And deposit protection schemes ensure that transactional balances up to £ remain interchangeable with cash even if that happens. This model is relatively recent. It was not ever thus. And as we think about new forms of digital payments, it is important that we do not take this for granted. A large number of financial crises of the last century have featured a loss of confidence in the reliability and safety of the money people rely on for transactions. Money that is usually considered safe. Money that people normally do not think about very much. In the emerging market financial crises of the 1990s and early 2000s, people and businesses lost faith in the state’s ability to maintain the value of their local currency against the dollar4. Other crises have had at their heart a loss of confidence in the ability of private issuers – commercial banks – to fulfil their IOUs with depositors and lenders and maintain the interchangeability and reliability of the money they issued. Think of the Great Depression-era bank run depicted in ‘It’s a Wonderful Life’. Think of the Northern Rock example – where worries about the Northern Rock’s funding led to a crisis of confidence; first from wholesale lenders and then from retail depositors – who suddenly worried that their deposits would no longer be interchangeable with cash or other bank deposits. Remember the queues outside of branches in 2007, as depositors rushed to exchange their deposits before – they believed – it might be too late5.
The Bank of Japan (BoJ) responded by reducing overnight interest rates from a peak of more than 8 percent in early 1991 to ½ a percent by the fall of 1995.2 Most studies of this period suggest that policy was generally appropriate given economic forecasts at the time, but too tight relative to the actual outcomes.3 Economic forecasts for Japan – both by the official community and by private sector agents – were consistently more optimistic than the actual outturns. It is noteworthy that as late as January 1995 – on the eve of deflation – 10-year Japanese Government Bond (JGB) yields were still at 4.7 percent. With the benefit of hindsight, we now understand that the disinflationary consequences of the asset price bust and financial stress where vastly more powerful than was widely realized at the time. As we later saw in the U.S., the forces of contraction and disinflation operated through many different channels – not just directly on household wealth, for example, but also through the impact of the asset price bust on the health of financial intermediaries and the supply of credit to households and businesses. Over time, the Japanese banking system came under mounting stress. This was a slowmotion crisis, as the assets were mainly loans that were not marked-to-market. Accounting practices and regulatory forbearance allowed banks to delay charging off bad loans and recapitalizing at the cost of impairing the availability of credit to new potential borrowers. A full-blown banking crisis finally materialized in 1997.