The Rise of the Current Banking System in Japan, 1868-1936

Learning by doing convinced the Japanese government to create in 1882 a relatively transparent and credible central bank, Bank of Japan, and adopted the gold standard in 1898 to prove it. Unfortunately, the government did not see it fit to enforce transparency on other financial and non financial institutions in an effort to maximize the supply of capital and reduce its cost. To remedy for this deficiency, the government imposed on Bank of Japan to offer implicit deposit insurance. For a long period, this arrangement helped the government of Japan to place the Japanese economy on a fast development track but it also created a serious moral hazard problem. Through various subterfuges, the government was able to escape the necessity to enforce a minimum amount of transparency. World War I brought about golden opportunities that the Japanese economy exploited full at the cost of high rates of inflation thanks to the exit of most developed countries, including Japan, out of the gold standard. The return of the US to the gold standard soon after the end of the war at the old parity forced Japan to reconsider moving to a flexible exchange rate regime or returning to the gold standard either at the old parity at the cost of a depression or at a new parity with a devaluation. For ten years, the government of Japan did not make up its mind. Instead, it instructed Bank of Japan to continue offering free implicit deposit insurance. The moral hazard problem became acute dragging the Japanese economy into many financial crises but the government refused to impose transparency. After falling initially for two decades following the creation of Bank of Japan, real and nominal interest rates meandered without any clear direction and remained on average relatively high. Finally, the government decided to return to the gold standard at the old parity to clean up the weaker and inefficient institutions and reduce the cost of capital. We demonstrate that the government walked into this trap knowing well the economic consequences. Thanks to the naivete? of an otherwise brilliant economist and a former governor of Bank of Japan, the return ended up in a disaster and the government still refused to enforce transparency, preferring instead to impose financial repression out of which the current banking system was born.