FRBSF Economic Letter
99-17; May 21, 1999
 Economic
Letter Index
Bank of Japan Purchases of Risky Assets: Lessons from Colonial America
In its recent efforts to assist Japan's troubled banking sector, the
central bank has purchased large amounts of assets other than Japanese
government bonds, including private sector commercial paper. The holdings
of the central bank, the Bank of Japan (BOJ), were not trivial. As of
November 1998, it held 6 trillion yen in commercial paper, about 43% of
the entire market and 7% of its total assets. While these numbers recently
have come down somewhat, they still represent significant components of
the BOJ's balance sheet. Private commercial paper differs from government
bonds in that it bears some degree of default risk that is directly linked
to the risk of insolvency in the firm backing the paper. It is unlikely
that the prices paid for the paper adequately compensated for this default
risk.
This Economic Letter explores the macroeconomic implications
of central bank purchases of risky assets at non-market prices. It is
worth noting first that such purchases do not raise concerns about the
solvency of the BOJ. The BOJ issues "fiat" currency, i.e., currency which
cannot be redeemed for some other asset, such as gold. Since an issue
of fiat money carries with it no promise of future redemption, the solvency
of the BOJ is never at issue. Unlike a commercial bank, the BOJ can always
create additional assets in the form of additional currency.
Instead, the differences resulting from the purchase of risky commercial
paper will depend on how the accumulation of this alternative asset alters
expectations about future monetary policy. In this Economic Letter,
we trace out the differential impact of expansionary monetary policy of
this type. We argue that purchases of risky paper rather than government
bonds can affect the public's perception of implied future monetary growth
and thereby affect current price levels.
We begin by examining a monetary regime in which money is formally backed
by promises of future redemption in goldthe case of the American colonies.
In this regime however, the public was uncertain as to whether these promised
redemptions would take place. Thus, the inflationary impact of a monetary
expansion was dependent on the public's perception of the credibility
and value of the promised future redemption.
We then turn to Japan. Despite the fact that Japan operates a fiat money
regime, we demonstrate that the inflationary impact of a monetary expansion
in Japan will also depend on the public's perception of the quality of
assets held by the central bank. In Japan's fiat money case, this works
through the impact of perceived central bank asset quality on expected
future monetary growth.
Evidence from the American colonies
To motivate the argument that the expansionary impact of an increase
in the money supply in Japan can depend on the assets purchased during
that expansion, it is useful first to consider the effects of a monetary
expansion in a simpler regime. One historical example which fits well
is that of colonial America.
The colonies were free to issue their own notes, which carried with them
the promise of future redemption; that is, the notes would be repurchased
for assets of value, usually precious metals. When issuing these notes,
colonial governments typically also legislated future tax levies to finance
their redemption.
However, the degree of credibility of these promises of future redemption
varied across colonies. Holders of these notes sometimes were uncertain
whether these future tax levies would generate adequate funds for the
redemption of the new notes issued, or whether the future revenues would
be allocated towards note redemption at all.
Smith (1985), studies the cases of North and South Carolina and Maryland.
In the case of the Carolinas, the credibility that future tax revenues
would be used to retire most issues of new notes varied with changes in
either the fortunes of the Carolina colonies or perceptions about the
policy preferences of the colony governments.
When the public doubted the credibility of promises of future redemptions,
they treated new note issues as permanent increases in the money supply.
As a result, these issues led to decreases in the value of existing Carolina
notes relative to other currencies, such as the British pound.
In contrast, during episodes when the governments moved to back their
note issues by providing adequate financing to redeem outstanding notes
and assuring that redemptions would actually take place, the public placed
a high probability on future note redemption. Expansions of notes during
these episodes were not seen as affecting the permanent money stock and,
hence, had little impact on the value of Carolina notes.
The experience in Maryland was similar. Maryland issued paper currency
in 1733 backed by promises of future redemptions to be financed by newly
designated tax levies. The proceeds of these tax levies were to be invested
in Bank of England stock and redeemed at fixed dates which were announced
at the time of note issue. Because these Maryland notes were to be completely
redeemed by the sale of the assets in the fund of Bank of England stock,
there was no systematic relationship between new money issues and the
value of existing Maryland notes. Instead, the impact of an expansion
in the stock of Maryland notes depended on the value of assets in the
fund set aside for future redemptions and the public's confidence that
these assets would be used for their announced purpose.
The experience in the colonies teaches us that impact on the general
price level of an expansion in the money stock is likely to depend on
the public's expectations about the credibility of assets backing the
future monetary redemption. If the public doubts the credibility of future
redemption, they will perceive the increase in the money stock as permanent.
The public's perceptions about the future money stock affects their expectations
about the future price level.
Increases in expected future prices, holding all else equal, will lead
to increases in the current price level. Inflation acts as a tax on holders
of cash balances. Investors perceiving an increase in this tax on holdings
of cash balances would be unwilling to hold the entire outstanding currency
stock at current prices. Current prices would therefore need to rise to
equilibrate the money market.
Japan's fiat money regime
Like most modern economies, Japan has a fiat money regime whose currency
is not backed by a promise of future redemption. Instead, these notes
have value due to their legal tender status, which ensures by law that
they must be generally accepted in exchange for goods and services at
prevailing price levels. As in the case of the colonies, where investors
doubted the credibility of the backing for notes, one would expect a positive
relationship between the rate of inflation and the expected future growth
rate of the money stock in a fiat money regime.
However, the composition of assets purchased during a monetary injection
can have an impact on the consolidated government's balance sheet, i.e.,
the sum of assets and liabilities of the Bank of Japan and the Japanese
Ministry of Finance. In doing so, it can influence the public's expectations
about the magnitudes of future monetary injections.
For example, consider the difference between the BOJ's "open market"
purchase of one yen's worth of commercial paper bearing default risk and
one yen's worth of Japanese government bills, which presumably carry no
default risk. Assuming that these assets are perfectly substitutable except
for default risk, they would yield the same increase in the monetary base.
Any difference in impact of these two transactions must then depend on
their implications for the asset side of the BOJ's balance sheet.
However, the manner in which open market purchases affect the expected
future growth in the money stock differs in the case of a fiat regime
such as Japan's, as compared with a specie regime. While redemption of
existing currency is not promised in the fiat regime, the assets acquired
during the monetary expansion can have implications for future consolidated
government deficits. Since the expected present value of a given nominal
amount of paper bearing default risk purchased at non-market prices would
be lower than the expected present value of the same nominal amount of
government bills, the expected future revenue stream from the purchased
paper also would be lower. This implies a reduction in central bank revenue.
Since central bank revenue is handed over to the government, a reduction
in central bank revenues implies a reduction in government revenues.
Holding government expenditures constant, this revenue reduction must
be offset in the future by one of three responses: (i) increased government
borrowing, (ii) increased taxes, or (iii) further expansion of the monetary
base. The manner in which the type of assets acquired by the BOJ affects
the impact of a monetary expansion on the Japanese price level cannot
be assessed without knowing the public's expectations about how a possible
future shortfall in revenues would be financed.
If fiscal policy is used, either in the form of a tax increase or an
increase in government borrowing, the net impact of a purchase of paper
that ended up in default by the BOJ is likely to be less expansionary
than if the given monetary injection were used to purchase government
bonds. Either form of fiscal policy would reduce aggregate demand: a tax
increase would directly reduce aggregate demand, while increased government
borrowing would push up the real interest rate. On the other hand if the
future shortfall is not expected to be financed through fiscal policy,
the shortfall in revenues implies the need for an additional future monetary
expansion in order for the government to satisfy its budget constraint.
As we described above, this increase in the expected future money stock
will lead to increased inflation today.
While fiat monetary injections are not formally backed, then, the budgetary
implications of the assets purchased through a monetary injection can
affect their impact. Expected future revenue from assets purchased through
monetary expansions can change the expected future expansion of the money
supply. Expectations concerning future monetary policy will influence
expectations about future interest and inflation rates, and therefore
influence long-term nominal rates today.
Monetary or fiscal policy?
Once a central bank purchases assets other than government debt, it is
no longer pursuing pure monetary policy. Indeed, some describe such activities
as implicit fiscal policy. This is precisely why, as we have demonstrated
in this Economic Letter, the assets that are purchased can affect
the influence of a monetary injection. Assets bearing default risk purchased
at non-market prices have implications for the future consolidated government
balance sheet.
In addition, the purchases of risky commercial paper at non-market prices
may have distributive implications. If the BOJ purchases assets bearing
default risk at non-market prices at face value, it is making a net transfer
to the private parties who are selling the paper. In general, these distributive
effects do not affect the macroeconomic implications of BOJ purchases,
though they do provide additional grounds for evaluating the appropriateness
of the policy.
As such, we do not attempt here to label the purchase of risky paper
by the BOJ as representing either monetary or fiscal policy, or to characterize
the merits of such a policy. We are merely interested in tracing the possible
impacts of such a transaction. In doing so, we find that, as in the colonial
case, the quality of assets "backing" a monetary expansion can affect
its impact. In particular, when the public places a positive probability
on monetization of the expected future revenue shortfall associated with
the purchase of assets bearing default risk, the expected shortfall should
have some additional inflationary impact.
Mark M. Spiegel
Research Officer
Reference
Smith, Bruce D. 1985. "Some Colonial Evidence on Two Theories of Money:
Maryland and the Carolinas." Journal of Political Economy, Vol.
93 (6) pp. 1,1781,211.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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