A note on the Japanese yen

My recent post on the yen triggered a number of interesting comments.  For instance, Miguel Sanchez responded to my claim:

“For those who don’t follow the yen closely, 77 is an insanely high level.”

with the following reply:

Aptly worded, though probably not in the way you intended. For those who do follow the yen closely, the real effective exchange rate is historically quite low, though it’s been off its all-time lows since the financial crisis.

I know there’s a huge and ongoing debate about how to gauge ‘fair’ value, but I would’ve thought the very basic test of whether a currency is overvalued is whether the country is running a trade deficit. Japan has and continues to run a massive trade surplus.

This is a widespread view, but it contains two misconceptions.  First, there is an implicit assumption that trade accounts should balance.  In fact, countries with good demographics (like Australia) would be expected to run current account deficits, and countries with bad demographics (like Japan and Germany) would be expected to run a surplus.  And that’s exactly what happened.  Indeed with optimal fiscal policy Japan’s surplus might well be much larger.

The second mistake is to assume that the real exchange rate is the correct variable for my analysis.  Monetary policy affects nominal exchange rates, and has no long run effect on real exchange rates. The way to tell if a currency is under or over-valued is not to look at trade balances, but rather NGDP.  By that measure monetary policy in Japan is too tight and the yen is too strong in nominal terms.

Miguel didn’t say this, but some proponents of “fairly valued” exchange rates claim that a weak yen actually hurts the rest of the world, by stealing jobs from others.  But as we saw today, the rest of the world actually gains from a weaker yen, at least when a strong yen is severely hurting the Japanese economy.

BANGKOK (AP) — Asian markets posted gains and European shares were headed higher Friday as the yen retreated from historic highs after the world’s seven leading industrial nations pledged to rein in the currency to help earthquake-stricken Japan.

This market response supports my “monetary view” of the overvalued yen, and goes against the “trade surplus view,” which implies the yen was undervalued even before the recent steps taken to depreciate it further.  As with China’s policy of fixing the yuan in late 2008 and 2009, an expansionary monetary policy during a worldwide recession helps all countries.  Macro is not a zero sum game.



18 Responses to “A note on the Japanese yen”

  1. Gravatar of dirk dirk
    18. March 2011 at 06:52

    Amazing the yen did not move down at all in anticipation of the G7 announcement, considering it had been publicly announced that the G7 was meeting to discuss such a coordinated move. I shorted it before the meeting but was beginning to sweat because the market behaved as if it didn’t have faith in the G7 to fulfill its supposed plans.

  2. Gravatar of James in London James in London
    18. March 2011 at 07:25

    “Good” demographics and “bad” demographics are only in the eye of the beholder. Some countries are extremely crowded and a bit (or a lot, even) of negative population growth is no bad thing. If you live in the wide open plains of the US then more people might seem like a good thing, if you live in Mumbai or my suburb of London, there are too many people. My quality of life would rise with less people, bring on bad demographics (assuming you’ve prudently saved enough for your old age).

  3. Gravatar of thruth thruth
    18. March 2011 at 07:40

    Scott, what do you make of Felix Salmon’s strange explanation (for an economist to grasp) of the rising Yen:

    “But what we’re seeing here is a function of ultra-leveraged hedge funds unwinding their carry trades. If you borrowed yen and invested in higher-yielding currencies like the Australian dollar or the South African rand, you made lots of money so long as the rate of appreciation of the yen was lower than the interest rate you were getting in the target currency. But when the yen starts to appreciate dramatically, you get margin calls, which force you to buy a lot of yen in an illiquid market, which in turn drives the yen up even further, which in turn not only increases the size of your margin call but also triggers a large number of stop-loss orders and other triggers embedded in exotic FX options. The result can be massive, as we’ve just seen.”


    My gut tells me you would say that speculators are merely removing the lags in signalling the AD slowdown inherent in Japan’s lagging policy response (perhaps with some overshoot).

  4. Gravatar of tom tom
    18. March 2011 at 07:44

    To buy the explanation that the market says a “weak Yen is good overall” you have to explain why the price of precious metals rose in all currencies overnight in relation to the same announcement. One doesn’t expect PM strength on the back of economic recovery.

  5. Gravatar of thruth thruth
    18. March 2011 at 08:30

    tom: Perhaps commodities rose for the same reason that shares in nuclear firms got hammered? Commodities are an extremely noisy signal of inflation/macro trends.

  6. Gravatar of tom tom
    18. March 2011 at 08:35

    tom: Perhaps commodities rose for the same reason that shares in nuclear firms got hammered? Commodities are an extremely noisy signal of inflation/macro trends.

    So are equities. If you are going to reason that the rise in equities results from future expectations of real growth then you have to account for the fact that other markets who usually work in opposite (or at least different) directions also rose. In fact PMs showed more strength (larger % rise) than US markets which makes simply noting the direction of change a dubious defense.

  7. Gravatar of bertusmaximus bertusmaximus
    18. March 2011 at 08:43

    i guess none of the funds used for intervention were sterilized. global money base goes up, PM (and all commodities) go up too in response to that. debase currencies, increase prospects of inflation, and risk markets react favorably to that. too simple?

  8. Gravatar of Philo Philo
    18. March 2011 at 11:06


    Why was G-7 intervention needed to drive down the Yen? Couldn’t the Bank of Japan do the job alone?

  9. Gravatar of ssumner ssumner
    18. March 2011 at 11:14

    dirk, I wish I had the courage of my convictions. I could have made lots of money after both QE1 and QE2 rumors began spreading. &%$#@*& EMH!!!

    James in London, You said;

    “My quality of life would rise with less people, bring on bad demographics (assuming you’ve prudently saved enough for your old age).”

    Having liven in London, I see your point. But have you considered the “quality of life” of the English babies that never get born, all because some selfish person wants less crowded subways? (I’m teasing of course.)

    thruth, Can you rephrase your last paragraph? For some reason I don’t follow. My general view is that it all comes back to the BOJ. Yes, things like the carry trade can affect the yen, but only if the BOJ lets it happen. The question is why would they let it happen (or be expected to let it happen.)

    Tom, You said;

    “One doesn’t expect PM strength on the back of economic recovery.”

    I’m not so sure, Asian gold demand has been rising fast–that’s partly a growth story. How did gold do in the period since August, when QE2 rumors started? I haven’t followed gold, as I never feel confident I know why it is moving.

    My other thought is that perhaps inflation expectations rose a bit with the G7 move.

    bertusmaximus. I should have read your post before my previous response–we think alike.

  10. Gravatar of ssumner ssumner
    18. March 2011 at 11:16

    Philo, I don’t know, maybe this was a symbolic show of support–showing markets that the other countries wouldn’t try to resist a falling yen, with offsetting actions.

  11. Gravatar of a a
    18. March 2011 at 13:24

    if you look at when the jump in the yen happened, it was around US market close, an incredibly illiquid hour. with few sellers, firstly because of repatriation and secondly because of the time of day, the jump to 77 is simply a case of market mechanics. illiquidity combines with cascading stop-loss orders. not everything is fundamental or monetary.

  12. Gravatar of Richard W Richard W
    18. March 2011 at 14:29

    It seems to me you were specifically referring to the USD/JPY pair and Miguel is speaking about the weighted average of the real effective exchange rate. Demographics does explain a lot about current accounts but the REER should respond to relative trade balances. However, what is fair value in relation to any particular pair is highly subjective.

  13. Gravatar of Mark A. Sadowski Mark A. Sadowski
    18. March 2011 at 17:44

    Perhaps the “fair” value of a nation’s currency should be defined as that level which yields maximum output with price stability (without forex intevention or capital controls of course). By that measure the Japanese yen is obviously way overvalued.

  14. Gravatar of 円について by Scott Sumner – 道草 円について by Scott Sumner – 道草
    18. March 2011 at 18:32

    […] by Scott Sumner // スコット・サムナーのブログから、”A note on the Japanese yen” (March 18th, […]

  15. Gravatar of Scott Sumner Scott Sumner
    19. March 2011 at 06:22

    a, Yes, but that’s not the entire story. Even a day later it was about 78, which is still a record high (except the 77 point, which I agree was a blip (and said so in the post.)

    Without G7 intervention it might still be about 78.

    Richard, I don’t know what REER means, but if it is exchanges rates I don’t agree. Economic theory predicts that exchange rates should not respond to trade balances.

    By analogy, S&D theory says prices should not respond to changes in quantities. A change in the quantity of oil should have no impact on the price of oil.

    Mark, Yes, I’d say stable NGDP growth, but we’re on the same page.

  16. Gravatar of Richard W Richard W
    19. March 2011 at 10:34

    The REER is the multilateral trade weighted exchange rate. The JPY currency measured relative to a basket of other major currencies adjusted for the effects of inflation. That was the exchange rate that Miguel was referring to as being ‘historically quite low ‘ I think it is around the long-term average rather than being low. Whereas you were referring to the bilateral USD/JPY exchange rate. The USD could be said to be at a discount because it buys fewer Japanese yen and as a consequence the JPY overvalued relative to the USD. However, there is no indication from the real effective exchange rate to say that the JPY is overvalued.

    It is the trade weighted REER that the central banks usually use in their calculations rather than just look at one pair. The weights are determined by comparing the relative trade balances, in terms of one country’s currency, with each other country within the index. Since the current account will obviously affect capital outflows and inflows, trade flows will impact the real effective exchange rate (REER). It is very difficult for the market to fight coordinated central banks especially the BoJ who effectively have infinite money. However, who wins in this battle will be fascinating to watch as the market will try and thwart them because they are trying to make the JPY undervalued. If the central banks lose the JPY could appreciate 15%+.

  17. Gravatar of James in london James in london
    19. March 2011 at 14:57

    Wow. I never realised you were against contraception, and in favour of maximising population growth. Am teasing too! Demographics should be left to the people, not central planners. Once through the demographic transition population decline is inevitable.

  18. Gravatar of ssumner ssumner
    19. March 2011 at 15:51

    Richard, I don’t think the concept of “under-valued” and “over-valued” currencies has much use. What matters for monetary policy is the nominal exchange rate, and hence the REER is not relevant for the question of whether the yen should be depreciated. The yen should fall because Japan needs a bigger NGDP.

    James, I’m glad you favor leaving demographics to the people, not central planners. I presume you favor free immigration to London, from anywhere in the world, rather than allowing central planners to decide how many people can move there.

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