Chapter 7: Japan during the Interwar Period: From Monetary Restraint to Fiscal Abandon

Thomas Sargent, George Hall, Martin Ellison, Andrew Scott, Harold James, Era Dabla-Norris, Mark De Broeck, Nicolas End, Marina Marinkov, and Vitor Gaspar
Published Date:
November 2019
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Nicolas ENd1

Shakkin nakereba kiken nashi.

[With no debt, there is no danger.]

Japanese proverb

This chapter draws on Japan’s historical experiences during the interwar period to highlight the implications of monetary-fiscal interactions for debt management and economic outcomes. For the half century preceding the Great Depression, the country had followed relatively sound economic and debt management policies, while finding its place in the international financial system. Debate on the timing and conditions under which Japan should return to prewar gold parity dominated domestic debate in the immediate aftermath of World War I (WWI). The return to gold was crucial to raise foreign financing and essential to Japan’s internationalization efforts. As such, adherence to the monetary rule was “a good housekeeping seal of approval”, which signaled to international capital markets that the country was committed to prudent fiscal and monetary policies.2 Confidence that the value of the currency would be stable and that debt would not be inflated away in the future provided assurances to Japan’s domestic and external creditors alike.

Fiscal activism increased when the gold standard was abandoned in the wake of the worldwide financial turmoil and crippling domestic deflation and depression. Between 1931 and 1933, the government switched to Keynesian policies, well ahead of other Western countries, to boost aggregate demand. Currency depreciation, fiscal stimulus, and easy monetary conditions helped Japan to recover from the worldwide depression earlier than most countries in Europe and North America.

Mounting militarism and the country’s subsequent inward turn in the mid-1930s, however, represented a regime shift for fiscal policy. Fiscal stimulus was directed to rearmament for war, and monetary policy assumed the role of financing this effort. The government increasingly relied on easy credit from the central bank and on financial repression to finance growing deficits amid capital controls and limited access to international markets. The political rhetoric and policy actions shifted from fiscal moderation to fiscal dominance as the country hurtled toward hyperinflation in the run-up to World War II (WWII). The result was a significant debt overhang and one of the longest quasi-sovereign default episodes in history (1947–52).

Theory suggests that whether fiscal or monetary policies are dominant or the extent to which they act in concert can have important consequences for macroeconomic performance.3 This chapter describes how Japan switched from monetary to fiscal dominance over a relatively short time during the interwar period, highlighting the fact that no middle ground was possible given the constellation of policies adopted.

The next sections shed light on the policies and transformation of the interwar period on the eve of WWI and describe the monetary dominance regime in the immediate aftermath of the war; the short-lived monetary subordination and cooperation regime between 1931 and 1933; and the fiscal dominance regime that became increasingly entrenched from 1933 to WWII.

Prologue: Japan in the Wake of World War I

The Meiji Era

To understand the history of Japanese public debt during the interwar period, it is necessary to go further back. Although a detailed review of the Meiji period (1868–1912) is beyond the scope of this chapter, early 20th-century Japan has interesting parallels with today’s emerging economies.4 The period also provides an important backdrop for the subsequent evolution of sovereign debt.

When the Tokugawa Shogunate ended in 1868, Japan progressively enforced a new constitutional monarchy regime, dubbed the Meiji restoration. Meiji restorers set out a determined reform program and coined a forceful slogan: “Rich Country, Strong Army” [Fukoku Kyōhei]. The engines of this sweeping rebirth were threefold: the concerns over the increasingly intrusive proximity of Western powers; the ambition to become an internationally recognized power; and the need to forge a new national identity after centuries of feudal, fragmented rule.

One crucial aspect of the Meiji architects’ plan was to catch up with the rest of the world after two and a half centuries of isolation. Such convergence required modern infrastructure and state-of-the-art industries. As a result, the government acquired machinery abroad for domestic industrial development and invested heavily in railroads and other network infrastructures. Large business conglomerates (zaibatsu) and state-owned enterprises played instrumental roles in implementing this industrial policy.

Building a strong military was considered essential for pursing Japan’s strategic interests. The country was regularly involved in overseas wars and territorial disputes, pursuing expansionist policies within the framework of its alliance with the UK and pecking for territories in China, Korea, and Siberia. Nationalism intensified after the war against Russia in 1904–5, triggering a new phase of continental expansion. Extending colonization was also a way to ensure captive demand and a supply of cheap commodities.

The modernization push extended to experimentation with new monetary and financial institutions that could foster growth and economic stability. The yen was created to replace feudal monies in 1871. The US model of a national banking system was imported shortly thereafter, and the Bank of Japan (BoJ) was founded in 1882 along the lines of the Belgian model. The Deposit Bureau was established in 1885 to help channel domestic resources using postal savings, mimicking the French Caisse des Dépôts. Investment was channeled to specialized public banks—namely, the National Hypothec Bank and the National Industrial Bank, also inspired by French models. In 1897, after 11 years on the silver standard, the country joined the gold standard.5

Japan actively encouraged national savings to support capital accumulation. At the beginning of the 20th century, nationwide savings campaigns were launched, promoting postal saving and disseminating the doctrine of building national strength through popular sacrifice (the Imperial Rescript on Diligence and Thrift, or Boshin Rescript). At the base of this pyramid headed by the Deposit Bureau, was an intricate network of postmasters, local notables, and priests that revolved around village “moral requital societies,” which were at once religious confraternities, tontines, savings groups, and neighborhood societies.6 The propaganda even included a “saving song”:

  • Yet if you compare those figures to England or America,
  • Or to Germany, Belgium, or Holland—
  • The civilized countries, that is—
  • We’re way behind,
  • And we’ve got to keep going—no slacking off.
  • If we really work at saving,
  • We’ll catch up,
  • And the day’ll come when we’ll surpass them all.7

Household savings in the form of postal and bank deposits were funneled into government securities through government financial institutions and private banks.

Meiji leaders also harbored ambitions for the country to feature prominently in the international financial network. They understood that, to gain such influence, the yen needed to become an international currency. Policies were implemented to actively to promote yen internationalization. As early as 1879, the National Bank Act had established the Yokohama Specie Bank (YSB), a public bank under the government’s direct control, which served as the main tool to promote and support the yen. The establishment of the YSB was a direct government response to the monopolistic role that Western exchange banks played in financing Japanese trade. The Ministry of Finance assembled a network of correspondent banks led by the YSB around the world. Bilateral banks, such as the Nitchi-Futsu Ginkō (also known in Paris as Banque Franco-Japonaise), were established in various countries. The YSB also sponsored Japanese government and corporate securities overseas through bank syndicates. Instead of public offerings on foreign stock exchanges, the government hired foreign and national banks to place foreign bonds (Annex Table 7.1.1).

These developments illustrate three aspects of public finance in interwar Japan. First, fiscal and debt policies were inextricably tied to costly reforms and wars, as tax capacity was in its infancy. The Tokugawa regime largely depended on taxes on land and harvest, customs fees, and loans from wealthy peasants and urban merchants—in other words, relatively inelastic and low-yielding taxes (Figure 7.1). In 1887, a progressive global income tax was introduced, modernizing the tax base.8 Nevertheless, the government had to borrow to service war expenditures and modernization efforts. By 1918, debt was approximately seven times the annual tax revenue, and interest payments represented one-fourth of tax income. Bonds dedicated to railways or new colonies accounted for one-half of outstanding debt instruments.9

Figure 7.1.Government’s General Account Revenues, 1910–40

(in Japanese Yen Billions)

Sources: Bank of Japan (1966); author’s calculations.

Note: CIT = corporate income tax; SOE = state owned enterprises. The figures in the chapter use the following convention: the fiscal year that ends in March t is labeled t.

Second, successive governments faced complicated trade-offs among militarist, industrialist, and internationalist ambitions. Imperial Japan was led by several competing forces, in addition to the government and the parliament (the Diet). The military and the navy constituted somewhat relatively independent institutions—reporting directly to the emperor and his privy council. At odds with Montesquieu’s recommended separation of powers, these competing entities were all simultaneous decision makers for budgetary and debt policies.10

Foreign engagement and international influence were the motto of leaders and elites during the Meiji and Taishō eras.11 Yet, views on the modalities of engagement differed.12 Some sought to develop diplomatic, constructive relations with the West and its bankers to transform Tōkyō into a financial capital (Annex 7.2). Other political participants, however, made it a priority to block the imperialistic expansion of Western powers in East Asia.

Third, 200 years of seclusion had left a legacy of general wariness to international dependency. Meiji leaders had observed how Europeans would intervene and sometimes occupy insolvent nations (for instance, China, Egypt, and Mexico). These supersanctions, spanning gunboat diplomacy to fiscal wardship, arguably represented a much costlier sanction for defaulting than in present times. The oligarch Toshimichi wrote in 1873: “If our country becomes involved in an unexpected misfortune … our inability to repay our debts to England will become England’s pretext for interfering in our internal affairs which would lead to baneful consequences beyond description”.13 This denigration of foreign financing was sometimes described as a “peacetime economic warfare” with Western powers.

Japan also shared many of the characteristics of today’s emerging markets: a small open economy with an expanding trade sector, insufficient domestic revenue mobilization, and need for international capital to finance economic development and wars. The decision to adopt the gold standard reflected these considerations.14Shizume (2011), for instance, notes that adherence to the gold standard enabled Japan to finance the 1904–5 Russo-Japanese War by borrowing from London and New York.

Participation in international financial markets was also consistent with other foreign policy goals, particularly in the context of the Anglo-American alliance. In 1902, the British Foreign Office sent a letter to Rothschilds London stating, “His Majesty’s Government regard it as a matter of political necessity that Japan should be able to raise in this country, rather than elsewhere, the money which she requires, and they hope that she will obtain a loan in London on reasonable terms” (September 22, 1902). At the same time, Japanese leaders and the Treasury tried to limit external debt, prioritizing it for development and other strategic purposes—prewar external debt was almost exclusively public or publicly guaranteed.

The First World War: An (Almost) Nonevent for Japan

Japan’s entry into WWI was more of an opportunistic maneuver. Having undertaken most of its military scaling-up efforts in the second half of the 19th century, the country’s engagement was restricted to war with Germany over Chinese territories and was not very costly.15 However, WWI enabled the country, as part of the victorious Allies, to expand its influence in Asia and the Pacific. Toward the end of the war, Japan increasingly filled orders for its European allies, fostering the country’s industrial diversification and transforming Japan into a net exporter of goods (hence, importer of gold) for the first time (Figure 7.2).

Figure 7.2.Balance of Payments, 1904–45

(in Japanese Yen Billions)

Sources: Bank of Japan (1966); author’s calculations.

The postwar era also brought Japan unprecedented prosperity in its immediate aftermath. In 1918, Japan was the second largest creditor country in the world, after the US. It attended the 1919 Paris Peace Conference as one of the world’s great international military and industrial powers, and it was catapulted into the selective group of permanent members of the League of Nations Council. Such recognition brought substantial economic benefits. Panel 1 of Figure 7.3 shows how industrial production and GDP grew rapidly until 1922.

Figure 7.3.Output and Debt in the Interwar Period

Sources: Bank of Japan (1966); Interwar Debt Database; League of Nations; Maddison Project Database (version 2013, Bolt and van Zanden 2014); Smits, Woltjer, and Ma (2009).

Note: JPY = Japanese yen; lhs = left-hand side; rhs = right-hand side. The industrial production index is built so that it is 100 on average in 1921–25; data are not available after 1945. Real GDP figures are computed by deflating nominal GDP with consumer price index.

While public debts were skyrocketing in Europe, the debt-to-GDP ratio was halved in Japan between 1913 and 1922 (Figure 7.3, panel 2). Several factors contributed to this outcome. First, as shown in Figure 7.4, although the size of the government increased after WWI, the budget was kept in surplus, reflecting a secular preference for balanced budgets.16 Second, the economy was booming, which brought in more tax revenues and contributed to reducing the debt ratio from the denominator. Third, the inflation tax played a role. After Japan went off the gold standard by imposing an embargo on gold exports in 1917, domestic prices doubled in less than three years. This helped the government to bring down domestic debt, although this was unlikely by design.17 Public debt nevertheless fell in 1920 to 20 percent of GDP.

Figure 7.4.Central Government Budget, 1900–36

(in Japanese Yen Billions)

Sources: Bank of Japan (1966); Ohkawa (1965); author’s calculations.

Note: In official figures, revenue (Rev.) included debt financing and drawdown of cash surpluses, whereas expenditure (Exp.) includes debt amortization. The figure corrects for this using data on outstanding debt instruments and includes a rough estimation of war expenditure. Furthermore, special war accounts, opened for the duration of conflicts, were not part of annual budget reports, so that official budgets appeared misleadingly balanced; this chart attempts to reintegrate these expenditures by assuming a constant disbursement schedule (yellow bars). See Annex Table 7.1.2 for more details.

Monetary Dominance Regime

The Return to Gold: The Domestic Debate

Following the Meiji restoration, an upsurge of pacifism and liberalism in the early 1920s coincided with the foundation of genuine party politics—a period dubbed the Taishō Democracy.18 Two main parties alternated power. The conservative Rikken Seiyiikai (Constitutional Association of Political Friendship) touted nationalist and expansionist policies; the more liberal Rikken Minseitō (Constitutional Democratic Party) preached fiscal retrenchment, military restraint, and international conciliation.19

Political debate between the two parties centered on the extent and pace of monetary and fiscal tightening required for a return to prewar gold parity against the backdrop of mild deflation, sluggish growth, and financial system fragility. The “repeal of the gold embargo” was considered an important economic goal in many quarters.20 Active proponents, which included most academics and public sector elites, outweighed the few opponents from the private sector who feared for their market shares.

The return to gold stalled for most of the 1920s amid a succession of adverse shocks: the collapse of inflated stock and commodity prices in early 1920, a series of domestic banking crises—particularly the 1927 Shōwa financial crisis (Annex 7.3)—and mounting nonperforming liabilities.21 Policymakers also feared that Japan might be unable to sustain the gold parity after its return to the gold standard. One area of concern was Japan’s persistent trade deficit during the 1920s and declining gold and international reserves—a consequence of waning competitiveness due to the high prices of domestic goods compared to foreign goods. A particular concern was the unfavorable terms of trade with China, which pegged to silver, a commodity whose price plummeted in the mid-1920s. Proponents believed that a return to gold would allow Japan to tap international capital markets at lower costs and lead to lower exchange rate instability.

The domestic debate reached its epitome in the late 1920s. Prime Minister Osachi Hamaguchi and his finance minister, Junnosuke Inoue (a former BoJ governor), actively promoted deflationary policies on assuming office in 1929. A large-scale propaganda campaign was launched in support of the fiscal austerity policies needed for the return to prewar gold parity. Finance Minister Inoue’s thinking revolved around what one today would call a front-loaded adjustment strategy: “Our economy remains very unstable because of the export ban on gold.22 We must liberalize gold exports as soon as possible. But we cannot liberalize gold exports without preparation. What is required in preparation? The government must tighten the budget. The people must accept this fiscal austerity and they themselves must reduce consumption. If that happens, prices will start to fall, and imports will begin to contract.”23

This rhetoric was already widespread in the media. As Nakamura (2005) notes, the influential newspaper Ōsaka Mainichi reported as early as 1928: “France realized the repeal of gold embargo: Japan should shame itself … why shouldn’t we repent ourselves of being left behind if we think our nation is a civilized and first-rate one?” (June 26, 1928). Slogans such as “Shrink first in order to extend!” (July 16, 1929) or “It may be painful for a while, but it is a hopeful pain” (September 10, 1928) made their way into the broader public discourse.

The gold embargo was lifted in January 1930 (Figure 7.5). The Ōsaka Mainichi headline read, “The day for the repeal of gold embargo has come. Be prepared for the difficulties before us” and underlined the need for further fiscal retrenchment; “In order to win the international economic battle, we must reduce our national debt on the fiscal side” (January 11, 1930).

Figure 7.5.Main Exchange Rates to the Yen, 1900–41

Sources: Bank of Japan (1966); author’s calculations.

Note: lhs = left-hand side; rhs = right-hand side. Shaded areas depict periods during which Japan was on the gold standard.

The Other Side of the Coin: Foreign Financing

As foreign lending to Japan resumed in the mid-1920s, after a brief hiatus brought on by the post-WWI liquidity drought in Europe, so too did the interest of foreign investors in Japan’s economic policies. Prior to the war, London was the center of Japanese overseas borrowing (see also Chapter 2); 32 out of the 40 Japanese foreign-currency-denominated bonds were traded in London. London was also where Japans international trade accounts, even those between Japan and the US, were settled.24 With the outbreak of the war, much of Japans foreign trade began to be settled in New York. After 1924, Japan’s sovereign and quasi-sovereign borrowing increasingly relocated to New York. Foreign financiers, notably American bankers, were particularly keen for Japan to return to the gold standard.

J.P. Morgan & Co.’s representatives—foremost, their Tōkyō emissary, Thomas W. Lamont—played a key role in underwriting Japan’s foreign loans and advising the government on external issuances.25 In the wake of the 1927 Shōwa financial crisis, J.P. Morgan & Co.’s representatives Lamont and Smith presented a “Memorandum on Japanese Conditions.” The memorandum criticized Japanese industrial and financial methods and exhorted the country to deflate back to the gold standard. The Morgans argued that the financial crisis was caused by incomplete restructuring in the business sector and postponement in the disposal of bad loans by financial institutions after the post-WWI economic boom. Deflationary policies were thus also seen as a means of eliminating inefficient industries.

Restoration of the gold standard in Japan was also posited as a precondition to the 1930 refinancing of Russo-Japanese War bonds and Japan’s participation in the Bank of International Settlements, which was created in 1930. From the Japanese perspective, particularly pressing were the second series of 4 percent sterling bonds issued in 1905 to help finance the Russo-Japanese War and coming due in January 1931. With Japan’s overseas specie holdings dwindling, refinancing the loan was considered a domestic priority. But the American bankers said that Japan had to stabilize the currency first.

In the face of mounting external pressures, Prime Minister Hamaguchi’s government took the unprecedented step of unilaterally cutting the 1929 current year budget, which had already been approved by Parliament, and announced further cuts for the following year. Hamaguchi stated that retrenchment was needed to “restore the nation’s credit and rescue a position of economic isolation” (Metzler 2006, 202). Commentators have noted that domestic political interests, including the military, were able to achieve consensus on tight fiscal policy as they recognized the importance of public debt credibility for achieving Japan’s national interests.26

The new cabinet’s policies earned the international financier’s seal of approval. Despite the New York stock market crash, the American and British consortium of banks consented to grant foreign credit (Annex Table 7.1.1, Figure 7.6). The agreement was announced on November 1929, together with the decree announcing that the gold embargo would be lifted in January 1930.

Figure 7.6.Imperial Japanese Government, 5.5 Percent External Loan, 1930

Source: Spink.

In the wake of the issuance, J.P. Morgan & Co. praised the Japanese government’s actions as “still another evidence of the determination of the Japanese government and people” to conduct their currency and finances “upon the highest bases of soundness and credit” (Metzler 2002, 215).

Implications for Sovereign Debt

Until the gold embargo was lifted in early 1930, the government kept public debt under tight control in the 1920s, despite a destructive earthquake and a series of financial crises and natural disasters (Annex 7.3). The debt-to-GDP ratio remained flat below 50 percent, in part because of the government’s commitment to fiscal consolidation. Interest rates on foreign debt increased in the wake of the global financial turbulence, but the overall impact was muted.

Returning to the gold standard also paid off in international markets: Japan issued foreign bonds in May 1930 in London and New York with a coupon of 5.5 percent, a reduction in servicing costs compared to the 1924 issuances when the country was off the gold standard.27 The government had also managed to convert its 4 percent sterling loan issued to finance the Russo-Japanese War ahead of maturity, which helped to restructure its liabilities to longer maturities (Figure 7.7).

Figure 7.7.Average Maturity of Public Debt, 1913–47

(In Years)

Source: Interwar Debt Database.

Note: There are several ways to envisage the maturity of a security D issued in t0. First, the contractual maturity is τ = tf – t0, where tf is the latest payment date (typically, when all the principal has been paid back). This measure underpins the general classification of short-term versus long-term bonds. Second, at any point in time t, it is possible to look at the remaining maturity tf-t. Third, the duration is a measure of the average maturity of all future cash flows, weighted by these cash flows. For a bullet bond, duration and maturity are identical. This figure plots the first two of these measures for total public debt. Namely, the maturity of a debt portfolio composed of nt instruments (Dit)1≤ i ≤nt is average weighted by the outstanding amount of each instrument: ΣiτiDitΣiDit; and its remaining maturity is Σi(tift)DitΣiDit.

No further major external issuance was required, implying lower reliance on international capital markets. Although foreign currency debt accounted for more than one-half of overall debt outstanding in 1914, this share had fallen to around 25 percent in 1930 (Figure 7.8). From a domestic political economy perspective, however, external pressure to maintain fiscal prudence was attenuated.

Figure 7.8.Currency Composition of Public Debt, 1913–47

Sources: Interwar Debt Database.

Note: “Other” includes foreign loans whose currency is unknown.

Fiscal Dominance Regime

Getting Off Gold: Combating Deflation

The internal devaluation policies of Prime Minister Hamaguchi and Finance Minister Inoue soon appeared ill-timed. Japan found itself forcefully deflating its economy in the midst of a domestic economic slump and at a time when the crisis that originated in the US would swiftly engulf other countries. Cha (2003) notes that a contemporary industrialist likened this policy decision to “opening the window in the middle of a typhoon.”

The economic consequences of the worldwide depression and the appreciation of the yen associated with the return to the gold standard were significant. A fierce deflation and a sharp contraction of economic activity ensued in 1930 and 1931—the Shōwa Depression. Although the real economic growth rate stayed positive (1.1 percent in 1930 and 0.4 percent in 1931), nominal GDP growth plummeted by almost 10 percent in both years due to rampant deflation.28 From 1929 to 1931, the wholesale price index fell by more than 30 percent, rice prices by 35 percent, and cotton prices by more than 40 percent.29

When the UK left the gold standard in September 1931, international investors speculated that Japan would be forced to follow suit.30 A rush to sell yen and buy US dollars led to massive capital outflows. Finance Minister Inoue announced that the government would stay on the gold standard. The BoJ raised discount rates twice in support of his announced policy, but this action failed to stem the tide. The capital outflow continued and intensified until December 1931. As unemployment rose, the campaign against Prime Minister Hamaguchi’s deflationary policy of keeping Japan on gold turned into a movement against party politics. The government eventually fell, and elections ushered the conservative party to power.

The veteran finance minister, Korekiyo Takahashi, was appointed and now stood at the helm of a three-pronged policy package to bolster the economy31:

  • Exchange rate policy. A gold embargo was immediately declared, and the yen was allowed to depreciate. The conservative party had decided the yen should depreciate by 20 percent, but the yen depreciated by 60 percent in effective terms in less than one year (Figure 7.9, panel 1). Starting in spring 1933, a peg to the sterling was ensured via the official foreign exchange bank (the YSB). Capital controls were limited to capital flight prevention measures until 1936.32
  • Monetary policy. Monetary policy was accommodative; the BoJ markedly cut its discount rates and increased its ceiling on bank note issuance (Figure 7.9, panel 2). Although the impact on the bank’s balance sheet was limited, these measures conveyed a strong signal to markets and helped reanchor inflation expectations above zero.
  • Fiscal policy. The government engineered a fiscal stimulus. Spending was increased, income taxes were cut, and transfers to sinking funds for the redemption of bonds were discontinued.33 The first ever deficit-covering bonds were issued, together with a supplementary budget that increased military expenditures and emergency relief programs for rural areas. The BoJ began underwriting government bonds. To signal fiscal discipline, the government announced a commitment to gradually reduce the outstanding stock of public bonds.

Figure 7.9.Indicators of Monetary Conditions

Sources: Bank of Japan (BoJ) (1966); Shizume (2016); author’s calculations.

Note: In panel 1, the shaded area indicates the brief period during which Japan was on the gold standard.

Kindleberger (1986) notes that Takahashi conducted quintessential Keynesian policies to boost aggregate demand.34 The idea of a fiscal multiplier underpinned Takahashi’s own words: “If someone goes to a geisha house and calls a geisha, eats luxurious food, and spends 2,000 yen, we disapprove morally. But if we analyze how that money is used, we find that the part that paid for food helps support the chef’s salary, and is used to pay for fish, meat, vegetables, and seasoning, or the costs of transporting it. The farmers, fishermen, and merchants who receive the money then buy clothes, food, and shelter. And the geisha uses the money she receives to buy food, clothes, cosmetics, and to pay taxes” (written in 1929).

Takahashi emphasized the temporary nature of the fiscal stimulus package, justifying debt financing for purposes of intertemporal tax smoothing. “We will finance the whole fiscal gap in 1933 with debt. This is because the primary factors of the increase in expenditures are temporary, too large to finance with an increase in taxes and other revenues, and because an increase in taxes and other revenues would break the budding economy recovery. This is not yet the right time for tax increases” (Shizume 2011, 1136).

The stimulus package proved successful: growth picked up, and deflationary expectations subsided (Figure 7.10, panel 1). The policy mix also helped a small, open economy like Japan to weather the Great Depression. Indeed, currency depreciation, fiscal stimulus, and easy monetary conditions helped Japan recover earlier than most European countries. By 1932, Japan’s economic activity had almost returned to its precrisis level, while the US and Western European economies were still 20 to 40 percent below their peak (Figure 7.10, panel 2).35

Figure 7.10.Inflation and Growth around the Great Depression

Sources: League of Nations; Shizume (2016); author’s calculations.

Note: Inflation expectations are defined as the spread between the one- and seven-year futures on cotton yarn. The shaded area represents Takahashi’s time as finance minister in the 1930s.

The effect of Takahashi’s policies on Japan’s public debt was surprisingly muted. On the one hand, the BoJ had incrementally pushed down interest rates, giving the government recourse to relatively cheap domestic financing. On the other hand, the increase in budget spending was costly, and the government was forced to issue deficit-covering bonds for the first time in January 1933. In addition, the yen depreciation affected debt denominated in foreign currencies, leading to a sharp decline in Japanese sovereign bond prices in overseas markets.

A key reason for the minimal impact on officially reported public debt was the promulgation of the Act on the Calculation of Government Bond Prices (promulgated on July 1, 1932). This law forced Japanese entities to use the official reference price, instead of the mark-to-market price, as the relevant book value for sovereign debt instruments. Ultimately, it attenuated the impact of the exchange rate and other price and valuation changes on reported debt numbers.36

From Sound Debt Management to Fiscal Dominance

Prior to Takahashi’s fiscal stimulus and the subsequent arms race in the run-up WWII, Japan had maintained relatively sound domestic debt management policies (Figure 7.11):

  • Apart from financing a few war-related financing gaps, and in contrast to many other Western countries, the BoJ did not provide advances until the onset of WWII. Moreover, most issuances were at a coupon rate of 5 percent, with the issuance price adjusted to ensure market clearance.
  • Most debt was redeemable, although there were a few sinking funds. The budget included a special account to provide for the settlement of debt obligations. As in other countries, sinking funds were used as a credibility-enhancing tool. For instance, foreign observers praised the government for the new sinking fund that was created in 192537 Similarly, market players saw the 1932 decision to reduce transfers to the sinking fund as a negative signal.
  • A large number of domestic debt instruments were issued in the interwar period. Most instruments were intended for a specific purpose, such as railroads, industrial policy instruments, and food certificates (Figure 7.12, Annex Figure 7.1.1). Earmarking bonds to specific policies within a legally binding context contrasted with the widespread use of deficit-covering bonds in other countries.38 Moreover, also in contrast to many other Western countries, only a handful of foreign loans were issued.
  • There were few issuers of public debt other than the central government. In contrast to other countries, state-owned enterprises could not issue quasi-sovereign or implicitly guaranteed paper, a situation that would change once the military assumed control.
  • Securities were generally carried on the books until maturity. There was no regular principal repayment unless market conditions made a conversion or refinancing possible; in such cases, the entire stock of initial bonds was redeemed.

Figure 7.11.Debt Indicators and Maturity, 1913–45

Source: Interwar Debt Database.

Note: rhs = right-hand side; in panel 1, the shares are given as a percent of the total outstanding amount of public debt.

Figure 7.12.Purposes of Exchequer Bond Issuances, 1913–40/45

Source: Interwar Debt Database.

Note: ivt = investment.

The Shōwa Depression and Takahashi’s stimulus policies of 1931–32 were a tipping point in terms of debt management policies. By then, the balance sheet of the Deposit Bureau, which had initially helped to channel domestic resources using postal savings, was increasingly encumbered with sovereign and quasi-sovereign paper due to the financial crises of the 1920s (see Annex 7.2).39 At the same time, institutional investors indicated a growing reluctance to absorb sovereign bonds.

With market conditions for sovereign issuances deteriorating in late 1931, the government resorted to other public underwriters—foremost, the BoJ—to avoid public offerings. Finance Minister Takahashi noted: “it has become unavoidable to newly issue revenue supplementing public bonds. … These new bonds would be accepted by the Bank of Japan, the Treasury Deposit Bureau of the Ministry of Finance and by using other funds available within the government. It is our policy to avoid the public offering of these new bonds on the general market.”40 By November 1932, the BoJ had become the government’s main underwriter (Figure 7.13).

Figure 7.13.Issuing Method of Government Bonds, 1922–46

(in Percentage of Annual Domestic Issuances)

Sources: Ministry of Finance (1954); author’s calculations.

Note: BoJ = Bank of Japan. “Other underwriting” includes bonds underwritten by the Banks of Taiwan and Korea, the Hokkaido Takushoku and Koike Banks, the Simple Life Insurance, and other financial institutions, as well as the Education Reform and Rural Revitalization Fund and the Railway Mutual Aid Association.

While circumspect, the BoJ agreed to this new role, in part because its staff expected seigniorage revenues from this activity.41 Such a scheme could have been justified in the face of large financing needs (for example, wartime spending) because domestic bond markets were deemed too shallow to supply needed funds. However, no quantity or time limit was set on the BoJ’s underwriting activity. Consequently, price distortions introduced by the underwriting activity became permanent.42

At the same time, a conflict of interest arose with the BoJ’s other mandate of regulating domestic liquidity. The discount rate that the BoJ applied for its liquidity facility on government bonds was relaxed in the hope of easing interest rate risks. Furthermore, the Ministry of Finance imposed a standard issue price to be used as book value, resulting in bondholders being able to avoid booking loss provisions in their account ledgers. This policy made it easier both to place bonds and to maintain their price at the expense of market transparency and price discovery mechanisms. Arguably, these measures succeeded in lowering sovereign yields. After 1932, the government could access funds at a 4 and 4.5 percent coupon, compared to 5 percent for most domestic issuances during 1913–31. However, these polices put the BoJ in a clear position of fiscal dominance (Figure 7.14).

Figure 7.14.Bank of Japan’s Net Claims on the Government, 1913–44

Source: Interwar Debt Database.

Note: CG = central government; rhs = right-hand side; T-bills = Treasury bills; T-bonds = Treasury bonds. For presentational purposes, 1945 is excluded; this is the year that the Bank of Japan’s (BoJ) balance sheet tripled in size. The special advances granted under the government guarantee are considered as an implicit claim on the government.

Fiscal and Monetary Discipline Lost

International rebuke for Japan’s foray into Manchuria in 1931 and its withdrawal from the League of Nations in March 1933 heralded the ascendance of militarism and the country’s mounting international isolation. Implementing sustainable debt policies proved challenging against the backdrop of growing discord between politicians and the military. Although the BoJ had initial success in issuing government paper, private demand for sovereign paper dried up by 1935. As Takahashi noted at a cabinet meeting on June 25, 1935: “When a huge amount of public bonds is issued every year, financial companies that already have a substantially large amount of public bonds feel a sense of unease; if even a small decline in public bond prices is projected, they will not, of course, be willing to increase the amount of public bonds they own and might feel like selling those they already own” (Tomita 2005a).

To avoid crowding out effects and dampen inflationary pressures, Takahashi attempted to reduce financing needs by trimming military expenditures. This move antagonized military leaders, who had been subjected to budgetary cutbacks in the past but were now firmly entrenched in positions of power.43 The various interest groups that framed Japan’s politics since the Meiji restoration had finally come to an overt clash. The two independent branches of the military— the navy and the army—and Takahashi’s stimulus had to compete for increasingly scarce financial resources.

Following its 1933 withdrawal from the League of Nations on account of the Manchurian Incident, Japan weaned itself off foreign resources and was cut off from international financial markets.44 On the domestic side, the situation was spinning out of control. In November 1935, during a 36-hour-long cabinet meeting, Takahashi argued that “If we are devoted to national defense only and invite vicious inflation and if our financial credibility is damaged, national defense as well can by no means be stable and strong.”

After a coup d’état attempt in 1936, in which Takahashi was assassinated, the official discount rate was lowered, and new 3.5 percent interest-bearing government bonds were injected into the financial system (Figure 7.15). Takahashi’s commitment to gradually reduce the outstanding stock of public bonds—a fiscal rule ahead of its time—was abandoned, and central bank independence eroded.

Figure 7.15.Typology of Sovereign Bonds, 1913–46

(Outstanding Amount in Japanese Yen Billions)

Source: Interwar Debt Database.

Note: gov’t = government; WWI = World War I; WWII = World War II.

With the military machine ramping up, the BoJ adopted an unconditional purchase policy for sovereign bonds.45 This policy rendered bonds almost as liquid as cash, thereby generating further incentives for banks to hold them. Figures 7.13 and 7.15 illustrate how the BoJ’s direct exposure to the government grew exponentially in the mid-1930s. After the failure of the placement of the “Ri” 3.5 percent Treasury bond in 1937, the government relied exclusively on the BoJ for financing.46

With the formal outbreak of the Sino-Japanese War in July 1937, Japan formally shifted to a wartime governance mode and widespread financial repression. The government began tapping noninstitutional lenders and expanded bond sales to individuals (Figures 7.13 and 7.16).47 The National Mobilization Law was enacted in March 1938. The Bank Fund Management Order of October 1940 used the provisions of the law to place all lending activities under government oversight. As in Italy (Chapter 5), the domestic sovereign bond market was now fully regulated at government-imposed rates and maturities. In 1943, the government established the National Savings Promotion Bureau to absorb any remaining private savings through neighborhood associations—the funds could be withdrawn only for the purchase of government bonds. Not surprisingly, these policies kept interest rates artificially low until the end of WWII. The government was thereby able to place massive amounts of debt with impunity.

Figure 7.16.War Poster

Note: Poster reads: “Third and fourth premium saving bonds—10 yen per piece, premium 1,500 yen Ministry of Finance, Nihon Kangyo Bank—sale period: June 10–25”

Amid large-scale nationalizations, the National Mobilization law gave the government authority to use unlimited budgets for war financing.48 The government scaled up income tax rates, topping the general tax with scheduler taxes, and set up a separate corporate tax regime. In addition, it increased the number of commodities that were subject to excise taxes and raised the rates. Despite these tax hikes, large financing gaps developed. Two laws enacted in 1936–37 shattered the budgetary discipline that had been enforced in the past. The government could now move cash easily between various budgetary accounts, including a reserve that could be used at its discretion.49 The government began to manipulate the budget, pumping cash resources from debt-financed special accounts into the general account (Figure 7.17). Fiscal policy relied heavily on easy credit from the central bank, financial repression intensified, and inflation surged.

Figure 7.17.Government’s Expenditure, 1927–44

(in Japanese Yen Billions)

Sources: Bank of Japan (1966); author’s calculations.

Note: The special accounts on panel 2 are as follows: Control accounts: price regulation of some commodities (and the exchange rate); insurance accounts: public insurances; loan accounts: on lending to targeted sectors and promotion of Treasury loans; settlement accounts: debt operations and debt consolidation funds. Neither the military section of the general account nor military special accounts include the Special War Expenditure Accounts that were used during wartime and subject to different budgetary rules.

The military regime had swiftly addressed the mother of debt-related questions: Should one honor one’s debt? In this case, the answer was: one need not do so.


Japan’s experience in the interwar period shows how the balance of power between fiscal and monetary policies—the extent to which one policy is subordinate to the other or the two act cooperatively—shapes economic outcomes. Three distinct episodes of fiscal-monetary interactions and their interlinkages with debt policy have been identified in this chapter.

The first period from 1918 to 1930 is characterized by relatively tight fiscal and monetary policies, anchored by a desired return to the gold standard and the ambition to internationalize the yen. Fiscal discipline and credibility were reinforced by the need to tap foreign financing in the 1920s, the implicit rule of targeting a balanced budget, and de facto central bank independence. These policies, in turn, paved the way for increased access to debt financing by the government and the adoption of relatively sound debt management policies.

The orthodox policies of balanced budgets, tight money, and fixed exchange rates against the backdrop of a series of domestic shocks and a worldwide economic collapse drove the economy into a severe depression. The depression in Japan, however, proved relatively short lived due to the triumvirate of policies adopted in 1931–33—fiscal expansion, accommodative monetary policy, and exchange rate devaluation. This period was characterized by monetary subordination and cooperation: fiscal deficits were financed in part by printing money, but the BoJ prevented inflation from getting out of control. The period also coincided with a limited need for external debt financing, thereby attenuating external pressure to maintain fiscal prudence. To signal fiscal discipline, the government announced a commitment to gradually reduce the outstanding stock of domestic public bonds. But this “fiscal rule” proved not to be credible in light of the country’s mounting militarism and international isolation.

The period from 1933 to WWII was one of clear fiscal dominance. Even though the government had access to domestic debt financing in the mid-1930s, central bank independence was eroded as seigniorage revenues were increasingly channeled to meet burgeoning fiscal deficits. The government also resorted to indirect mechanisms to finance deficits once domestic debt financing became less readily available. Financial repression methods during the late 1930s guaranteed that part of household savings was used to finance government deficits and allowed the government to partially default on interest payments because the fiscal and monetary authorities unilaterally determined the remuneration of confiscated savings.

Annex 7.1. Background Information
Annex Table 7.1.1.Intermediaries Involved in the Placement of Foreign Bonds
Bond NameCurrenciesBank Consortiums Involved
5% Bonds (1897, 1902)JPYBaring, HSB, YSB
4% Sterling Loan I (1899)GBPChartered Bank, Parr, HSB, YSB
4.5% Sterling Loan I (1905)GBP, USDChartered Bank, Parr, HSB, YSB
4.5% Sterling Loan II (1905)GBP, USD, DEMChartered Bank, Parr, HSB, YSB, Warburg
4% Sterling Loan II (1905)GBP, USD, DEM, FRFChartered Bank, Parr, HSB, YSB,
Deutsch-Asiatischen Bank (and partners), Rothschilds
5% Sterling Loan (1907)GBP, FRFRothschilds
4% Franc Loan (1910)FRFRothschild Paris
4% Sterling Loan III (1910)GBPParr, HSB, YSB
5% Franc Exchequer Bonds (1913)FRFRothschild Paris
6.5% Gold Bonds (1924)USDMorgan, KL, NCB, FNB
6% Sterling Loan (1924)GBPWestminster, HSB, Rothschilds, Baring, Henry Schroeder, Morgan London, Panmure Gordon, YSB
5.5% Sterling Loan (1930)GBPWestminster, HSB, Rothschilds, Baring, Henry Schroeder, Morgan London, YSB
5.5% Gold Bonds (1930)USDMorgan, KL, NCB, FNB, YSB
Sources: Metzler (2006); Moody’s; author.Note: DEM = Deutsche mark; FNB = First National Bank of New York; FRF = French franc; GBP = British pound; HSB = Hongkong and Shanghai Bank; KL = Kuhn, Loeb and Co.; NCB = National City Bank of New York; Rothschilds includes both Rothschild Paris and London; USD = US dollar; YSB = Yokohama Specie Bank. The table shows only sovereign securities; there were also government-guaranteed industrial loans that involved the same international banks.
Sources: Metzler (2006); Moody’s; author.Note: DEM = Deutsche mark; FNB = First National Bank of New York; FRF = French franc; GBP = British pound; HSB = Hongkong and Shanghai Bank; KL = Kuhn, Loeb and Co.; NCB = National City Bank of New York; Rothschilds includes both Rothschild Paris and London; USD = US dollar; YSB = Yokohama Specie Bank. The table shows only sovereign securities; there were also government-guaranteed industrial loans that involved the same international banks.
Annex Table 7.1.2.Wars Fought by Japan
WarJapan’s InvolvementSpecial Account Period
Sino-Japanese WarAug 1894–Apr 1895Jun 1894-Mar 1896
North China Affair (Boxer Uprising)Aug 1899–Sep 1901
Russo-Japanese WarFeb 1904–Sep 1905Oct 1903–Mar, 1907
WWI and the Siberian ExpeditionAug 1914–Jun 1922Aug 1914–Apr 1925
Shandong ExpeditionMay 1928–May 1928
Mukden Incident (Manchuria)Sep 1931–Feb 1932
China Incident and WWIIJul 1937-Sep 1945Sep 1937–Feb 1946
Source: Author.Note: WWI = World War I; WWII = World War II. Special war accounts were extrabudgetary procedures that were opened to finance the warring armies.
Source: Author.Note: WWI = World War I; WWII = World War II. Special war accounts were extrabudgetary procedures that were opened to finance the warring armies.
Annex Table 7.1.3.Political and Economic Leadership during the Interwar Period
DatesPeriod [Emperor]Prime MinisterMajority PartyFinance MinisterBank of Japan Governor
1868–1912Meiji (明治)[Mutsu Hito]
July 1912Taishō (大正) [Yoshi Hito]Korekiyo Takahashi
December 1912General KatsuraTarōNoneWakatsuki Reijirō
February 1913Admiral Yamamoto GonnohyoeMilitaryTakahashi KorekiyoYatarō Mishima
April 1914Ōkuma ShigenobuRikken DōshikaiWakatsuki Reijirō
Taketomi Tokitoshi
October 1916Marshal Terauchi MasatakeMilitaryTerauchi Masatake
Kazue Shōda
September 1918HaraTakashi1Rikken SeiyūkaTakahashi Korekiyo
March 1919Junnosuke Inoue
November 1921Takahashi KorekiyoTakahashi Korekiyo
June 1922Marshal-Admiral Katō TomosaburōMilitaryOtohiko Ichiki
September 1923Admiral Yamamoto GonnohyōeJunnosuke Inoue
January 1924Kiyoura KeigoNoneKazue Shōda
June 1924Katō Takaaki (twice)Osachi Hamaguchi
Seiji Hayami
January 1926
December 1926Shōwa (昭和) [Hiro Hito]Wakatsuki ReijirōKenseikaiKataoka NaoharuOtohiko Ichiki
April 1927Tanaka GiichiRikken SeiyūkaTakahashi KorekiyoJunnosuke Inoue
June 1928Chuzo MitsuchiHisaakira Hijikata
July 1929Osachi Hamaguchi1Rikken MinseitōJunnosuke Inoue
April 1931Wakatsuki Reijirō
December 1931InukaiTsuyoshi1Rikken SeiyūkaiTakahashi Korekiyo
May 1932Admiral Saitō MakotoMilitary
July 1934Admiral Keisuke Okada1
June 1935Machida ChūjiEigo Fukai
March 1936Kōki HirotaNone (prowar)Eiichi Baba
February 1937General Senjūrō HayashiMilitaryToyota roYukiSeihin Ikeda
June 1937Fumimaro KonoeNoneOkinori Kaya Shigeaki IkedaToyota roYuki
January 1939Hiranuma KiichirōSotaro Ishiwata
August 1939General Nobuyuki AbeMilitaryKazuo Aoki
January 1940Admiral Mitsumasa YonaiYukioSakurauchi
July 1940Fumimaro Konoe (thrice)Taisei YokusankaiIsao Kawada MasatsuneOgura
October 1941Hideki TōjōOkinori Kaya
July 1944Kuniaki KoisoSotaro Ishiwata
April 1945Kantarō SuzukiJuichiTsushimarKeizo Shibusawa
August 1945Prince Naruhiko HigashikuniImperial family
October 1945Kijūrō ShideharaNihon ShimpotōKeizō ShibusawaEikichi Araki
May 1946Shigeru YoshidaJiyutōTanzan Ishibashi
Source: Author.Note: In Imperial Japan, eras are named from the emperor’s official name.The North American convention is used, and first names are given first.

Indicates prime ministers who were murdered, thought to be murdered, or injured during attempted murder while in office.

The main political parties during the period are as follows:Jiyūtō = Liberal PartyKenseikai = Constitutional AssociationNihon Shimpotō = Japan Progressive PartyRikken Dōshikai = Constitutional Association of AlliesRikken Seiyūkai = Constitutional Association of Political Friendship (conservative)Rikken Minseitō = Constitutional Democratic Party (liberal, successor of the latter)Taisei Yokusankai = Imperial Rule Assistance/Aid Association (fascist)
Source: Author.Note: In Imperial Japan, eras are named from the emperor’s official name.The North American convention is used, and first names are given first.

Indicates prime ministers who were murdered, thought to be murdered, or injured during attempted murder while in office.

The main political parties during the period are as follows:Jiyūtō = Liberal PartyKenseikai = Constitutional AssociationNihon Shimpotō = Japan Progressive PartyRikken Dōshikai = Constitutional Association of AlliesRikken Seiyūkai = Constitutional Association of Political Friendship (conservative)Rikken Minseitō = Constitutional Democratic Party (liberal, successor of the latter)Taisei Yokusankai = Imperial Rule Assistance/Aid Association (fascist)

Annex Figure 7.1.1.Public Debt Instruments in Japan, 1913–46

Source: Interwar Debt Database.

Note: Each outstanding instrument is represented by a horizontal line. Years are calendar years. Domestic instruments are at the top, and foreign debt constitutes the block at the bottom. This chart represents how the number of domestic issuances skyrocketed over time, while interest rates were pushed down. It also illustrates how foreign issuances were rare by comparison.

Annex 7.2. Japan’s Internationalization Efforts

Prior to WWI, and in its immediate aftermath, Japanese authorities harbored ambitions of forming a yen block and transforming Tōkyō into an international financial center. In their minds, this endeavor had to be underpinned by a free market for gold—thus adherence to the gold standard (Metzler 2002, 2006). Japan started in 1916–17 to make loans, in yen, to Britain, France, and Russia, either directly or through Japanese banks, so that these countries could, in turn, buy Japanese goods (see Annex Table 7.2.1 for a list of loans). Increasing the share of trade invoiced in yen as opposed to dollar or pound was also considered important for forming a yen block in Asia. Underlying these policies were ambitions to internationalize the yen and create a yen-based gold-exchange standard for neighboring countries. This policy met with success in Korea—the Dai-Ichi Ginkō (First National Bank) acted as a de facto central bank. The 1917–18 Nishihara loans to China were intended to follow the same model.

Despite these efforts, the country remained relatively isolated from international capital markets. Why did the yen not catch up as an international currency, and why did Tōkyō not emerge as an international marketplace? Several explanations can be put forward, drawing on the literature on international currencies that has identified a number of factors that determine whether a currency is suited for international currency status (McKinnon 1979; Matsuyama, Kiyotaki, and Matsui 1993; Rey 2001).

  • For most international investors, Japan remained a distant and minor player and the yen an untested currency. These investors could scarcely trust a currency without the prospect of the country reconvening with the gold standard.
  • As a small economy, Japan’s weight in global output and trade was limited and its government financing needs were too small to provide the volume and frequency of transactions necessary to ensure liquidity.
  • Japanese capital and money markets were not sufficiently developed, open, and liberalized. Persistent capital controls were incompatible with internationalization ambitions. Initially, limited capital flow management measures were intended to limit carry-trade opportunities for domestic liquidity. However, they became entrenched after 1933.
Annex Table 7.2.1.Japanese Loans to Allies and China, 1914–18
Issue DateCountryName of the LoanInterest (annual)Maturity (years)Amount (JPY millions)Issuers
Nov 1915FranceFrench Military Bonds (first series) Bank
Dec 1915ChinaFirst Armament Loan9.05.02.4Mitsui Bussan, Mitsubishi Gomei, KZ, Taipei Group
Feb 1916RussiaRussian Government Treasury Bills (first series) 18-bank syndicate
Jul 1916BritainBritish Sterling Treasury Bills6.01.094.6MoF Deposit Bureau
Sep 1916FranceFrench Military Bonds (second series) Bank
Sep 1916RussiaRussian Government Treasury Bills (second series) syndicate
Oct 1916BritainBritish Treasury Bills5.03.75.2Sale and Frazer Co.
Oct 1916RussiaShort-Term Military Bonds (first to third series) and Frazer, Russo-Chinese Bank
Oct 1916RussiaRussian Government Liberty Bonds5.01.02.7Sale and Frazer, Russo-Chinese Bank
Dec 1916BritainBritish Military Bonds5.03.03.8Sale and Frazer, IBJ
Dec 1916Britain1916 British Government Yen Treasury Notes6.03.0100.018-bank syndicate
Jan 1917ChinaFirst Banking Facilities Loan7.51.05.0IBJ, Banks of Taiwan and Chōsen
Feb 1917RussiaRussian Government Treasury Bills (third series) syndicate
Mar 1917FranceFrench Yen Treasury Bills (four issues)6.01–1.7526.2MoF Deposit Bureau
Apr 1917RussiaRussian Government Treasury Bills5.00.515.5MoF Deposit Bureau
Jul 1917France1917 French Government Yen Treasury Notes6.03.050.018-bank syndicate, Franco-Japanese Bank
Sep 1917RussiaRussian Government Treasury Bills (fourth series)6.01.0105.018-bank syndicate
Sep 1917ChinaSecond Banking Facilities Loan7.51.020.0IBJ, Bank of Taiwan, Bank of Chōsen
Oct 1917RussiaRussian Government Treasury Bills6.00.715.5MoF Deposit Bureau
Oct 1917RussiaRussian Government Treasury Bills (fifth series) syndicate
Nov 1917FranceFrench Military Bonds (third series), Franco-Japanese Bank
Nov 1917ChinaSecond Armament Loan9.02.80.9Mitsui Bussan, Mitsubishi Gomei, KZ, Taipei Group
Dec 1917ChinaThird Armament Loan9.02.815.4Taipei Group
Jan 1918BritainBritish Yen Treasury Bills5.01.080.0MoF Deposit Bureau
Feb 1918ChinaNaval Wireless and Telegraph Loan10.030.05.2Mitsui Bussan
Apr 1918ChinaTelegraph Cable Loan8.05.020.0IBJ, Bank of Taiwan, Bank of Chōsen (via EBC)
Jun 1918ChinaKirin-Kainei (Hueining) Railway Preliminary Loan7.50.510.0IBJ, Bank of Taiwan, Bank of Chōsen
Jul 1918ChinaFourth Armament Loan9.02.212.5Taipei Group
Aug 1918ChinaMine and Forestry Loan7.50.530.0IBJ, Bank of Taiwan, Bank of Chōsen (via EBC)
Sep 1918ChinaManchuria-Mongolia Four-Way Railway Loan8.010.020.0IBJ, Bank of Taiwan, Bank of Chōsen
Sep 1918ChinaSanto Two-Way Railway Preliminary Loan8.00.520.0IBJ, Bank of Taiwan, Bank of Chōsen
Sep 1918ChinaWar Participation Loan7.01.020.0IBJ, Bank of Taiwan, Bank of Chōsen
Nov 1918France1918 French Government Yen Treasury Notes6.03.050.018-bank syndicate, Franco-Japanese Bank
Source: Bytheway and Metzler (2016).Note: EBC = European Business Council in Japan; IBJ = Industrial Bank of Japan; JPY = Japanese yen; KZ = Kawasaki Zosensho; MoF = Ministry of Finance; YSB = Yokohama Specie Bank.
Source: Bytheway and Metzler (2016).Note: EBC = European Business Council in Japan; IBJ = Industrial Bank of Japan; JPY = Japanese yen; KZ = Kawasaki Zosensho; MoF = Ministry of Finance; YSB = Yokohama Specie Bank.
Annex 7.3. Financial Crises in 1920s Japan

Starting in 1920, a series of financial stress episodes, largely originating in the banking sector, hit the country. In each instance, an exogenous element triggered bank runs and financial panic—expectations of a hard landing of the Japanese economy after the WWI boom, the failure of a local company, an earthquake, and a mistaken announcement by a finance minister. According to Shizume (2009), remnant weaknesses in banking supervision and the lack of a resolution mechanism hindered financial markets from settling nonperforming loans. Although the economic impact of these crises was relatively muted (industrial production plateaued rather than collapsed), an environment of distrust and low confidence in the banking sector prevailed. The crises also contributed to the concentration of economic activity around a handful of zaibatsu.

Given its dependence on domestic financing sources, the Japanese government had a clear interest in keeping the banking system afloat. But since fiscal discipline prevailed in the 1920s, the government wanted to limit the direct impact on nominal public debt. Thus, outright bailout or budget support was not provided. Instead, the government strengthened financial regulation, declared banking moratoria, and relied on BoJ interventions (Shizume 2009). Specifically, the BoJ issued “special” loans—loans granted to a wider range of borrowers or backed by collateral of lower grade than usual.

The Great Kantō Earthquake of 1923 is an illustration of how BoJ-sponsored interventions worked. The earthquake disrupted the operations of businesses and banks, damaging the financial assets of banks, as well as their physical capital, and triggering financial panic. To help suppliers, the government declared a moratorium postponing the settlement of debts and commercial bills. In parallel, a system of Earthquake Casualty Bills was established, described by Western commentators as “legislation of rather startling character” (Lamont and Smith 1927). Banks bought commercial bills from the devastated area, regardless of the issuer’s outstanding credit, with the BoJ rediscounting them.

These schemes involved government guarantees but had no direct budgetary impact. Moreover, the loans kept the banking system afloat, allowing the government to secure financing domestically. However, they undermined the banking sector’s and BoJ’s role in pricing risk. The burden that these earthquake bills represented was so important for the BoJ’s balance sheet that the government had to exchange them against Treasury bonds when the 1927 Shōwa financial crisis hit.

Overall, the volume of special loans issued remained relatively contained. The BoJ sterilized its support by reducing its claims abroad and through regular repo operations on government securities. Yet, the schemes also implied a steadily growing BoJ exposure to the government.

More importantly, the impact on the financial sector was less benign than it seemed, as the BoJ lost the ability to discriminate among borrowers. An obvious example of regulatory forbearance, the cleanup of bad loans was put off for years and the Earthquake Casualty Bills extended twice. This would become a trigger for the 1927 Shōwa financial crisis. The government eventually had to exchange the earthquake bills for Treasury bonds to indemnify against BoJ losses and buffer its balance sheet. Shizume (2009) notes that Eigo Fukai, then an executive director of the BoJ and later governor, wrote: “In summing up the fundamental causes of massive bank failures in 1927, we can conclude that the original sources were the inappropriate business practices during the post-war collapse and the temporary stop-gap measures to fix them. Ultimately, it all came to the inevitable end.”


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1The author would like to thank Professors Shizume (Waseda University) and Tomita (Chūō University and Nomura Research Institute) for their kind assistance.
3Seminal contributions include the dichotomy between dominant fiscal or monetary regimes in Sargent and Wallace (1981), polar Ricardian and non-Ricardian regimes in Aiyagari and Gertler (1985), and Leeper’s (1991) characterization of active and passive fiscal and monetary policies.
6See Wilson (2013) for details.
8Kaneko (2009) and Shiomi (1935) describe the tax system.
9Japan’s first national loan, a 9 percent sovereign bond issued in London in 1870, financed railway construction.
10The 1889 Meiji Constitution still granted a real political role to the emperor, who could appoint a cabinet that did not represent the Diet’s majority. In practice, the emperor delegated his policymaking powers to its privy council and a group of extraconstitutional elder statesmen (Bower 1932).
11Meiji (enlightened government) and Taishō (great righteousness) were the names two successive emperors chose for the period they would reign, and as well the name they would receive posthumously. In Western dating, the Meiji and Taishō eras were 1868–1912 and 1912–26, respectively.
13Wilson (2013). The year 1873 was the year of the second loan in pounds, whose terms were extremely unfavorable to Japan, and marked the beginning of 25 years of abstinence from foreign capital (Tomita 2005b).
14Mitchener, Shizume, and Weidenmier (2010) describe the political economy of gold standard adoption in Japan. Evidence from the legislative debates of the 1890s suggests that policymakers believed gold standard adoption could impact borrowing costs, debt issuance, domestic investment, and trade.
16See Savage (2002). The special account dedicated to financing war efforts initially drew on the government’s accumulated cash reserves (Sakamoto 2014).
17Deliberate resort to seigniorage would entail observable flows in the central bank accounts. However, the BoJ’s balance sheet remained broadly stable over this period.
18In January 1920, Emperor Taishō issued an “imperial ordinance on the restoration of peace,” exhorting citizens to take advantage of peace and move forward in line with the progress of the age. In 1928, Japan ratified the Kellogg-Briand Pact along with Western powers and pledged the renunciation of war.
19See Annex Table 7.1.3 for a political chronology.
20Hamada and Noguchi (2005); Fletcher (1991).
21The 1927 Shōwa financial crisis originated in a mistaken announcement by the finance minister on the failure of a key bank. A nationwide financial panic was sparked shortly thereafter when financial difficulties between banks and trading companies came to light (see Annex 7.3).
22Author note: The yen’s non-convertability to gold and the resulting exchange rate fluctuation.
23This translation of Junnosuke Inoue’s Essays (volume 1, 1935) is from Ohno (2006). A famous anecdote tells that Inoue’s nationalistic rhetoric was so moving that a woman once threw a coin at him from the crowd, a gesture normally reserved for deities in Japanese tradition (Hamada and Noguchi 2005).
24The Bank of England had opened accounts for and provided payment facilities to the BoJ and the Japanese sovereign. Historically, these were created for the settlement of China’s reparation payments in 1895 (Bytheway and Metzler 2016).
25The Morgans underwrote several foreign loans, including the first Japanese bond issued in the US market in 1924 (Chernow 2010). In 1927–28, Lamont helped underwrite several bond issuances for various power and light companies. He also organized bridge loans for the government while negotiating the gold bonds that were eventually issued in 1930 after restoration of the yen convertibility to gold (Mitzakis 1939).
27The 1924 issuances were more expensive, with coupons of 6 percent in London and 6.5 percent in New York. In addition, issue prices were £87.5 for a face value of £100 in London, and $92.5 for every $100 in New York, implying a substantial premium (versus £90 and $90 in 1930). Issuance fees charged by Japan’s underwriters were also smaller in 1930, 4 percent instead of 5 and 4.5 percent in 1924 (Metzler 2006).
29BoJ (1966).
31Takahashi had long retired, after multiple stays at the Ministry of Finance and the central bank, when he was called back in 1927 with the support of the military to reassure international and domestic markets.
32When Japan went of the gold standard, capital flow management measures were motivated by a desire to limit carry-trade opportunities and focus domestic liquidities on domestic bond issuances. These controls would never be lifted.
34A biography of Takahashi’s nicknamed him “Japan’s Keynes” (Smethurst 2009). Kindleberger (1986, p. 166) noted that “his writing of the period showed that he already understood the mechanism of the Keynesian multiplier, without any indication of contact with the R. F. Kahn 1931Economic Journal article.”
36Finance Minister Takahashi thought it was also advantageous for bondholders: “[This bill] is a way of stating that one can hold sovereign bonds with confidence. … Inevitably, public debt will rise, bondholders will then be tempted to sell; thus, the market price of public bonds will fluctuate intensely. With this bill, since one can value bonds at its acquisition price, one can keep bonds confidence even if market price [goes down]” (June 7, 1932, speech to the Parliamentary Committee; Nagahiro 2013; author’s translation).
38In the Imperial Japan budget system, the general account was expected to be balanced through taxes and other current revenues; special accounts were recipients of the proceeds of public debt placements.
39In addition to investing in war and development bonds, the Deposit Bureau was used to operate on the secondary market and stabilize prices and to underwrite municipal and industrial bonds.
40Excerpt of the financial address to the 62nd Imperial Diet session on June 3, 1932 (Tomita 2005a).
42Tomita (2005a) comments on the growing spread between Japanese government bonds priced in yen domestically and those traded in London during this period.
43The military had never stopped playing a central role within successive governments, weighing in on fiscal decisions and bearing an effective veto on the budget process (Shizume 2011).
44Japan continued to extort financing from its colonies. Overseas central banks, such as the Bank of Taiwan, were used in the same vein as the BoJ to underwrite and promote public debt. As the war progressed, the military authorities issued Southern Development Bank Notes to replace local currencies in newly acquired colonies (namely, the Dutch East Indies, Brunei, Burma, Malaya, New Guinea, North Borneo and Sarawak, the Philippines, Singapore, and the Solomon and Gilbert Islands).
46The Japanese authorities maintained a system of marks to differentiate the large numbers of Treasury securities on their books. Some bonds were numbered, but most were attributed a symbol in the Japanese syllabary.
47For instance, post offices sold the 3.5 percent “Ru” government bonds, underwritten by the BoJ. The government also used public organizations, companies, and stores, as well as investment banks, such as Nomura Securities, as brokers.
49Kept out of the parliament’s control, the budgets did not operate on a fiscal year basis. Instead, they were typically kept open until the end of the conflict and often beyond.

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