

•   •   •

O
n January 1, 1999, the euro launched, first for electronic transactions, and three years later as a paper currency. Its value was fixed in stone that day: 1.95583 German deutschmarks, or 2.20371 Dutch guilders, or 1,936.27 Italian lira. To make it easier to refer to the new currency, the European Commission ordered up a new symbol, similar to those for the dollar or the pound. Designers settled on a sign that has origins as old as European civilization’s: €, an adaptation of the Greek letter epsilon.

The new currency worked surprisingly well in its first several years, with no major economic downturns and low and steady inflation. But how many years of success had to pass before the “it can’t last”–ers seemed just as wrong as the “it can’t happen”–ers? Choosing a president had been contentious enough—what about fighting the aftereffects of a megacrisis?

Les jeux sont faits, rien ne va plus
.

Masaru Hayami, Tomato Ketchup, and the Agony of ZIRP

W
oodstock, Vermont, is a ridiculously charming New England town of three thousand people, and the Woodstock Inn a particularly quaint destination at its center. On two days in October 1999, however, the group that gathered there was interested in something other than antiques stores and fall foliage. Some of the world’s highest-profile economists and central bankers descended on Woodstock that month to discuss “Monetary Policy in a Low Inflation Environment,” a conference organized by the Federal Reserve Bank of Boston. Among them were a number of the top economic policymakers of Japan—and where they went, so did a surprisingly large contingent of the hypercompetitive Japanese press corps, buzzing around with television cameras and tape recorders.

Most industrialized nations were booming in the late 1990s. But Japan was the big exception. The world’s second largest economy was experiencing the aftermath of a giant property bubble, mired in a cycle of zero growth and falling prices. In Woodstock, the message from American and British economists to the representatives of the Bank of Japan was: This is your fault. You can solve it. But to beat back deflation, you will need to be a lot bolder than you’ve been in the past. One of the speakers, Princeton professor Ben Bernanke, saw a particularly bewildering failure of policy.

“
Extreme policy mistakes were the primary cause
of the Great Depression,” Bernanke said from the lectern at the Woodstock Inn. “And today in Japan one hears statements from policymakers that are eerily reminiscent of the 1930s. . . . There are strong reasons to believe that aggressive monetary expansion . . . could raise prices and stimulate recovery in Japan. But the downside of central bank independence is that, if for whatever reason the central bank seems determined not to take necessary policy measures, there is little that can be done, at least in the short run.”

“Does the technical feasibility of preventing deflation imply that protracted deflation will never occur?” Bernanke asked, before giving his own answer. “No, because we cannot legislate against timidity or incompetence.”

It is hard to overstate the extent to which, in the late 1980s, the economic juggernaut of Japan seemed to be taking over the world. Four decades removed from the end of World War II, the nation was growing faster than the United States or Europe. It was exporting the most advanced electronics and most reliable automobiles in the world. And it was buying land—lots and lots of land.

The things that got people’s attention in the United States—and inspired some jingoistic outrage—were the high-profile acquisitions by Japanese investors on U.S. soil: Rockefeller Center in 1989, Pebble Beach golf course in 1990. But big deals abroad were nothing compared to what was happening in Japan’s domestic real estate market, where the prices of office and apartment buildings in Tokyo and the other major cities were being bid up to unfathomable levels.
It was calculated that the garden around the Imperial Palace
in Tokyo, all 1.3 square miles of it, was worth as much as the entire state of California. The market value of the land in Chiyoda, a Tokyo district with thirty-nine thousand residents in 1990, was equal to that of all the land in Canada, home to twenty-eight million. Rents for residential space in Tokyo were four times higher than in New York City—and the price of residential land was a hundred times higher.

The run-up in prices was a classic case of credit-fueled mania, facilitated by some financial engineering, or
zaitech,
as its Japanese variant came to be called. The savings of an increasingly prosperous nation, one running trade surpluses with the rest of the world, was channeled into Japanese banks. Those banks, in turn, lent to anyone who planned to buy land, which served as collateral. After all, land prices had always gone up in modern Japan. It seemed reasonable to believe they would continue to do so.
Loan officers would even show up
unannounced at companies with which they had no prior business relationship and offer them money for real estate purchases premised on future appreciation.

People dreamed up theories of how the high land prices and extraordinary amount of bank lending made sense: Japan is an island, so its land is finite—yet its capacity for growth is apparently infinite. That analysis overlooked the fact that the appreciation was concentrated in six major cities, and that there remained huge undeveloped expanses of rural Japan that could accommodate further growth.

The Bank of Japan played an important, if poorly understood, role in the economic boom. In the years just after World War II, the Japanese central bank was remarkably powerful, not merely managing the supply of yen in the economy, but also actively making decisions on what major industrial companies could and couldn’t invest in. Governor Hisato Ichimada, first appointed with the approval of U.S. occupiers in 1946, was so powerful that, a colleague once explained, “
He was called Pope
, because under him the central bank’s power was stronger than that of the government.” When Kawasaki asked for permission to build a steel plant, Ichimada answered, “
Japan does not need any more steel
,” adding that “I can show you how to grow [the wild herb] shepherd’s purse there.”

In the years that followed, the BOJ became a more conventional central bank. In the late 1980s, as the speculative bubble was inflating, all that money the banks were pumping out was going to bid up the prices of assets like office buildings and shares of stock—not driving up the prices of rice or gasoline. With inflation well under control, the BOJ saw no need to tighten the money supply, and the boom continued unabated. By 1989, when things were getting truly out of control, the bank finally hiked interest rates, trying to prick the bubble. In hindsight, the action succeeded all too well.

The end of the Japanese bubble wasn’t so much a pop as a fizzle. Soon, the very cycle that had led to ever-rising asset prices and bank lending was working in reverse: Prices for real estate and other assets fell, banks faced losses so they cut back on new lending, and economic growth ground to a halt. In the early 1990s, the Bank of Japan did what a central bank is supposed to do when the economy weakens: It cut interest rates, giving businesses more incentive to invest for the future and consumers more incentive to spend their money instead of save it. But it did so slowly, failing to understand the degree to which the national economy was in peril. It lowered its rate from 6 percent in 1991 to 0.5 percent in 1995. The Japanese economy seemed to improve a bit in 1996 before resuming its fall in 1997.

In a milder version of the deflation that paralyzed the world economy in the early 1930s, prices were stagnant to falling. That made the overhang of debt incurred in the boom years even more onerous, as the yen being used to repay loans were more valuable than those that had been originally lent out. Steady deflation even made the BOJ’s low-interest-rate policies less effective at boosting growth, because it meant that “real,” or inflation-adjusted, interest rates were higher than they would have been during a time of inflation.

On March 20, 1998, Masaru Hayami, a longtime corporate executive who had worked at the BOJ many years earlier, became the central bank’s twenty-eighth governor. It was four days before his seventy-third birthday. He inherited a once booming economy that was mired in nearly a decade of economic stagnation and falling prices. The usual tool a central bank uses to guide the economy was already proving ineffective. What could Hayami-san do to try to fix the Japanese economy? And, more importantly, what
would
he do?

•   •   •

E
conomists call it ZIRP: zero-interest-rate policy. The challenge that Hayami inherited—and which seemed at the time to be a uniquely Japanese phenomenon—was that the Bank of Japan had already cut rates to zero and the economy was still lousy. Cutting interest rates further isn’t very plausible. A negative rate would mean, in effect, charging bank customers to keep their money in savings accounts, and would lead to people taking their money out of banks to avoid that charge.

As Japan started grappling with this problem in the late 1990s, some of the biggest minds in academic economics, both Eastern and Western, started coming up with possible solutions, arguing that the BOJ still had plenty of ability to boost economic activity—if it was courageous enough to act. They pointed out that because the institution had the unique and unlimited ability to create Japanese currency, there was no reason it had to allow the yen to become too dear. The BOJ, for example, could pledge to keep its low interest rates in place for many years to come, or until inflation finally returned to normal levels. If people viewed the promise as credible, the economy would pick up as businesses started charging higher prices in anticipation of higher inflation.

But talk is cheap, and the BOJ could, these economists argued, move more directly to increase the supply of money in the economy. The bank could create yen from thin air and use them to buy things—government bonds, shares of stock, office buildings. The existence of all those extra yen in the economy would create enough inflation to break the cycle of falling prices.
In one story that made its way around the Bank of Japan
and was repeated by economist Richard Koo, but which may be apocryphal, Bernanke visited Tokyo in the early 2000s as a Fed governor and argued that the BOJ could pump yen into the economy by buying
anything
—even tomato ketchup. (Bernanke doesn’t remember saying it and doubts he would have been so flippant. Former BOJ officials interviewed in 2012 had heard about his comment, but none could attest to hearing it themselves.)

Even if Bernanke never used it, the ketchup line gets at one of the basic problems facing a central bank in a zero-interest-rate world: Although the bank has the unlimited ability to create money, getting that money circulating around in the economy isn’t necessarily easy. When a bank raises or lowers interest rates, it changes the price of money in the economy, but it doesn’t determine who gets money and who doesn’t. It doesn’t, in other words, favor the makers of ketchup over those who make mustard—or, for that matter, houses or clothing or automobiles. In theory, choosing winners and losers in the economy is a job for democratically elected officials—for fiscal policy, not monetary policy. Modern societies have generally accepted that it’s a good idea to have unelected economists turning the dials of the money supply. If they start deciding not just the amount of money created but also what it’s used to buy, however, they’ve gone an undemocratic step too far.

In a time of ZIRP, a central bank needs some help from fiscal authorities to spread its newly created money through the economy. Getting it can mean violating the independence from politics that modern central banks hold dear.
Bernanke acknowledged this reality in a 2002 speech
about Japan’s troubles: A central bank, he said, could buy government bonds, and fiscal authorities could then use that money to temporarily cut taxes. It would be a “helicopter drop” of money on an ailing economy.

Later, when critics nicknamed him “Helicopter Ben,” Bernanke surely regretted invoking that particular metaphor.

•   •   •

M
asaru Hayami spent his adult life witnessing a Japan ascendant. Born in 1925, he spent the middle decades of the twentieth century rising through the ranks of the Bank of Japan. Although he held only an undergraduate degree, he worked on the international staff, representing the bank in Basel and in other overseas forums. He was a devout Christian, unusual in a predominantly Shinto and Buddhist nation, and peppered his public comments with references to Bible verses. He also had, people who knew him said, a deeply felt sense that a strong currency was equivalent to a strong nation. “In the first half of the postwar period, he attended many negotiations with Western countries when the yen was very weak,” said Kazuo Ueda, a BOJ policymaker from 1998 to 2005 and now a University of Tokyo professor. “Probably he thought the weakness of currencies is painful. . . . Over time the economy developed, the yen became stronger, and maybe he saw some causal relationship between the two.” That made him reluctant, as governor of the Bank of Japan, to do anything that would push the value of the yen down sharply—even if that’s exactly what economic theory suggests the nation needed to get its economy back on track.

Besides, he saw many other problems that needed repair before the country could return to long-term prosperity: a banking system that was slow to write down bad loans and recapitalize, networks of industrial companies that protected each other from the brutality of global competition, a political system that wasn’t capable of making hard decisions. He seemed skeptical of the theories that academics, both inside the BOJ and from the West, offered as answers to the nation’s problems. According to some who were in policy meetings with him, he didn’t always understand other economists’ technical arguments.

In late 1998, the interest rate that investors demanded to lend the government money rose sharply, from 0.7 percent to 2 percent for ten-year Japanese government bonds. Politicians pressured the BOJ to intervene in the bond market by buying securities in order to push rates downward. But Hayami viewed such an action as a grave threat to independence, comparing it to when the bank printed money to fund the government’s military buildup in the 1930s and ’40s, resulting in a period of high inflation. “
Purchasing Japanese government bonds can’t be an option
,” Hayami told the parliament. “It would be detrimental to fiscal discipline and generate vicious inflation.”

Hayami, however, was willing to make more conventional interest rate cuts and use the power of communication. In February 1999, the Bank of Japan went all in on ZIRP, cutting its target short-term interest rate from 0.25 percent to 0.15 percent. (It had been 0.5 percent when Hayami took office the previous year.) The governor pledged that ultralow rates would stay in place “until there are prospects for an end to deflationary fears,” which would seem to imply a fairly long time. Yet the cut held for little over a year.