Executive Summary
1. Preface
In December 1997, the Bank of Japan established the Forum on the Development of Electronic Payment Technologies and Its Implications for Monetary Policy to examine the influence of the development of electronic payment technologies including electronic money on monetary policy. The forum released the Interim Report in May 1999. Subsequently, the forum expanded the scope of its examinations to the information technology (IT) revolution in general, including electronic payment technologies, and the forum’s name was changed to “Technological Innovation and Banking Industry/Monetary Policy: Forum on the Development of Electronic Payment Technologies and Its Implications for Monetary Policy.” The forum held active discussions regarding the changes to the financial and economic structures prompted by the IT revolution and its effect on monetary policy, based on papers prepared by experts from academia and by the forum’s secretariat (refer to Attachment 1 for a list of the Forum’s members, and to Attachment 2 for an outline of the reports presented in each meeting). This report summarizes the main points that were clarified during the forum’s subsequent discussions, based on the Interim Report.
2. Essence of the IT Revolution
The distinctive characteristics of the present IT revolution, as exemplified by the rapid development of computer technologies and the Internet, may be summarized as follows: (1) the integration of information processing and telecommunications technologies; (2) the consequent acceleration of the speed of information processing and transmission, reduction of information processing costs, and increase of the geographical distance over which information can be transmitted (globalization); and (3) the astounding speed at which IT is spreading among the public.
The IT revolution has increased the efficiency of the information processing used in goods and services production processes. As a result, it has facilitated price reductions for existing goods and services as well as the production of new goods and services that was practically impossible in the past. Moreover, the reduction in information transmission costs utilizing networks has greatly decreased the costs of information collection (search costs), and increased the potential for enterprises to find new trading partners that offer more advantageous terms of trade.
On the other hand, the increase in the volume of information brought about by the reduction in information transmission costs is not expected to eliminate the asymmetry of information (the imbalance of information between the buyers and sellers of goods and services). It is not yet clear whether the increase in the volume of information will generate an additional social burden, but if this is the case, frameworks to lessen the burden (such as credible information intermediaries) will become necessary.
The merits of the IT revolution, such as improved production efficiency and reduced search costs, have the potential to radically change the conventional socioeconomic structure. To begin with, the increase in capacity for information processing and transmission and the reduction of their costs will render existing technologies outdated, and make it easy for enterprises to rapidly enhance their competitiveness with the introduction of the latest technologies. Furthermore, the reduction of search costs utilizing networks is expected to greatly influence the ways businesses are implemented (changes in trading partners and in enterprise management methods).
3. Development of Electronic Commerce, Changes in Trading Patterns and Price Setting Mechanisms, and Influence on Monetary Policy
The integration of computers and telecommunications networks has facilitated electronic commerce over the Internet, and E-commerce is rapidly expanding. First of all, in terms of business transactions, the development of E-commerce has facilitated direct transactions between producers and consumers. Some assert that this phenomenon will result in the elimination of the distribution sector, and of inter-corporate keiretsu/subcontractor transactions. In terms of price setting, others have noted that the simplification of distribution sector promotes price reductions, facilitates frequent price revisions, and may lead to the emergence of a “perfect market” without any “market friction” whatsoever.
Examining these points, E-commerce is indeed changing transaction patterns. It increases direct transactions between producers and consumers, and for certain intermediate goods, trading is now transcending the conventional business-to-business transaction framework, such as inter-corporate keiretsu/subcontractor transactions, and taking place on a global scale. Nevertheless, E-commerce cannot resolve the “agency problem” for direct transactions just as under conventional transactions, so the role of the intermediation business will likely remain important. The emergence of a vast number of intermediation sites on the Internet suggests that the intermediation business will continue to play an important role, even with the spread of E-commerce. Among business-to-business transactions, the merits of Internet transactions related to the production of finished goods that require a large number of customized parts and close communication between parts suppliers and assembly manufacturers are relatively small. However, there is a strong likelihood that the trading of general-purpose intermediate goods with a wide range of applications to many finished goods will take place on a global scale and transcend the framework of inter-corporate keiretsu transactions.
Turning to price setting, price levels on the E-commerce markets are lower than those on conventional markets, and price revisions are being conducted more frequently, in small steps. However, in the E-commerce markets, the law of one price does not hold because of the “lemon problem” (the problem whereby buyers have risks to purchase inferior-quality products [lemons] due to the imbalance in product information between buyers and sellers), the switching costs incurred when changing the sites where buyers purchase goods, suppliers’ price discrimination in favor of certain customers, and so on.
As for the influence of the spread of E-commerce on monetary policy, particularly from the perspective of changes in price setting, first it is generally believed that the central bank should accept the reduction in price levels from the spread of E-commerce, as this is interpreted as a downward shift of the aggregate supply curve. Second, because increased price discrimination makes it difficult to compile accurate price indices using conventional methodologies, the issue of how to maintain and improve the quality and reliability of price indices will become increasingly important. Third, the increasing price flexibility resulting from the reduction in menu costs may reduce the effect of monetary policy on the real economy. However, there is another view that this is no great cause for concern because the strengthening of the market mechanism through flexible price adjustments will reduce the necessity of monetary policy itself.
4. Influence of the IT Revolution on the Financial Industry
Even with the IT revolution, the essential functions of the financial industry--such as the provision of payment and settlement services, the intermediation of risk (or risk taking), information production, and the provision of liquidity--will remain unchanged. However, major changes are expected in the specific contents of financial products and services, and in the financial institutions that provide these products and services.
The IT revolution has facilitated the provision of derivative products, the development of securitization, and the emergence of electronic payment and settlement means. Thus, technological innovations have raised the quality of financial products and services, and dramatically improved the risk management capabilities of asset managers. Moreover, the development such as the Internet has also enabled the provision of financial services via new delivery channels.
These changes in financial transactions increase the variety of financial products traded in financial markets, especially through securitization. In addition, the huge reductions in information processing and transmission costs have made arbitrage trading on financial markets much more active, and promoted the development of such trading. Amid this expansion of financial markets, financial intermediaries are substantially changing the contents of their services. One direction is to handle financial products that are difficult to standardize and seldom traded on financial markets. For example, financial intermediaries are moving to improve the efficiency of financial transactions for lending to small and medium enterprises, which entail high agency costs, by adopting the new method of credit scoring. Another trend is to transform advanced, complex financial products into simple ones that are easily understood by consumers and businesses, and then offer these products as new services. For example, the provision of new financial products incorporating derivatives and the expansion of off-balance-sheet transactions seem to reflect such development.
Considering these developments, how will financial intermediaries change in the future under the influence of the IT revolution? The financial industry is now witnessing a wave of mergers and alliances (concentration) based upon the greater economies of scale prompted by the IT revolution. On the other hand, the IT revolution is leading to a deterioration of the comparative advantages of banks in information production, the unbundling of existing financial services, and the development of the Internet. These are facilitating the advent of financial institutions specializing in particular services as well as entry into the financial intermediation market by firms in different industries (diversification). The future direction of this concentration and diversification in the financial industry is not yet entirely clear, but considering the reduced comparative advantages of banks in information production, the future providers of financial intermediation services may not be limited to firms in the present financial industry. There is a high probability that firms in other industries will utilize the fruits of the IT revolution to provide financial intermediation services. Additionally, considering that the strong economies of scale from the IT revolution may be limited to certain financial services, the present simultaneous trends toward concentration and diversification may well continue.
Regarding the effect of these financial changes on the monetary policy transmission mechanism, first the development of domestic financial markets is expected to increase the speed at which policy interest rates affect short-term and long-term interest rates via more active arbitrage trading. Meanwhile, in terms of availability channels, the effectiveness of monetary policy will probably decline if a greater variety of fund-raising methods other than bank loans is available and credit rationing decreases from the development of derivatives. Next, as for the influence of the changes in financial intermediaries, the increased competitive pressures from the entry of firms in other industries to the financial intermediation industry may reinforce the response of lending rates to policy interest rates and thus increase the importance of interest rate channels. Conversely, there is a view that if the IT revolution improves financial institutions’ abilities to monitor their borrowers, the transmission effect through changes in corporate collateral value (balance-sheet channels) may be reduced.
5. The IT Revolution and Globalization
Since the Internet lessens geographical and spatial restrictions, it will probably make national borders less important and accelerate the globalization of trade and financial transactions. Cross-border E-commerce transactions are not yet very popular for the trade in goods and services, but the reduction in search costs, the dramatic decrease in the transportation costs for digital goods, the changes in transaction patterns, and enhanced product differentiation are expected to increase cross-border E-commerce transactions and accelerate the tempo of trade growth. In terms of international financial transactions, the decrease in information transmission costs has made foreign financial trading much easier than in the past, increasing the substitutability of domestic and foreign financial assets. Therefore, the Internet will probably bring about more international portfolio diversification as well as further convergence of domestic and foreign real long-term interest rates. Additionally, the increase in trade resulting from the development of E-commerce may promote currency substitution through the wider use of the U.S. dollar for the settlement of domestic business-to-business transactions.
As for the influence of further globalization on monetary policy, to begin with, the rising dependence on foreign trade is expected to strengthen the transmission effect via foreign exchange rates. This implies that interest rate channels, which are closely related with foreign exchange rates, will become more important. Moreover, the higher substitutability of domestic and foreign financial assets may increase the influence of interest rates on foreign exchange rates. Nevertheless, it should be noted that it may become more difficult for policy interest rates and short-term interest rates to influence long-term interest rates because of the worldwide convergence of long-term real interest rates when exchange rate expectations are unchanged.
6. The IT Revolution and Monetary Policy
Central banks conduct their monetary policy under an uncertain environment where various changes such as exogenous shocks occur continuously and where it is difficult to grasp the influence of these changes accurately in real time. The IT revolution is expected to change financial and economic frameworks (structures), resulting in additional uncertainties. For example, with the IT revolution, it is becoming increasingly difficult to grasp potential growth rates and price trends accurately in real time. Accordingly, central banks must exert every possible effort to grasp the changes accompanying the IT revolution promptly and accurately, and to minimize the uncertainty faced in making policy decisions. For these purposes, central banks will need to raise the level of their capabilities to analyze monetary and economic conditions and to improve the quality of their economic statistics.
As for the influence of the IT revolution on the effects of monetary policy and the monetary policy transmission mechanism, there is a strong likelihood that the development of electronic payment technologies and the emergence of new financial products will structurally and unstably decrease the demand for the monetary base. To lessen fluctuations in the real economy in this situation, it is desirable for central banks to adopt interest rate stabilization policies. As almost all nations presently adopt short-term interest rates as their operational targets, the reduced demand for the monetary base is not expected to exert a significant influence on the present frameworks for money market operations. Also, even if the demand for the monetary base does decrease, since central banks are monopolistic suppliers of the monetary base, in principle there seems to be no reason why central banks will lose the controllability of short-term interest rates.
Regarding the influence of the IT revolution on the monetary policy transmission mechanism, (1) the effects of monetary policy via interest rates and foreign exchange rates will likely become stronger, while (2) the effects of monetary policy via funds availability (or balance sheets) will likely diminish.
The IT revolution will not only change the relative importance of monetary policy transmission channels, but there is also some possibility that it may reduce the necessity and the effectiveness of monetary policy itself due to the reduction in menu costs, the development of electronic money, and the increased domestic use of the U.S. dollar for settlement purposes. Nevertheless, taking information asymmetry into account, for the time being it is not realistic to believe that all transactions will be conducted over the Internet or that pricing will become completely flexible. Moreover, there is a low likelihood that the U.S. dollar will be used for all domestic transactions. Thus, for the foreseeable future, monetary policy will remain both necessary and effective, even though the necessity and effectiveness of monetary policy may decline somewhat.
7. Conclusions
The forum made every effort to grasp the effects of the IT revolution on a comprehensive basis, but it was not possible to cover every possible aspect. Issues that require further examination include (1) the best practices for communication between central banks and other market participants when information is exchanged on a real-time basis; (2) the effects of the increased speed and globalization of financial transactions on the stability of financial markets; and (3) the influence of the IT revolution on financial market stability, and the appropriate prudential policies to maintain financial market stability.
This is the English-language version of the Japanese report, which was originally published in Japanese on November 9, 2000.
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.