As the first nation to experience the zero bound in modern times, Japan was an early pioneer in developing unconventional tools and strategies. Its experiences, both good and bad, along with lessons from other periods such as the Great Depression, have helped to inform the policies adopted by the United States (U.S.) and other nations in recent years. The evolution of policy in Japan, in turn, has been informed, in part, by the experience of the U.S. and other nations.

So what have we learned to date? Let me highlight six key points.

First, and most importantly, managing expectations is critical in the execution of monetary policy at the zero bound...

Second, in managing expectations, good communication is essential...

Third, actions speak louder than words alone. Thus, there is an important role for asset purchases that ease financial conditions to support growth and keep inflation expectations well anchored.

Fourth, the policy instruments interact so that policy as a whole exceeds the sum of its parts.

Fifth, at the zero lower bound, risk management becomes extremely important. In particular, because the costs of getting stuck in a liquidity trap with chronic deflation are high, a central bank should put substantial weight on avoiding this outcome.

Sixth, the constraints imposed by the zero bound limit what monetary policy can accomplish by itself. This increases the importance of complementary fiscal, financial, and structural policy actions. Credible fiscal policies, actions to ensure a healthy financial system, and structural reforms that lift the potential for growth are very important.

Let me be clear. This was the time to act. With the problems we face and the potential dangers lying ahead, it is essential to do as much as we can now to bolster the resiliency and vibrancy of the economy. We cannot be complacent and assume that the economy is not being damaged if no action is taken.

If we continue to take only modest, cautious, safe policy actions, we risk suffering a lost decade similar to that which Japan experienced in the 1990s. Underestimating the enormity of our problems and the negative forces holding back growth itself exposes the economy to other potentially more serious unintended consequences. That type of passivity is a gamble that is not worth taking.

Now Japan has had a difficult two decades, certainly. I think there are some important differences between Japan and the United States. One that I would particularly stress is that Japan has had deflation, falling prices now for quite a long time and combined with interest rates that can't go below zero, that creates financial tightness in their economy which prevents, to some extent, investment and growth.

Also, the Japanese were not as quick as the U.S. to recapitalize their banks, as we did in 2009. They were the first into the situation. They didn't have the benefit of seeing others deal with it, grapple with it. We learned from them.

They continue to provide monetary policy support. I think it's important to note that yet one other difference is that Japanese demographics are quite different from that of the U.S. The workforce is actually beginning to shrink because they have very low birth rates and low population growth rates, and that is certainly going to be a factor that's going to keep their growth down in the period to come.

From the Q&A Session

Well, I'm a little bit more sympathetic to central bankers now than I was 10 years ago.

I think it's very important to understand that my comments, both in my comment in the -- published comment a decade ago, as well as in my speech in 2002 about deflation, my main point was that a determined central bank can always do something about deflation. After all, inflation is a monetary phenomenon, the central bank can always create money, and so on.

In response to a question from Yomiuri Shimbun about his earlier criticism of the BOJ.

One idea from the Japanese experience is that, with nominal interest rates at very low levels, more attention may have to be paid to quantitative measures of monetary policy. By announcing and maintaining targets for key monetary quantities, the Fed may be able to keep inflation and inflation expectations near target and ward off either a drift toward deflation or excessively high inflation. This will be an important issue for the Fed in coming months and represents a challenge in the communication of monetary policy going forward.

The Japanese case is interesting because it does demonstrate that financial factors do matter for Main Street, so to speak.  But in that case, there were some important differences, notably the Japanese banks hid their losses for many years. And even though they were functionally insolvent, it was not evident in terms of their bookkeeping that they were.  Eventually it became necessary for the government to bail out those banks.

Our banking system is much more open, in terms of describing its financial condition. And while many banks certainly have taken losses and there have been problems, it is, on the whole, very solvent and has a high level of capital.  And so we're nowhere near the situation that government bailouts are needed for our financial system.

From the Q&A session

Just as a healthy financial system promotes growth, adverse financial conditions may prevent an economy from reaching its potential.  A weak banking system grappling with nonperforming loans and insufficient capital or firms whose creditworthiness has eroded because of high leverage or declining asset values are examples of financial conditions that could undermine growth.  Japan faced just this kind of challenge when the financial problems of banks and corporations contributed substantially to sub-par growth during the so-called "lost decade." 

Japan's experience provides another example, though the context was different. There is a perception in parts of Asia that the Japanese government's decision to let the yen appreciate in the late 1980s was principally responsible for Japan's so-called “lost decade” of low growth. And, Japan, viewed through this prism, is cited as an example of the perils of letting an exchange rate move up in response to changing fundamentals. The reality is more complex. The problems of the Japanese economy in the 1990s were largely due to the aftereffects of the collapse of the real estate and asset price boom of the preceding decade, a boom fueled in part by efforts by the monetary authorities to limit the appreciation of the yen.

The size of the negative shock to demand from the collapse of the bubble was very substantial, and the capacity of the government and the central bank to mitigate the damage was constrained by the weakness in the banking system. A more forceful macroeconomic policy response, however, might have brought about a quicker recovery. In any case, the problem with the exchange rate choice was not the decision to let the rate adjust, but the decision to resist it and the role that played in magnifying the bubble, and thereby the subsequent damage from the fall.

[T]he BOJ's most recent financial statement showed that of the 68 percent of its assets held in the form of government securities, about two-thirds are long-term Japanese government bonds (JGBs)... If the Bank of Japan were to succeed in replacing deflation with a low but positive rate of inflation, its reward would likely be substantial capital losses in the value of its government bond holdings arising from the resulting increase in long-term nominal interest rates.

With such concerns in mind, BOJ officials have said that a strengthening of the Bank's capital base is needed to allow it to pursue more aggressive monetary policy easing. In fact, the BOJ recently requested that it be allowed to retain 15 percent (rather than 5 percent) of the surplus for the 2002 fiscal year that just ended to increase its capital, and the Ministry of Finance has indicated that it will approve the request. Even with this additional cushion, however, concerns on the part of the BOJ about its balance sheet are likely to remain.

The public debate over the BOJ's capital should not distract us from the underlying economics of the situation... Indeed, putting aside psychological and symbolic reasons, important as these may be in some circumstances, there appear to be only two conceivable effects of the BOJ's balance sheet position on its ability to conduct normal operations. First, if the BOJ's income were too low to support its current expenditure budget, the Bank might be forced to ask the MOF for supplemental funds, which the BOJ might fear would put its independence at risk... Second, an imaginable, though quite unlikely, possibility is that the Bank could suffer sufficient capital losses on its assets to make it unable to conduct open-market sales of securities on a scale large enough to meet its monetary policy objectives.

In short, one could make an economic case that the balance sheet of the central bank should be of marginal relevance at best to the determination of monetary policy. Rather than engage in what would probably be a heated and unproductive debate over the issue, however, I would propose instead that the Japanese government just fix the problem... I am intrigued by a simple proposal that I understand has been suggested by the Japanese Business Federation, the Nippon Keidanren. Under this proposal the Ministry of Finance would convert the fixed interest rates of the Japanese government bonds held by the Bank of Japan into floating interest rates. This "bond conversion"--actually, a fixed-floating interest rate swap--would protect the capital position of the Bank of Japan from increases in long-term interest rates and remove much of the balance sheet risk associated with open-market operations in government securities.