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The Bank of Japan Averts a Financial Earthquake

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
March 21, 2011
Financial Times


Japan's tragedy is a testament to the power of nature and the frailty of man. But one human creation will emerge from this mess looking stronger than before: Japan's central bank. In the days since the earthquake, the Bank of Japan has printed trillions of new yen. If you doubt this activism was warranted, consider what followed earthquakes in the era before central banks.

The April 1906 earthquake in San Francisco is a case in point. The damage amounted to about 1.5 per cent of US gross domestic product; to meet the flood of claims, insurers shipped gold from New York to San Francisco and Wall Street was emptied of liquidity. By March 1907, American stocks had declined by about a fifth from their peak, even though the stimulus of reconstruction might have been expected to support them.

Borrowers could no longer get credit. New York City failed to find takers for a bond issue and nearly defaulted, while bank runs threatened several large trust companies, the forerunners of today's investment banks. The trusts scrambled to raise money by dumping stock portfolios, and by late 1907 US equities were down by half from their peak. Meanwhile, unemployment jumped from under 3 per cent to more than 8 per cent.

With nobody to provide emergency liquidity, the contagion threatened to rage on indefinitely. So, a private citizen stepped forward. J.P. Morgan, the era's pre-eminent banker, locked the biggest financiers of his day into his library until they agreed to participate in a bail-out fund. There was no central bank, so Morgan effectively became one.

His intervention ended the crisis, and both the real and the financial economies recovered quickly. The lesson was not lost: a few years later, in 1913, the Federal Reserve System opened for business, ending 80 years in which the US had done without an official lender of last resort. To begin with, the powers of this bank were limited because the currency was backed by gold. But when US president Richard Nixon abandoned the gold link in 1971, the modern central bank was born. Money was paper or, increasingly, numbers on a screen. It could be conjured in unlimited amounts whenever crises warranted it.

In the past couple of years, the awesome power of central banks has not always been popular. In a celebrated interchange after the Lehman bust, an incredulous Republican Barney Frank asked Ben Bernanke chairman of the Federal Reserve whether he had the $80bn necessary to bail out AIG. “We have $800bn,” Bernanke replied, though even that astronomical number was an understatement. Since then, the Fed's relentless money printing has sent nervous investors scurrying from paper currencies, causing the gold price to double. Emerging economies have denounced the money glut as currency warfare, and have fought back with capital controls.

Yet, however popular it has become to beat up central banks, Japan's tragedy underlines their huge advantages. Relative to national output, the Japanese disaster may end up being two or even three times costlier than the San Francisco quake. However, thanks to monetary activism, Japan's payment system has kept on functioning, even though the stock market has oscillated viciously. In an echo of the San Francisco disaster, the repatriation of money by insurers has disrupted the value of the yen. But the disruption is contained by the existence of a central bank that is ready to intervene if the currency appreciation becomes excessive.

Of course, believers in modern central banking don't need Japan's earthquake to convert them. They have watched the Fed save the US financial system after Lehman and the European Central Bank contain the rot in the sovereign debt markets of the eurozone. But central banking sceptics, who charge that we are stuck with scarily powerful central banks only because we tolerate stupidly leveraged finance, should take note of Japan. The risk of a reactor meltdown there is awful enough. What if we were also panicking about a financial meltdown?

The writer directs the Maurice R. Greenberg Center for Geoeconomic Studies at the Council on Foreign Relations.


This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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