The Yo-Yo Yen: And the Future of the Japanese Economy

The Yo–Yo Yen

Also by Brendan Brown THE FLIGHT OF INTERNATIONAL CAPITAL MONETARY CHAOS IN EUROPE ECONOMISTS AND FINANCIAL MARKETS

The Yo–Yo Yen and the Future of the Japanese Economy Brendan Brown Foreword by Robert Z. Aliber

© Brendan Brown 2002 Foreword © Robert Z. Aliber 2002 All rights reserved. No reproduction, copy or transmission of this publication may be made without permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patent Act 1988. First published 2002 by PALGRAVE Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE is the new global academic imprint of St. Martin’s Press LLC Scholarly and Reference Division and Palgrave Publishers Ltd (formerly Macmillan Press Ltd). ISBN 0–333–92949–7 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Brown, Brendan, 1951– The yo-yo yen: and the future of the Japanese economy/Brendan Brown. p. cm. Includes bibliographical references and index. ISBN 0–333–92949–7 1. Yen, Japanese–History. 2. Money–Japan–History. 3. Monetary policy–Japan–History. I. Title. HG1272.B76 2002 332.4⬘952–dc21 2001059054 10 9 8 7 6 5 4 3 2 1 11 10 09 08 07 06 05 04 03 02 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire

Contents List of Figures

vi

List of Tables

ix

Acknowledgements

x

Foreword by Robert Z. Aliber

xii

Introduction

1

1

Historic Roots of the Yo–Yo Yen (1859–1949)

5

2

A Brief History of the Modern Yen (1960–87)

30

3

Who Pulls the String of the Yo–Yo Yen?

63

4

From Bubble Economy to Yen Bubble (1988–93)

116

5

Yen Opportunity Gained and Lost (1993–2000)

163

6

What To Do About the Yo–Yo Yen?

215

Bibliography

240

Index

244

v

List of Figures 1.1 1.2 1.3 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 2.14 2.15 2.16 2.17 2.18 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 3.14

Gold–silver parity, 1868–94 US$/yen exchange rate, 1880–97 US$/yen exchange rate, 1918–25 Real effective exchange rate index of the yen, 1971–2001 Japan vs. Germany economic growth in the 1960s Real appreciation of the yen vs. dollar, 1960–71 Japan vs. US economic growth, 1965–76 Yen exchange rate vs. US$ and DM, 1971–9 Japan budget deficit (per cent of GDP), 1960–2000 Japan vs. US business cycles, 1965–76 Japan interest rates, 1970–80 Real exchange rate index of the dollar against yen, 1970–2000 Japan business investment and saving (per cent of GDP), 1960–80 Japan vs. US inflation, 1971–9 Japan vs. US economic growth, 1976–90 Japan vs. US government bond yields, 1975–80 Japan current account balance, 1970–80 Exchange rates: yen/DM and yen/US$, 1979–87 Japan current account balance, 1981–90 Japan vs. US government bond yields, 1985–6 Japan vs. US money market rates, 1985–6 Switzerland current account balance vs. real effective exchange rate, 1980–2000 US Federal funds rate vs. Japan unsecured overnight call rate, 1991–5 Euro corner, 1973–7 US dollar corner, 1973–7 Japanese yen corner, 1973–7 Euro corner, 1978–81 US dollar corner, 1978–81 Japanese yen corner, 1978–81 Euro corner, 1982–5 US dollar corner, 1982–5 Japanese yen corner, 1982–5 Euro corner, 1986–90 US dollar corner, 1986–90 Japanese yen corner, 1986–90 vi

12 14 22 32 34 36 37 42 43 45 46 47 48 52 53 54 55 57 58 60 61 69 74 81 82 83 84 85 86 87 88 89 90 91 92

List of Figures vii

3.15 3.16 3.17 3.18 3.19 3.20 3.21 3.22 3.23 3.24 3.25 3.26 3.27 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 4.11 4.12 4.13 4.14 4.15 4.16 4.17 4.18 4.19 4.20 4.21 4.22 4.23 4.24 4.25 4.26 4.27 4.28 4.29

Euro corner, 1991–4 US dollar corner, 1991–4 Japanese yen corner, 1991–4 Euro corner, 1995–7 US dollar corner, 1995–7 Japanese yen corner, 1995–7 Euro corner, 1998–2001 US dollar corner, 1998–2001 Japanese yen corner, 1998–2001 Sterling, 1995–2001 Swiss franc, 1995–2001 Singapore dollar, 1992–2001 Taiwanese dollar, 1992–2001 Japan, US and euro-area GDP per capita, 1990–5 Japan, US and euro-area GDP per capita, 1995–2000 Japan productivity growth, 1985–90 Japan inflation, 1987–94 Japan money supply, 1988–94 Japan money rates, 1989–95 US dollar vs. DM and yen, 1987–92 Yen vs. US dollar and DM, 1987–92 Japan vs. US money rates, 1986–91 Japan vs. US equity markets, 1987–93 Finnish mark real effective exchange rate, 1985–95 British pound real effective exchange rate, 1988–95 Japan, UK and Finland current account balances, 1987–95 Switzerland real effective exchange rate, 1988–2001 Switzerland inflation, 1988–2000 Switzerland yield curve, 1988–2001 Switzerland current account surplus vs. general government balance, 1987–2000 US$–DM–yen triangle – US dollar corner, 1987–92 US$–DM–yen triangle – DM corner, 1987–92 US$–DM–yen triangle – yen corner, 1987–92 Japan vs. US leading indicators, 1986–92 Japan 10-year JGB yield vs. overnight call rate, 1990–5 Japan, US and (West) Germany real GDP, 1990–4 3-month euro-yen, dollar and DM rates, 1990–3 Japan vs. US current account balance as per cent of GDP, 1987–95 Japan industrial production vs. real GDP, 1990–2001 10-year JGB yields vs. 10-year T-bond yields, 1991–5 Japan vs. US leading indicators, 1992–8 Japan, US and euro-area real GDP, 1989–2001

93 94 95 96 97 98 99 100 101 110 112 114 115 118 119 122 124 125 128 129 130 131 134 136 136 137 138 138 139 139 141 142 143 144 145 147 148 151 152 159 160 161

viii List of Figures

5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 5.13 5.14 5.15 5.16 5.17 5.18 5.19 5.20 5.21 5.22 5.23 5.24 5.25 5.26

Yen vs. US dollar and DM, 1993–8 US dollar vs. yen and DM, 1993–8 DM corner, 1993–8 US dollar corner, 1993–8 Yen corner, 1993–8 10-year yield spreads, T-bond over JGB and Bund, 1993–5 10-year JGB, T-bond and Bund yields, 1994–7 Japan equity market vs. 10-year JGB yields, 1993–2001 Japan private consumption deflator, 1985–2001 Japan official discount rate vs. overnight call rate, 1993–7 Yen vs. US dollar and DM, Feb–April 1995 US dollar vs. yen and DM, Feb–April 1995 10-year JGB vs. T-bond yields, 1996–9 Japan, US and Germany real GDP growth, 1993–7 Real GDP: Japan, US and euro-area, 1995–2000 10-year bond spread (T-bond over JGB), 1996–2000 3-month Japan CD rate vs. 3-month euro-dollar rate, April–May 1997 10-year JGB vs. T-bond yields, April–May 1997 US$ vs. Yen and DM, April–May 1997 Yen vs. US$ and DM, April–May 1997 US dollar vs. Yen and DM, October 1998 Japan yield curve, 1995–2001 10-year JGB yield vs. 3-month CDs, June 1998–March 1999 Euro currency corner, 1999–2001 US$ currency corner, 1999–2001 Yen currency corner, 1999–2001

164 165 171 172 173 174 174 175 177 178 181 181 190 191 191 193 197 197 199 199 206 208 209 210 211 212

List of Tables 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10

Japan savings–investment balance, 1960–72 Japan savings–investment balance, 1974–82 Japan savings–investment balance, 1984–9 Japan savings–investment balance, 1990–9 Switzerland savings–investment balance, 1990–7 US savings–investment balance, 1982–90 US savings–investment balance, 1992–9 Euro-area savings–investment balance, 1991–8 Solo and axis movement in the US$–euro–yen triangle: how frequent? US$, euro and yen: how long has each been in the limelight?

ix

64 65 66 67 70 77 78 79 103 104

Acknowledgements On arrival at the University of Chicago’s Graduate School of Business, I had no idea that my career would be in international finance and that my academic source of inspiration would be Robert Z. Aliber. On departure, I was certain about both points. The era of floating exchange rates had just dawned. The Smithsonian fix between the yen, US dollar and DM had broken down. A new frontier – full of danger and opportunity – had opened up for international business decision-makers, whether as investors or borrowers. In his classes Bob Aliber introduced us to the essential tools – Fisher Open, Fisher Closed, PPP, economic risk exposure (versus accounting) – for rational strategy-making in the face of expected and unexpected exchange rate change. I had some floating intention of immediately proceeding with doctoral study on these topics at the University of Chicago. But Bob was in no doubt about the advantages of first engaging oneself in the real world of markets and offered me (jokingly!) a two-year forward contract of a place in his PhD programme. He must have known that once immersed in markets and in the European centre of action I would not exercise the contract. Just around the time when the contract would have matured, I had gone into an art museum near the Bank for International Settlements. Suddenly a familiar voice called out my name. Bob had also been visiting the Bank and was travelling on the same plane to London that evening. I do not recall whether we spoke about Japan, but that flight was the start of a continuous dialogue between us which has been a never-ending source of stimulus to my thinking about international financial developments. My recollection is that Japan became a big topic in our discussion by the early 1980s. Huge Japanese capital inflows into the US were helping to sustain a strong dollar despite a record size US current account deficit. Bob had no doubts about the driving force behind the new pattern of global capital flows – the big private sector savings surplus in Japan which had emerged as its economic miracle faded away. He made the key comparison with Britain in the twenty years before the First World War. Unfortunately, policy-makers in Washington and Tokyo did not share Bob Aliber’s grasp of the essential problem – how Japan’s savings surplus would be absorbed in the global economy. Prophecy is a lonely business. And there is no doubt about Bob’s prophetic powers. His visits to my office in London were wake-up calls to what lay ahead – whether the bursting of the Tokyo equity market bubble, the entry of the US economy into a low inflation era, the Asian crisis of x

Acknowledgements xi

summer 1997, and most recently the bursting of the US bubble and subsequent recession. The one prediction where I can claim to have disagreed with Bob and been vindicated is about the future of floating exchange rates. Bob thought it possible that the end of the worldwide inflation storm which had raged through the 1970s would bring a return to fixed exchange rates between the major currencies. As is so often the case, correct foresight was based on thinking which was in fact incomplete. I failed to take full account of the Japanese-related factors impeding a return to fixed rates. The focus of my argument (in favour of no return being likely) was too narrow and parochial. I took the Bundesbank as the centre of the currency world. That distortion of vision – too much importance to the DM and too little to the yen – should have corrected itself during the many years I have had the deep privilege of being a member of the research team at Tokyo–Mitsubishi International (and previously Mitsubishi Finance). Experience of talking to clients and to my colleagues about the outlook for yen markets in particular stretches back to the years of Japan’s bubble economy. Economic research activity at Tokyo–Mitsubishi International enjoys high respect from senior management and takes place in an environment of total professional independence. The views expressed in this book are strictly personal and in no way reflect those of my colleagues either individually or as a group. When I mentioned to Bob some time ago that I was embarking on a book about the yen he had no doubts about the title. Back came the mail, crossing out my suggestion as too narrow, and replacing it with ‘Yo–Yo Yen and the Future of the Japanese Economy’. I know now from where the idea came for the title of his bestseller The International Money Game. A game suggests there are winners and losers, which there certainly are in international financial markets. The yo–yo yen has showered big gains and losses on different groups both inside Japan and outside. On balance, though, the successive throws of the yo–yo have been a drag on Japanese economic prosperity and exposed flaws in the international economic order. It is time to change the rules of the game. BRENDAN BROWN

Foreword The economic developments in Japan in the last fifteen years present one of the most interesting sets for economic analysis and one of the most challenging for policy makers. The rate of economic growth has declined from one of the most rapid in forty years prior to 1990 to one of the slowest among the industrial countries. Japan is now experiencing its third economic contraction in the last ten years. The consumer price level is declining by 1 per cent a year, and there is the prospect of a debt-deflation cycle; because prices are declining more rapidly than costs, profits are squeezed and the business failure rate has soared, which constrains the growth of bank credit which leads to further downward pressure on prices. The banks and other financial institutions have been struggling under a mountain of non-performing loans as a result of the implosion of the asset price bubble of the late 1980s and the recessions; because of the high rate of bankruptcy, banks have to dispose of old loans at an increasingly rapid rate to avoid an increase in the number of non-performing loans on their balance sheets. The nominal interest rates on short term deposits and short term government securities are zero and real interest rates are slightly positive; the nominal interest rates on ten-year government bonds are below 2 per cent and real interest rates are about 3 per cent. The fiscal deficit has been in the range of 8 to 10 per cent a year for each of the last four years, and the ratio of government debt in the hands of the public to GDP is much higher than in any other large country. Either tax revenues must increase relatively to government expenditures by 6 per cent of GDP, or the government eventually will default on its debt, either formally a, more likely, informally. Still the cranes are back in Tokyo and the capital city is experiencing another major construction boom. Despite the economic slowdown, there remain fabulously successful Japanese firms – Toyota, Sony, Fuji Film, Fujitsu, Fanuc, Canon, DoCoMo, Honda, Nikon, Komatsu, Kubota and Toshiba. Moreover Japanese-owned foreign assets are much larger than those of all other creditor countries combined; the ratio of these assets to the country’s GDP is twice the peak value for this same ratio for the United States. In the last fifty years Japan has achieved the highest rate of growth of per capita income in any of the industrial countries. In the late 1940s per capita incomes had been at the equivalent of the proverbial $100 a year, a result of the tremendous physical damage from the bombing during the last several years of World War II, the loss of what had been its colonies, and limited ability to gain the advantage of international specialisation because of the lack of the ability to produce goods that could be sold in foreign markets. xii

Foreword xiii

By the early 1990s per capita incomes in Japan were comparable to those in other industrial countries. Japan now is a rich country, indeed a very rich one even though many Japanese are still in a time warp and continued to think that the country is poor. The foreign exchange value of the yen had been set at 360 yen per US dollar in 1949 when Japan was still occupied by the US military forces; this parity was viable only because a wide array of trade and exchange controls limited payments for imports and foreign services and foreign securities. If market forces had been allowed to set the foreign exchange value of the yen on the basis of the competitiveness of Japanese goods in foreign markets, the Japanese yen price of the US dollar would have been in the range of 500 to 600 yen. By the end of the 1970s, the yen traded at 150 yen to the US dollar and by 1995 the yen briefly had traded at 80 yen. Both the real appreciation of the Japanese yen and its variability around the trend were greater than for the currency of any other industrial country. The counter part of this remarkable appreciation of the currency is that by the year 2001 the Bank of Japan had accumulated more than US$400 billion of foreign exchange reserves, much larger than those of any other country. The sharp appreciation and the remarkable increase in foreign exchange reserves resulted from the exceptionally rapid growth in the country’s exports and its foreign exchange earnings. The 1990s was a devastating decade for Japanese expectations. In the early 1970s ‘Japan: The First Super-state’ appeared; the successor volume in the 1980s was ‘Japan as Number One’ to many in Tokyo. It seemed only a matter of a few years before Japan displaced the United States as the dominant super-power. Until 1990 the rate of economic growth in Japan was higher than the comparable rates in any other industrial country. In the 1950s and the 1960s, the annual growth rate averaged 10 per cent; there were step-like reductions in the growth rate in each of the next two decades. Still in the 1980s the rate of economic growth was higher than in most other industrial countries, at the same time asset prices were rising sharply, especially in the last three years of that decade. There was a sharp unanticipated decline in the growth rate in the 1990s, and for most of the decade the country was in the economic doldrums, with a rate of economic growth substantially below that in the United States and the industrial countries in Western Europe, even below the rate in Great Britain, a country with a much lower saving rate, a much less robust industrial sector, an ageing capital stock and a much more truculent labour force. Throughout the 1990s domestic supply capabilities were increasing more rapidly than domestic demand; by the end of the decade the output gap

xiv Foreword

may have been in rage of 10 to 15 per cent. Nominal interest rates declined, and the creditors who depended on interest receipts for a substantial part of their income experienced a real decline in their incomes; they became increasingly sensitive to the differences in the prices of similar goods. There was a surge in imports of competitive manufactures from Korea, China, and other countries in the region, which contributed to the downward pressure on the price level. The ‘100 yen’ stores greatly increased their share of the domestic market with consumer goods produced in China – often in Japanese-owned plants dedicated to producing for the markets in Tokyo and Osaka – and there are 2000 such stores in Japan. The prospect of ‘debt deflation’ cycle increased – a downward spiral in prices and bank capital. Excess supply resulted in downward pressure on prices. Profit rates and profit levels were squeezed because prices were declining more rapidly than costs. Many firms incurred losses, and some went bankrupt; some of the losses were transferred to the bank lenders. The value of bank capital declined and became more uncertain, and so it became more difficult for banks to raise capital. The banks were reluctant to expand their loans to all except the most creditworthy borrowers, and the sluggish growth in credit meant that investment spending was not increasing and so excess supply continued to place downward pressure on the Japanese price level. Japan continues to have the basic inputs that enabled it to achieve high rates of economic growth in the 1970s and the 1980s – the savings rate is high and the supply of capital is large, the labour force is skilled and diligent and hard working, and firms are leaders in their ability to develop new technologies and to adapt those from other countries to the Japanese circumstances. The likelihood is high that the implosion of the asset price bubble of the late 1980s derailed the economy. But why has the economy failed to move back to its growth trajectory? Why has Say’s Law failed to operate in Japan for a decade? Why hasn’t the remarkable supply capability created its own demand? The central question is whether the tepid economic performance of Japan in the last decades reflects the shortcomings of government policy – both the adoption of policies that were inappropriate following the implosion of the asset price bubble and the failure to adopt policies that would have been appropriate – or whether instead there has been a ‘market failure’ and if so in which market and why? The failure of government policy may reflect the delay in formally recapitalising the banks after the large loan losses, or the increase in the consumption tax, or the efforts of the Bank of Japan to talk up the foreign exchange value of the yen, or the tepid approach to a more aggressive monetary policy in the early 1990s, to cope with the effects of the implosion of a massive asset price bubble. To some extent the failure of government

Foreword xv

policy might be attributed to the US authorities who at times were reluctant to see the yen depreciate and the trade surplus of Japan increase. The policy failure also might reflect that the ‘Japanese establishment’ was reluctant to accept the financial losses and to accept the inevitable restructuring of industry so that corporate Japan would be more profitable. The market failure would instead reflect that either the level of investment or the level of saving are not sufficiently sensitive to the declines in interest rates. Thus the usual expectation is that as interest rates decline, investment would increase and saving would decline until the amount that households wish to save, when the economy is fully employed, would correspond to the amount that business firms wish to invest. Moreover, to what extent has the seemingly lost decade been an extended transient factor associated with the implosion of the bubble, and to what extent has the implosion revealed some permanent and underlying structural defects in the economy that had previously been obscured? The next section of this introduction summarises the unique aspects of Japan’s industrial structure and the relation between this structure and the composition of the country’s foreign trade. The third section considers the impacts of the implosion of the asset price bubble and on the relationship between the banks and their affiliated firms. The fourth section develops the major hypothesis that the dominant problem in Japan is that the amount that households wish to save, if the economy were growing at capacity, is significantly larger than the amount that Japanese firms would wish to invest at home and can profitably invest at this rate of growth. The fifth section evaluates the proposals for getting the Japanese economy to grow again in terms of this statement of the problem. The sixth section discusses direct approaches to increase consumption spending relative to income. The final section evaluates the major theme of the ‘The Yo-Yo Yen’.

Economic structure and the foreign exchange value of the yen Japan is different from the other industrial countries. The domestic resource base is limited; virtually all raw materials, much of energy, and many foodstuffs are imported. The surprising aspect of the Japanese economy is that the ratio of imports to GDP is remarkably low, much below those of other industrial countries with much richer resource bases. If this ratio had been more nearly similar to that of Germany or Great Britain, then the ratio of exports to GDP also would have been higher, and Japan would have had to have grown its exports and increased its share of the domestic markets in most other industrial countries at more rapid rates. For most of the period 1950 to 1990, Japan’s exports were increasing twice as rapidly as world exports. At the beginning of the period, most of the exports were inexpensive commodity-like manufactures – textiles, apparel, toys, and bicycles – goods that were sold on the basis of a price

xvi Foreword

advantage. Relatively few products then had recognisable brand names. The more rapid growth of Japanese exports than of world exports reflected that the Japanese firms were able to increase their share of foreign markets – despite many protectionist barriers – on the basis of declines in price and improvements in quality and the development of a more favourable attitude in foreign countries toward Japanese brands. The change in the composition of exports has been impressive. There was the move into steel and radios and then TVs and then motorcycles and then small cars and then computers and sophisticated electronics. The ratio of Japanese value, added to the total price of the product, seemed to be increasing exponentially; Japanese brand names became dominant in autos and electronics and photo-optics. Much of the growth in exports was in goods that Japan had begun to produce relatively recently. By the mid-1980s Japan had become an economic superpower, second only to the United States. Japanese firms had become dominant players in the global markets for autos, steel, electronics, and photo-optics. Toyota was one of the four or five major competitors in the global auto industry, while Honda had become one of the most innovative firms. Sony set the standard for innovation and quality in the electronics industry – and there were many firms like Matsushita and Sanyo with extensive product lines and others like Denon and Luxman and Yamaha and Nakamichi with market niches in quality components. Japanese financial institutions dominated the hit parades of the world’s largest firms. The assets of Nomura Securities were larger than the combined assets of the five largest US investment banks. The rapid growth in Japanese exports was facilitated by its unique industrial structure that nurtured the development of new firms in new industries. Most of the major industrial groups have organised around what had been feudal families – the Mitsuis, the Yamamotos, the Sumitomos. Before the Second World War, each group had a bank holding company that controlled a trading company, a shipping line, an insurance company, and a firm in each of a large number of manufacturing and service industries. This zaibatsu arrangement was outlawed by the occupation, but its substance was retained with significant cross-shareholdings between the banks and the firms, and among the firms. The cross-shareholdings accounted for about two-thirds of the total share ownership of the relevant firms. (Not all firms were part of one of these groups.) Perhaps 30 per cent of the labour force was employed under ‘lifetime contracts.’ The firm was a ‘village’ and the wage payment based on seniority meant that the residual owners were the employees. The stockholders traded titles to ownership in a casino, but the managers of the firms felt no commitment to enrich the anonymous shareholders. Because wage rates were firm-specific, the less efficient firms could match the prices charged by the more efficient by providing less rapid increases in wages

Foreword xvii

and bonuses. The first call on the firm’s revenues was the funds to expand and enrich its product line. There were and are many more firms in each industry than in the United States and Western Europe; for example, for a long time there were nine free-standing firms in the automobile industry (Toyota, Nissan, Honda, Mitsubishi, Mazda, Suzuki, Isuzu, Subaru, Daihatsu), more than the combined number for the United States and Western Europe. The flexibility in the wage payment system meant that the smaller and less efficient firms could continue to compete with the leaders in their industries. Industrial policy captured by the motto ‘Japan Inc.’ facilitated economic growth. The domestic market was protected from imports until Japanese firms had reduced their costs so that they were internationally competitive. Government financial regulations were extensive and led to high levels of investments; the system was rigged so that household savers required subsidised industrial borrowers. Interest rate ceilings on bank deposits after were at levels below the inflation rate, so the real rates of interest were negative. Initially loans were subject to interest rate ceilings. The demand for credit at these low interest rates was larger than the supply, and some firms with access to credit profited by lending some of the funds at rates significantly higher than the regulated rates. Exchange controls prevented household savers and financial intermediaries from buying foreign securities. Japan had a ‘dual economy’ or more of a dual economy than other industrial countries. Firms in a few industries were super international competitors, with output per worker per hour significantly higher than in other industrial countries. A typical statement might be was that it took 78 worker-hours to produce an automobile in a Toyota factory in Japan, and 110 worker-hours to produce an automobile in a Ford factory in the United States. These descriptive comparisons applied to perhaps 30 or 40 per cent of the firms in various manufacturing industries. In the remaining sectors of the economy – agriculture, the rest of manufacturing industry, and the service sectors – productivity was much below that in the United States. Observers noticed the large numbers of service personnel in department stores and hotels. Most of the industries in the productive sector produced tradable goods, but not all the industries that produced these goods were in the modern sector, the operative distinction appears to be between those firms that produce relatively new goods at those in traditional manufacturing. The rapid growth of exports led to the secular appreciation of the yen; at the same time the reduction in trade and exchange controls led to an increase in imports that limited the appreciation of the yen. Japanese foreign investment began to surge in the early 1980s as exchange controls were relaxed; initially in the purchase of foreign securities and subsequently in the acquisition of established firms in the United States and to a lesser extent in Western Europe. The Japanese authorities apparently realized that domestic savings were sufficiently large so that foreign investment would not significantly

xviii Foreword

‘crowd out’ domestic investment, and that the purchase of foreign securities and assets would limit the appreciation of the yen. Japanese investors were attracted to the higher anticipated rates of return abroad. By the end of the 1980s Japan had displaced the United States as the world’s largest creditor country. This trend continued throughout the 1990s, and at the end of that decade, Japanese net foreign assets were more than $2,000 billion, larger than the net foreign assets of all other creditor countries combined. Japan’s net foreign assets were one-third of its GDP. The country’s net foreign assets were increasing by about 2 per cent of its GDP, or about $100 billion a year, and the investment income on the net foreign assets had increased to about one half the value of the trade surplus. The United States had become the world’s largest debtor, and its net liabilities were larger than the combined net foreign liabilities of all other debtor countries as a group. To a large extent, the development of the US international debtor position was the mirror-image of the changes in the Japanese external balance. One of the major questions is whether the secular trend to a higher foreign exchange value of the Japanese yen resulted from the productivity surge in autos and steel and electronics; the story is that continued high levels of productivity growth led to declines in selling prices which led to increases in foreign sales which led to increases in export earnings which led to increases in the foreign exchange value of the yen. The competing story is that the appreciation of the yen induced placed many firms between the proverbial “rock and the hard place”; their profits on exports disappeared, and either they would have to reduce costs to maintain the profitability on export sales or their market share would have declined. Both stories are true for different industries at different times. When the productivity gains in a particular industry were especially large, because of the rapid growth in production and sales, the firms in this industry reduced their selling prices and that led to increases in exports and the appreciation of the yen. Then five or ten years later, the rapid productivity gains occurred in a second group of industries, and the resulting appreciation of the yen led to a decline in the profitability of the firms in those industries that had experienced their most rapid productivity gains earlier, and so the firms in these industries would experience a sharp decline in profits on exports unless they reduced their costs significantly. As long as Japanese imports consisted primarily of foodstuffs and basic raw materials, the volume of Japanese imports was not sensitive to changes in their prices. Japanese exports did not appear especially sensitive to change in the foreign exchange value of the yen; the caricature was that Japanese firms would sell abroad at any price and that the profits on sales in the protected domestic markets were subsidising the losses on export

Foreword xix

sales. Few firms would reduce their exports in response to the increase in the foreign exchange value of the yen and the apparent decline in the profitability of export sales. Because of the combination of the composition of imports and the market share orientation of exporting firms, relatively large changes in the foreign exchange value of the yen were necessary to effect a significant change in Japan’s trade balance that might be associated with changes in the price of imports like a change in the price of oil or changes in the volume of capital outflows from Japan. If the range of Japanese imports had been much broader – if a large proportion of these imports had been competitive with goods produced in Japan – then the shocks in the form of capital flows and changes in the import prices would have had a smaller impact on the foreign exchange value of the yen. It is plausible that the economic planners in Tokyo fifty years ago asked the ‘Never Again’ question, ‘How can we minimise our dependence on the rest of the world?’ Their answer might have been, ‘To the extent possible, minimise the dependence on imports – which also will have the advantage that the protectionists and other problems that we will encounter in increasing our share of foreign markets will be minimised.’ Initially the whole array of government controls facilitated the development of an industrial structure that was minimally dependent on imports. The consequence of this skewed structure is that the range of the movement in the foreign exchange value of the yen in response to a share is much larger than it would have been if there had been a significantly more diverse composition of imports.

The asset price bubble and its implosion In the 1980s Japan experienced a massive asset price bubble. Real estate prices increased by a factor of eight or nine, and the ratio of real estate prices to GDP increased by a factor of seven. The increase in the price of real estate led to an increase in the price of stocks by a factor of seven. Real estate was the primary collateral for bank loans, and as the value of real estate increased, individuals and firms borrowed more from the banks. There was a massive investment boom, and consumption spending increased at an above trend rate. Because banks and other financial institutions owned large amounts of both real estate and stocks, the increase in the value of these assets led to large increases in bank capital and in the ability of the banks to grow their loans. It seemed like a perpetual motion machine. Increases in property prices and stock prices meant that the value of the collateral of the borrowers was increasing at the same time that bank capital was increasing. Bank lending had some of the characteristics of ‘evergreen finance’ because the borrowers were able to use the cash from new loans to pay the interest on outstand-

xx Foreword

ing loans. Loan losses were trivial because the increases in the value of real estate collateral were larger than the interest rates on bank loans. It was too good to last and so it did not. Stock prices have fallen to one fourth of their value at the peak, and real estate prices have declined by a comparable amount. The Japanese financial community learned that the perpetual motion machine worked in reverse, and that the loan losses of the lenders and the value of their capital were highly correlated. The Japanese banks and other financial institutions have been de-capitalised. Still there were few ‘runs’ on banks; the Japanese savers believed that the banks were ‘too big to fail’ – that in effect they had 100 per cent deposit insurance. Until the 1980s the major function of the credit officers of the banks was to ensure that the market value of the real estate pledged as collateral for loans more or less corresponded with the values stated by the borrowers in their loan applications. The de-capitalisation of the Japanese banks de-stabilised the relationship between the main banks and their traditional borrowers. The credit officers in the banks were caught in a generational change – once real estate prices began to decline, their algorithm for evaluating credit risk had become obsolete. The de-capitalisation of the banks has doomed the keiritsu arrangement; the main bank is no longer able to act as lender of last resort to firms that had been within its group. Twelve or so banks have been merged into four main groups, and the party lines among the feudal groups have been shattered. Now the credit officers in the banks must determine whether new loans would have a positive impact on the cash flows of the borrowers. Once the banks began to use financial data to scrutinise loan applications, the borrowers had to developed a capital budgeting approach to determine whether potential projects would add to the firm’s market value. The likelihood is high that many firms needed to develop new accounting systems before they could make this evaluation. One policy innovation in the 1990s was that Japanese firms and banks were required to unwind their cross-shareholdings. A notable objective for the long run. This was like a massive initial public offering; the major impact was to reduce share prices and increase the cost of capital to Japanese firms. As more Japanese firms began to apply the capital budgeting approach to current and new proposed activities they found that many of their existing projects were not earning their capital costs. The implication is that firms must raise the rates of return on these activities or exit the businesses. The economic intuition is that many of the firms that first began to follow this approach have decided to shrink activities and for a while at least are paying down bank loans.

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Eventually the Japanese banks will learn how to do credit analysis and corporate Japan will develop an understanding of the usefulness of the capital budgeting algorithm in evaluating the profitability of the plants and branches of large firms with many subsidiaries and activities.

Identifying the problem – what went wrong? There is a long tradition across the Pacific that countries with the successful track record for economic growth offer advice to the less successful ones to adopt ‘our types of policies’. In the 1980s Tokyo offered a lot of advice that the United States should increase both the national savings rate and the expenditures on research and development and the policies to improve labour-management relations. Washington offered a lot of industry-specific recommendations that were grouped under the heading of the Strategic Impediments Initiative; most of these suggestions were intended to reduce the Japanese trade surplus. There has been an extensive debate about the policies that the Japanese government should adopt to get the ‘country moving again’. A distinction should be made between targets and instruments. For example financial restructuring is an instrument that might be used to increase investment spending (which is the target). But the story needed for the links between this instrument and target often is vague. In the best of all possible worlds, each proposal might be adopted, unless there were a conflict among them. Most proposals would impose costs on the well-being of one or several groups if adopted. Proposals can be ranked in terms of their benefit-cost ratios – their ability to lead to an increase in the rate of economic growth in terms of minimal cost in terms of welfare losses to particular groups. One set of proposals is macro and includes a more aggressive monetary policy for the Bank of Japan, for a while a more aggressive fiscal policy, and a more ambitious approval to reduce the foreign exchange value of the Japanese yen. The set of micro-policies include corporate restructuring and financial restructuring. Those who advocate one of the macro policies believe that the major problem is that demand is too modest relative to the supply capabilities, and that either investment demand or consumption demand should be increased. One shortcoming in the debate is the failure to distinguish targets and instruments. The targets are the output gap or the rate of growth of real income, the instruments are the macro-policies and the micro-policies. Those who advance one of the micro-policies need to identify the linkages between these policies and one of the targets. There has been relatively little discussion of the features or attributes of the model of the Japanese economy at full employment. For example,

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given the upper limit to the rate of potential growth of the Japanese economy, what would be the ratio of investment to GDP and what would be the household savings rate? There was a minor debate about the upper limit to feasible rate of Japanese economic growth. As the observed rate of economic growth had declined, estimates of the potential rate of economic growth have been revised downward. The prospective decline in the population growth rate seemed to be associated with the decline in the estimates of productivity growth, even though the economic intuition is that the prospective shortage of labour should lead to increases in the investment rate as capital is substituted for labour. The higher the rate of economic growth, the larger the share of domestic saving that would be absorbed by investment in plant and equipment, and the smaller the problem – if any – with insufficient aggregate demand. Those who advocate one of the macro-policies believe that the major problem is that demand is too modest relative to the supply capabilities, and that either investment demand or consumption demand should be increased. The amount that Japanese households would wish to save if the economy were to grow at a rate consistent with the Japanese version of full employment is significantly larger than the amount that Japanese firms could profitably invest at this rate of economic growth. If the potential rate of growth of GDP is 2.5 per cent a year and the marginal capital output ratio is 4, then the investment-GDP ratio would be 10 if the economy were to grow at this capacity rate. If the potential rate of economic growth is 3 per cent, then this ratio would be 12 per cent at the same marginal capital output ratio. Japanese households save about 20 per cent of their income. The core economic problem is that the amount that Japanese households would like to save if the economy were to operate at full employment growth is substantially larger than the amount that Japanese firms wish to invest at home. The savings rate in Japan is higher than in other industrial countries, and one of the major questions is how the economy has adjusted to this rate in the previous five decades, and the policies that might be adopted now to use these savings efficiently. Two adjustments are necessary to the new financial environment in Japan. There needs to be a permanent adjustment so that there is a sustainable relationship between savings and investment; either institutional arrangements will develop so that savings can be used efficiently and profitably or the economy will fail to grow at its potential rate, much as in the 1990s, and a non-trivial part of actual savings will be wasted – and there will be foregone savings because income will not increase at the potential rate. Then there is an extended transition from a time when the Japanese financial arrangements were effectively segmented from those in the

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United States and other industrial countries; during this period there was no systematic relation between the return on capital in Japan and these other countries. During this transition – which has been on-going for nearly ten years – a large number of assets in Japan must be re-priced. There are a limited number of ways in which Japan can adjust to its much higher savings rate. The investment rate in Japan might be much higher than in other industrial countries; either because the growth rate is much higher while the marginal product of capital is comparable to the levels in other countries or because the growth rate is similar to those in other industrial countries and capital is used much more inefficiently. Part or all of the excess of Japanese savings over Japanese domestic investment might be invested abroad – used to buy foreign securities and real assets abroad. Part of the excess might be used to buy government securities and to finance the government’s fiscal deficit; the excess of government expenditures over tax revenues could be used to build roads and schools and housing for the elderly and the poor and improve the water and sewage and transportation systems. Finally, if together these several measures are not sufficient to absorb all of domestic saving, then Japan will adjust to the excess of ex ante saving over ex ante investment by producing at a lower level of output. In the 1950s and the 1960s, the real rate of economic growth averaged 10 per cent a year, and domestic investment was modestly greater than domestic saving; the economy tended to become ‘over-heated’ and there was a secular tendency toward current account deficits at least until the late 1960s. The capital-output ratio was relatively low, and the rate of return on investment was high. In the 1970s the rate of economic growth declined and so domestic saving began to exceed domestic investment; the capitaloutput ratio began to increase and there was a sharp decline in the rate of return on domestic investments. Moreover, the Bank of Japan began to purchase US dollars to limit the appreciation of the yen and so foreign investment increased. In the 1980s more of the excess saving was used to buy foreign securities and real assets including real estate; foreign investment increased to 2 per cent of GDP. The combination of this level of investment and the rate of economic growth of 4 per cent meant that the capital output ratio was nearly 5 – the rate of return on investment had declined sharply, and a significant part of Japanese domestic investment was inefficient or wasteful. Because the economy was growing rapidly and household wealth was increasing at a rapid rate, the waste in the use of saving was not readily apparent. Domestic investment declined sharply in the 1990s. There was a modest increase in foreign investment, in part because foreigners were borrowing in Tokyo to finance offshore activities. The major adjustment was the increase in the fiscal deficit; the story or part of the story was that spending

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on public works increased sharply, and there were roads that went no where, airports without traffic, and parallel bridges across Tokyo Bay. Determining the value component and the waste component of these public works expenditures is complex. The wasteful private investment spending of the 1980s had been replaced by the wasteful public investment spending of the 1990s. Finally, the rate of growth of income was modest because foreign investment and the fiscal deficit together were not sufficiently large to absorb all the saving that would have been available had the economy operated at full employment levels. One component of the waste was that productive potential was underutilised. In the long run, the rate of return on investment in Japan and the capital-output ratio must be comparable to those in the United States and other industrial countries. The question then becomes the costs of the various adjustments to the higher ex ante savings in Japan, and whether these savings will be used efficiently.

Proposed solutions – restructuring and demand-expansion The various proposals to solve the problem of the large and growing output gap in Japan can be evaluated in terms of the story that the amount that Japanese households would want to save if the economy operated at its full employment level is significantly higher than the amount that Japanese households would want to invest. The challenge for the proponents of individual measures to get the economy moving again is how the suggested measures will impact the relationship between saving and investment. The dominant practice among analysts is to propose a modest number of proposals – a more expansive monetary policy, a more expansive fiscal policy (at least until the ratio of government debt in the hands of the public begins to approach 150 per cent), re-capitalisation of the banks and other financial institutions, corporate re-structuring, and an increase in household consumption. One reason that the policy makers may have been sluggish in adopting these measures is that almost always some group would become less well off if a particular measure were adopted. An alternative approach is to endow the policy makers with ‘one thousand points.’ Their objective is to chose those policies which will be most effective in reducing the output gap in terms of the costs to different constituencies. The one thousand points is a metaphor for a budget constraint, the policy makers now have to choose among competing proposals. This choice now requires that they have a ‘production function’ for each of these proposals, so that they can be readily compared in terms of their effectiveness in closing the output gap relative to their costs. Each of the proposed policies that has been advocated to get the economy moving again can be evaluated in terms of how well the measures

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would enable the Japanese economy to begin to close the output gap by reducing the imbalance between saving and investment. Corporate restructuring and financial restructuring often are viewed as ‘twins’. Today financial restructuring might complicate or delay corporate restructuring. Corporate restructuring is necessary for banks and other financial institutions but it is distinct from financial restructuring. The objective of the corporate re-structuring is to increase the profit rate on assets already on the ground. Those who advocate corporate re-structuring believe that the excess capacity is so extensive in some industries that the anticipated profit rate on new investments would be significantly below the cost of capital and that additional investments would depress the market value of these firms. Until the implosion of the bubble, most Japanese firms were interested in market share or in developing more sophisticated products; few were interested in the relationship between the cost of capital – which was quite low in the bubble years of the 1980s – and the anticipated rate of return on investment. Now the cost of capital to Japanese firms is much higher than in the 1980s as a result of the tumble in stock prices – a decline which has been intensified by the untimely decision to reduce and eliminate crossholdings. The implosion of the bubble and the financial stringency of Japanese firms mean that money is no longer ‘free’ for Japanese firms, as it had been in the 1980s and earlier decades, Now these firms have to convince both lenders and investors that their investment projects will be profitable. The required change in the investment behaviour of Japanese firms toward the use of capital is seismic. These firms need to increase the rates of return on the assets that are already on the ground so that they are comparable to the rates in the United States and other industrial countries. Selling prices must be increased relative to costs. The managers must recognise and accept that the increases in selling prices may lead to a decline in sales and market share. If selling prices cannot be increased, then costs must be reduced. Labour costs might be reduced by attrition of the number of employees. Increasing the rate of return on the assets that are ‘already in the ground’ requires that the owners of these assets revalue them downward – in effect to take a re-structuring charge and perhaps a large charge. These assets need to be priced so that their rates of return would be comparable to the rates of return on new investments. Some assets might be scrapped. The economic loss associated with the decline in the market value of these assets relative to their historic cost already has occurred. The owners of these assets must recognise these losses. The firms can shrink their non-profitable subsidiaries and activities, and stop, or at least sharply diminish, the cross-subsidisation from the prof-

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itable to the non-profitable. The non-profitable activities and subsidiaries can be spun off, and allowed to sink or swim; swimming would likely mean that the labour costs would be reduced, perhaps in part by reducing wage rates. The Japanese government can encourage mergers to reduce excess capacity. The government might sponsor measures for labour retraining and early retirement. Increasing the rate of return on new investments is difficult as long as there are many similar assets whose current market value is significantly below their reproduction costs. The objective of financial re-structuring is to encourage banks to be more aggressive lenders. Those who advocate financial re-structuring believe that banks would make a larger number of loans and investment spending would be significantly larger if banks were more adequately capitalised. As a result of loan losses, the market value of the assets of many banks and financial institutions has declined below their liabilities; these institutions have levels of capital below the required level. Nevertheless there have been very few runs on Japanese banks; the Japanese public believed that their deposits were fully guaranteed by the government. As long as there was substantial uncertainty about the value of many of the loans held by the Japanese banks, there was substantial uncertainty about the value of their capital, and it was virtually impossible for the banks to raise additional capital in private markets. As long as banks are not confident that they are adequately capitalised, they are likely to be cautious in extending new loans. The cliché that ‘they would lend only to those firms that didn’t need to borrow’ is relevant. Private investors were reluctant to buy ‘a pig in a poke’; the insiders generally believed that the value of bank capital after recognition of these losses was much higher than the outside investors. It was only in1997 that the Japanese government developed a programme that would enable the banks to become formally re-capitalised. One of the buzz-words for financial re-structuring is the ‘sale of non-performing loans’. This term is generic and has several different meanings. Usually banks allocate part of each year’s income to a loan-loss reserve on the assumption that loan losses are episodic and that it is desirable to smooth reported income from the occasional losses. When loan losses are first recognised, the value of the loan-loss reserve (an entry in the bank’s capital account) and the loan are reduced. Subsequently the banks can sell the loans or they can sell the collateral that they might have acquired in the settlement of the loan; if the funds received from the sale are larger than the value of the loan on their balance sheet, the banks have a capital gain. The view that financial restructuring might occur at a more rapid pace might mean that the amounts that the banks were adding to their loan loss

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reserves were too small or that the banks were too slow in writing down the value of the loans or that the banks were too slow in selling the loans that were in default or the collateral acquired from the borrowers that defaulted. The sluggishness in re-capitalising banks could have two impacts. One is that the banks were reluctant to lend to many firms because they were so uncertain about the value of their own capital; the implication is that if the banks had been better capitalised, they would make a larger volume of somewhat riskier loans, and the level of business investment would be higher. The second way in which the sluggishness of banks in selling nonperforming loans affects the real economy is that the overhang of these assets on the market would depress the prices of these assets. Firms would be reluctant to invest because of the concern that a more rapid sale of the nonperforming loans would lead to a decline in the value of real estate assets. Both factors may operate at the same time. If the dominant factor is that banks are sluggish lenders, then the interest rates spread between government securities and securities of commercial borrowers should be exceptionally large. If the dominant factor is that the borrowers are reluctant to increase their loans because of the concern that the sale of non-performing loans will depress asset values, then the interest rate spread should be exceptionally low. If both factors are operating, then the relation of interest rates on bank loans to interest rates on government debt would provide the basis for inferring which factor was relatively more important. Even if the banks had sold all their non-performing loans and had been fully re-capitalised Japan would still face the problem that the amount that households would like to save, if the economy were operating at full employment, would exceed the amount that firms would like to invest domestically. Moreover, domestic investment might still be significantly below the level associated with full employment because many Japanese firms still had not been able to increase the anticipated rate of return on their investments to correspond with their cost of capital. The Japanese banks eventually will be re-capitalised and they will sell their non-performing assets. Still these measures should receive priority only after a much larger number of firms have been successful in increasing the profit rates on their current investments. The necessary condition for believing that financial restructuring should be a priority for the government is evidence that there are significant numbers of firms with profitable investment projects that cannot obtain finance. That seems unlikely. The decline in the rate of business investment in the late 1990s is evidence that more and more firms realise that they must raise the rate of return on their investments to their cost of capital. The decision to require that banks and firms reduce their cross shareholdings has increased the cost

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of capital by depressing share prices. The firms that are among the first in their industries to understand the importance of increasing the rate of return to match the cost of capital will be capturing market share from the slow learners. The banks – at least some of the banks – understand the new financial environment and now are reluctant to lend to those firms who have failed to learn the lesson. Those who favoured macro-policies believed that the dominant problem was that aggregate demand was inadequate – that the amount that Japanese households would want to save if the economy were operating at its full potential is significantly higher than the sum of the amounts that Japanese firms can invest profitably domestically and the amount that firms and individuals can and want to invest abroad. This type of comparison leads to the conclusion that measures should be adopted to increase consumption – in effect to reduce saving. One of the objectives in most countries is to increase the savings rate so that the consumption levels in the future will increase more rapidly. The savings rate in Japan is significantly higher than in virtually every other industrial country. But Japan is different from other countries, and the key question is whether the households are myopic and are saving too much. Assume that the objective of saving is to smooth consumption over the life cycle, so that spending to maintain the living standards in the postretirement period will be comparable to the standards in the working years. The wealth of Japanese households is in the range of three to four times their incomes; assume that this same ratio is in the range of six to eight on the eve of retirement. Assume that the life expectancy of individual Japanese at age 65 is twenty five years. Finally, assume that the real rate of return on household wealth is zero. During each of the retirement years the individual Japanese would sell some of the assets acquired while in the active labour force to get the funds to finance current consumption. If the spending is constant during the twenty five years of retirement, then the individual Japanese would be able to spend twenty four per cent of pre-retirement income if the wealth to income ratio is six on the eve of retirement and thirty two per cent of the pre-retirement income if this ratio is eight. If consumption had been 80 per cent of personal income, then the consumption spending in retirement would be 30 per cent and 40 per cent with the two different values for the wealth-income ratio on the eve of retirement. In addition many Japanese would have corporate pensions and government pensions, but in general these pensions are modest. The funds available to finance consumption from the depletion of capital must be adjusted for the real rate of return on household saving. During most of the period since 1950, the real rate of return to household savers was not significantly above zero, since the inflation rate more or less corresponded with the nominal interest rate.

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The higher the real interest rate on household savings, the larger the income of the retired. Moreover, the higher the real interest rate, the more rapidly the stock of saving would increase. At some stage, the increase in the stock of saving from a higher real rate of return on the previously accumulated savings would be so large so that households could achieve their wealth targets with a lower level of saving from current income. The conclusion, from the comparison of the amount available for consumption in the post-retirement years with the pre-retirement years, is that Japanese households have not been saving too much. Many households are likely to experience a sharp decline in the funds available for consumption in the retirement years. The reason that Japanese households may have such a high savings rate is that they have responded rationally – and inadequately – to the very low real interest rate on their household savings. (In a curious way this is the ‘saver’s revenge – for decades the mandarins in the Ministry of Finance used interest rate ceilings to ‘tax’ savers to subsidise business investment.) Households responded by increasing the amount they saved out of current income. Hence there are two somewhat overlapping transitions. The first transition is that Japanese firms are adjusting to the requirement that they invested only in those projects that will prove sufficiently profitable that they ‘earn their cost of capital.’ Japanese savers are adjusting – slowly and cautiously – to the increase in the real rate of return on their savings. The implication is that the most effective approach that the Japanese policy makers might adopt to reduce the savings rate is to facilitate an increase in the real rate of return to the savers. Nevertheless, there is likely to be an extended period in which the amount that Japanese households wish to save will be significantly larger than the amount that Japanese firms can and want to invest domestically. A more expansive fiscal policy would stimulate final demand; to the extent that tax rates were reduced, consumption spending and investment spending would increase since after-tax incomes would be higher. Otherwise government expenditures would be increased. A more expansive monetary policy would stimulate business investment and household consumption spending. The exchange rate policy would lead to a lower foreign exchange value for the Japanese yen. During the 1990s Japan adopted a large number of programmes to stimulate government spending. By the late 1990s the fiscal deficit had increased to the range of 7 to 10 per cent of GDP; the government debt outstanding had increased to 130 per cent of GDP and government debt in the hands of the public had increased to 100 per cent of GDP. These ratios increase by 20 percentage points after adjustment is made for the increase in government expenditures required to formally re-capitalise the banks and other financial institutions.

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The persistence of a large output gap despite the large fiscal deficits has been interpreted to mean that the increase in the fiscal deficit has not led to a decline in the output gap. The alternative interpretation is that the output gap would have been significantly larger if the fiscal deficit had been significantly smaller. The Japanese government is on a non-sustainable fiscal trajectory; debt cannot continue to increase relative to GDP without leading to a reduction in the willingness of the public to hold government debt. The credit rating agencies already have begun to downgrade government debt. If the ratio of debt to GDP continues to increase, these agencies will continue to reduce the credit ratings. It is arguable that the agencies are mistaken in down-rating Japanese government debt, since the government can always rely on the banking system to finance the maturing debt. At some stage however that process would lead to a depreciation of the yen, and the purchasing power of the yen securities would decline. As the ratio of debt in the hands of the public to GDP increases, an increasingly large number of investors might shift more of their wealth into foreign securities and the yen would depreciate. Interest rates on yen securities will increase, and the interest component of government payments would increase. At some stage and probably in the not-too-distant future, the Japanese government must reduce the primary fiscal deficit from its current level of 6 per cent to 5 per cent to 4 per cent; eventually the government must have a primary fiscal surplus. The investors and the credit rating agencies must be convinced that the fiscal policy is on a sustainable trajectory. The implication is that the reduction in the fiscal deficit will lead to a decline in aggregate demand, and so the excess of household saving over domestic investment will increase. One inference from the combination of the short term interest rates hovering about zero and the large level of bank reserves is that the Bank of Japan has followed an expansive monetary policy. Some economists have argued that the Bank of Japan should be even more expansive and adopt a price level target, perhaps an increase of 1 or 2 per cent a year. The Bank of Japan would buy assets as well as securities until the annual price level target had been achieved. One rationale for the price level target is that the more expansive monetary policy would lead to an increase in investment spending. The implicit assumption is that real interest rates would decline because the increase in the inflation rate would be larger than the increase in nominal interest rates. Thus the cost of capital to Japanese firms would decline relative to the anticipated profit rate on domestic investments. The alternative result is that the increase in the inflation rate would be smaller than the increase in nominal interest rates because investors would want to maintain the purchasing power of their interest income and principal.

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The Bank of Japan’s monetary policy might be able to forestall the increase in short term interest rates, but it is not likely that conventional monetary policies could prevent an increase in nominal and real interest rates on longer term securities. A second rationale for the more expansive monetary policy is that consumption spending would increase because households would be concerned that the purchasing power of their time and saving deposits would decline, and so they would increase their spending to forestall or dampen the decline in their purchasing power of these balances. The competing view is that household saving would increase as the real purchasing power of the money balances declined. One possible result is that investment spending would increase if the Bank of Japan were to follow a policy of price level targeting while household spending would decline and partially or fully offset the increase in investment spending. That result may seem a bit paradoxical, since one of the motivation for the increase in investment spending would be a more rapid increase in consumption spending. Moreover, even if the household spending increases, it is not clear that the increase in spending will make a significant dent in reducing the output gap. The more expansive monetary policy is likely to lead to a decline in the foreign exchange value of the yen as Japanese investors adjust to the increase in inflationary expectations by reducing their holding of yen securities. The counterpart of the increase in the capital outflow would be an increase in the current account surplus; the increase in Japan’s net exports would close part of the output gap. Moreover the increase in the yen price of the US dollar would lead to an increase in the profit rate on the production of exports and import competing goods, which in turn would lead to a higher level of investment. The alternative approach to increasing the Japanese trade surplus is for the Bank of Japan to buy US dollar securities – in effect the Bank of Japan would conduct its open market operations in US dollar securities. A major difference between these two approaches is that the yen rate of return on Japanese foreign investments has been significantly smaller than the rate of return measured in the foreign currencies because of the secular tendency toward the appreciation of the yen. The revaluation losses that Japanese investors have encountered on their foreign investments varies with the choice of holding periods; this loss has been in the range of 3 to 4 per cent for most extended holding periods involving the purchase of US dollar securities. The Bank of Japan might be more willing to incur the revaluation losses than private investors because of the positive externalities for the country of a larger trade surplus. One question is the relation between the increase in the capital outflow from Japan, and the decline in the foreign exchange value of the yen.

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Japan’s major trading partners and particularly the United States may conclude that attempting to reduce the output gap by significantly increasing net exports and the current account surplus, smacks of a ‘beggar-thy-neighbor’ policy. In part the US reaction to the increase in the Japanese trade surplus of a given amount will depend on the change in the foreign exchange value of the yen associated with the increase in the Japanese trade surplus. The smaller the decline in the foreign exchange value of the yen associated with the increase in the Japanese trade surplus, the less likely is an adverse or hostile reaction from US policy makers. One of the empirical concerns is how much of the output gap in Japan might be closed by an increase in the trade surplus. The second factor limiting the reduction in the output gap that might be associated with the increase in the Japanese trade surplus is that at some stage Japan must move from being a young creditor country to a mature creditor; then Japan would have a trade deficit that would be fully financed from the income on its foreign investments. That transition is likely to be associated with a real appreciation of the yen. In the past Japanese investors who have purchased foreign securities have experienced revaluation losses as the Japanese yen has appreciated; the nominal appreciation has absorbed most of the excess of interest rates on US dollar securities over the interest rates on comparable yen securities. If the yen were pegged to the US dollar, then Japanese investors might conclude that the likelihood of a revaluation loss would be smaller and the amount of this loss would be smaller. In the short run, say for a year or two, Japanese purchases of foreign securities would be smaller because they would lack confidence in the stability of the parity. As their confidence increases, their purchases of foreign securities would increase. The review of the menu of alternatives available to the Japanese government is complete. Corporate restructuring with the intent to increase the profit rate on new investments and hence on old investments is top priority. Financial restructuring in contrast is low priority because the problem is not the shortage of funds available for lending – and the sale of assets would depress the rate of return on new investments. (At some stage these assets must be sold, but the sale should wait until the rate of economic growth has increased toward the rate of growth of output.) Fiscal policy must move into a less expansive stance. Monetary policy is highly risky. Exchange rate policy may be successful in closing part of the output gap, but the window for a potent increase in the trade surplus began to narrow rapidly when the United States moved into a recession. Japan’s competitors in the export markets are unlikely to accept a significant decline in their own competitive position, and the United States is not likely to accept a major increase in its trade deficit with Asian countries as a group.

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Adjusting the savings gap One of the central questions noted at the beginning of this introduction is whether the increase in the output gap in Japan should be attributed to the failure of government policy or to a market failure. The companion question is whether the surge in the output gap is more nearly a transient phenomenon or whether instead the increase is permanent. There have been failures in Japanese policy – errors because of the failures of economic analysis and of an appreciation in Tokyo and in Washington about the major changes in the financial environment effected by the implosion of the bubble. The major policy errors were the effort to ‘talk up’ the foreign exchange value of the yen and the timid and belated efforts to formally re-capitalise the banks. The major problem is that a great deal of time would have been required for those involved in finance at the corporate level and the banking level to recognise the implications of the need for the rates of return on assets in Japan to adjust to world levels. The adjustment has been complicated because there is a strong presumption that there has been a market failure – that Japanese savers as a group will not reduce the amount they want to save as interest rates decline in conformance with the usual textbook model. So a non-trivial component of saving has been ‘wasted’. During the 1980s the waste involved an excessively high level of private investment; in the 1990s the waste involved the excessive expenditures on public works and an increasingly high level underemployment. ‘Saving is a private virtue and a public vice’, at least for the last twenty years in Japan. The implosion of the bubble effectively de-capitalised the banks, with the consequence that Japanese firms now for the first time must satisfy a costof-capital test comparable to the one faced by firms headquartered in most other industrial countries. Many Japanese multinational firms already are comfortable in dealing with this global standard. The seismic shift is that for the first time the managers are being required to be concerned with the profitability of the firm’s subsidiaries and other activities. The task of increasing profitability is immensely more difficult because of the commitment to lifetime employment. The attention to financial restructuring is misplaced. There is relatively little evidence tha the sluggishness in investment has resulted because the banks were tepid lenders; the dominant factor has been that firms have been adjusting their investment spending downward as they strive to increase the rate of return on existing assets. The dominant economic problem of a large and growing output gap in Japan reflects that the domestic saving rate at the full employment level of output growth would be significantly larger than the amount that business firms wish to invest at this output level. In the 1980s the primary adjust-

xxxiv Foreword

ment to this imbalance involved an excessively high level of private investment. Some of this investment was wasteful, and ongoing adjustments to this level of investment continue to depress investment spending. In the 1990s and especially in the second half of the decade, the growing and large fiscal deficit absorbed some of the excess saving; part of the public works spending and perhaps a large part was frivolous. The second adjustment was that the output gap continued to increase. The government’s fiscal policy now is on an unsustainable trajectory. As long as the annual fiscal deficit continues to increase much more rapidly than GDP, the credit rating agencies will lower the ranking of government debt. At some stage the government will be obliged to reduce the primary deficit; initially the government may place a ceiling on the interest rate on this debt. This interest rate ceiling will reduce the nominal and real rate of return to Japanese savers. A monetary policy of inflation targeting might lead to an increase in investment spending if real interest rates decline. But it is a bit ironic to think that the Japanese savers will passively adjust to the decline in the real value of their saving; they might tend to increase their saving to compensate for the decline in the purchasing power of their saving. The increase in the trade surplus associated with a more expansive domestic monetary policy, either with the purchase of domestic securities that leads to an increase in the Japanese purchase of foreign securities or the purchase of US dollar bonds by the Bank of Japan will absorb some of the ‘excess saving’. The sad experience for Japanese savers is that the ‘promises’ that have been made to them by the system about the real purchasing power of their savings have not been maintained. In the 1950s, the 1960s and the 1970s, the annual inflation rate generally was higher than the nominal interest rate. In the 1980s many savers experienced large real rates of return on their holdings of stocks and real estate, but a large part of these gains have been erased by the decline in the prices of these assets since the early 1990s. The market failure is that there appears to be no interest rate at which the level of household saving would decline to the amount that the economy is prepared to invest. The savings function may be backward bending; as interest rates decline, households may increase the amount that they wish to save. The failure of saving to adjust leads to the question of whether the Japanese government should adopt direct measures to reduce the saving rate – or more appropriately to alter the form of saving. The Japanese government might be encouraged to distribute ‘housing investment vouchers.’ Each household that intends to build a new home would be given a government voucher that would pay for 30 or 40 per cent of the cost of the house. Private investment in housing would be encouraged at the same time that debt financed public works spending would decline.

Foreword xxxv

‘The yo-yo yen’ Brendan Brown’s contribution to this debate highlights that saving is a ‘public good’ and that global welfare would be enhanced by an increase in Japanese foreign investment. His model is that of Great Britain in the nineteenth century and especially in the last third of that period; about half of the country’s saving was re-invested abroad. Much of the investment was in the ‘new lands’ – the United States, Canada, and Australia – areas that in terms of law and business practice were extensions of Great Britain. Japan could readily invest 5 or 6 or 7 per cent of its national income abroad if the institutional mechanisms were accommodating. Because Japanese national income is so large, the amount that Japan could invest abroad is large relative to the domestic saving in the developing countries. Asset preferences seem mis-matched; the Japanese portfolio investors are reluctant to acquire claims on developing country borrowers. These investors can satisfy their demand by purchasing US dollar securities and the securities available in a few other developed countries, and investors resident in these countries in turn would purchase securities issued by the borrowers in the developing countries. Large flows of financial capital from one country to another raise the question of the transfer problem – what is the mechanism that will induce the changes in relative prices and incomes so that the transfer of real resources that is the counterpart of the transfer of financial capital can be effected? Currency values were pegged in the nineteenth century although the US dollar floated for nearly twenty years after the beginning of the Civil War. The transfer mechanism appears to have operated less efficiently in the last twenty years. Part of the answer may be that a large part of British foreign investment flowed to what had been its colonies; in effect a very large share of this foreign investment occurred within a group of countries that were parts of an English-speaking club with similar business practices. Part of the answer is that exchange risk is significantly larger when currencies float. When currencies are pegged, the authorities in each country – or at least most of them – have significant commitment to adopt domestic financial policies so that the parities can be maintained. They succeed extensively but occasionally they fail. In contrast when currencies are not pegged, there is one less constraint on the choice of domestic financial policies with the frequent result that the inflation rates are higher and more variable. Japanese household savers must have concluded that the financial environment is hostile. In the 1950s, the 1960s and the 1970s real rate of interest were negative. When they began to invest abroad – diversification is next to motherhood as a classic virtue – they incurred revaluation losses that may have led them conclude that they should have stayed at home.

xxxvi Foreword

During this period the United States was often viewed as having a unique role as an international banker – investors in one group of countries would buy US dollar securities, and Americans in turn would be able to buy a comparable amount of foreign securities, with the US trade and current account deficits largely unchanged. The story was that the foreign investors would buy short term US dollar securities and so the United States would provide liquidity services, while American investors would buy longer term foreign securities. Nice in theory, but in practice for most of the last twenty years the United States has proven to be more of a destination than a conduit. Interest rates on foreign securities have been higher than those on US dollar securities, but not by enough to compensate foreign investors the additional risks they associate with these investments. Thus the transfer mechanism has been partially frustrated both in the flow of capital from Japan and the flow of ‘imported capital’ from the United States. In the best of all possible worlds, Japanese savings might have added $200 billion to $300 billion a year to the real assets of the capital importing countries. Exchange risk and uncertainty about exchange rates has deterred the flow of capital. In part the Japanese decision to minimize dependence on imports has contributed to this uncertainty, since shocks have led to a much greater range of movement in the foreign exchange value of the yen. In part the decision to adjust the exchange rate to the price level rather than the price level to the exchange rate has also contributed, since the revaluation losses associated with the appreciation of the yen has deterred the capital outflow. Brendan Brown has provided a comprehensive and compelling story of the waste of hundreds of billions of dollars of Japanese savings that otherwise could have contributed to the enhancement of living standards around the world. ROBERT Z. ALIBER

Introduction

Why tell the history of a currency? That is an obvious question to ask at the start of a book which though not primarily a historical narrative does contain four out of six chapters whose focus is the yen’s past. After all, what happened to the yen when linked to gold or silver surely has little relevance to us understanding the situation of the modern yen. Of course there is always the unifying theme of curiosity. People visit museums to see what life was like in their cities in previous eras. In the same way Japanese today may be curious about the type of currency problems – both at a micro and macro level – that previous generations of Japanese faced. And that curiosity can extend to non-Japanese with an interest in Japan. But the aim here goes well beyond the satisfying of the historically curious – though if some satisfaction for some readers is provided on that score, then all to the good. A knowledge of yen history should help us understand the present situation of the yen in a number of ways. First, there have been some distinctive characteristics to Japanese currency problems through the last 150 years which justifies grouping them together for the purpose of analysis. Our understanding of the old problems should help us understand at least some aspects of some newer and maybe some future problems. Examples of distinctive characteristics include periodically strong aversion to the risk of investing in foreign assets; the occasional giant waves of foreign speculation in the Japanese currency market; an officialdom which is uneasy with taking bold stances on currency or monetary policy on the basis of any particular economic theory, even though within the senior ranks of policy-makers there exist pockets where these theories are well understood; a sometimes bloated perception (amongst both market-participants and policy-makers) of Washington’s power; and a pendulum in monetary policymaking which swings between tolerance of inflation and a weak currency, and obstinate pursuance of deflation and hard money doctrine. Second, policy-makers and some market-participants refer to the laboratory of their own currency’s history when diagnosing the present situation and creating possible scenarios for the future. In the period around the 1

2 The Yo–Yo Yen

collapse of Bretton Woods, for example, Japanese officials studied the last period in which Japan ran large current account surpluses – during the First World War. And in the banking crises of the late 1990s they referred back to Japan’s previous crisis period of the 1920s. Market-participants in the 1990s were still haunted by the Nixon shock (1971) and the Plaza minishock (1985). When the Kobe earthquake struck in January 1995 some market-participants looked back to the currency impact of the Great Tokyo Earthquake in September 1923. Hence to understand the reaction of policymakers and market-participants to events we should have some knowledge of the national laboratory to which they refer, even if it is arguable whether that is the most relevant and whether they should have paid more attention than they did to foreign laboratories. Third, by putting ourselves in the situation of market-participants at previous crucial points in the history of the yen, assessing the possible scenarios of what could have occurred and comparing these with what actually happened, we should be able to sharpen our probabilistic vision regarding the future – both of the yen and indeed of wider issues concerning the global flow of international capital. (Probabilistic vision means the mapping out of the main possible scenarios for the future, attaching probabilities to each outcome.) The bulk of the historical narrative in this book relates to the 30 years of floating exchange rates since the final breakdown in 1971 of the Bretton Woods international monetary order, and so any sharpening of probabilistic vision is likely to be of considerable relevance to a whole range of decision-makers over coming years. Is the exercise of putting together a factual and counterfactual history of the yen – and drawing broader implications for the Japanese economy – not one which can be better done in Tokyo than London (or any other global financial market-place)? That is a type of question that often arises when an author writes about a subject where he or she is at some apparent geographic disadvantage. But in the case of currency analysis it would be hard to press the case that any geographic advantage exists. There are two currencies traded against each other in any exchange market. An understanding of global capital flows together with what drives them is surely much more important than any extra anecdotal evidence which might be obtainable from a specific geographic location regarding one of the issuing economies. Indeed throughout the narrative in this book the yen’s fluctuations are presented in a global context. A methodology is presented in Chapter 3 for distinguishing periods when the yen is in the limelight of the currency market from when the other two major currencies – the US dollar and the euro (previously the DM) – are holding sway, either unilaterally or together. Currency motion within the key US dollar–euro(DM)–yen triangle takes the form of either unilateral moves by one of the three currencies or axis dominance by one pair of currencies (sometimes the euro–dollar axis, sometimes the euro–yen axis, and sometimes the yen–dollar axis). And why

Introduction 3

do we speak of a key currency triangle in which the yen is one corner, rather than a quadrilateral which includes the British pound, or a pentagon which includes the pound and Swiss franc? Fitting the yen into a geography of currencies is the final topic of Chapter 3. Chapter 3 is in fact the watershed in this book. Having finished telling the pre-history of the modern yen (in the years from 1860 to 1935) and then the evolution of the yen through the Bretton Woods period up until the Plaza Accord (1985), there is then a pause in the narrative to draw out a central theme. The violent fluctuations and prevailing misalignment (overvaluation) which have marred the post-Plaza history of the yen (1987–2001) stem from a malfunctioning of the normal equilibrating mechanisms which would export a huge domestic savings surplus into the rest of the world. This malfunctioning was already apparent at times in the late 1970s when Japan’s private sector savings surplus first emerged in size. But the problem became acute in the aftermath of the bursting bubbles in Japan’s real estate and equity markets, from 1990 onwards. Japan should have been running massive capital exports with the yen at a competitive level, its current account surplus reaching the peak levels seen in previous history and in contemporary times for other high savings economies. Instead, an infernal set of circumstances caused the yen to rise towards the sky and the huge private sector savings surplus to be deployed in building bridges and dams in the middle of nowhere. Analysis of that infernal set is the subject-matter of Chapters 4 and 5, based on a provisional hypothesis put forward already in Chapter 3. According to this hypothesis, neo-mercantilists in Washington were not the prime cause of malfunction. They could not have inflicted serious harm without many coincidental factors in Japan playing an important role. Chief amongst these were first grave errors in monetary policy. And second, two heads of the Bank of Japan (1990–4 and 1998– ) believed in a strong yen for its own sake, hoping that the shock of currency appreciation would help trigger economic reform. They failed to see, let alone broadcast the message, that the surge in the savings surplus which followed the bursting of the bubble economy should mean both a huge current account surplus and a weaker yen. Third, the lack of constitutional-type rules for either monetary policy or fiscal policy created a vacuum where an unholy alliance could develop between Liberal Democratic Party (LDP) big spenders and Washington. Fourth, antieconomic reformers in Tokyo saw advantage in a strong yen as a way of deflecting US pressures to demolish restrictive practices. And fifth, traditional groups within the Japanese bureacracy (particularly in the Foreign Office) that favoured a reorientation towards Asia and away from the USA were pleased with the transplantation of Japanese industry into neighbouring economies brought about by the strong yen, even if that process of hollowing out meant zero or low growth in Japan.

4 The Yo–Yo Yen

For a brief period in 1996 and early 1997 it seemed that the infernal set of circumstances was about to disintegrate as capital exports gained considerable momentum and the yen fell. Briefly Japan was at the top of the G-7 growth league. But a series of events – including Japan’s acquiescence in a bizarre appreciation of the yen under pressure from Washington, a failure of monetary policy to accommodate the brief attempt to rein in fiscal deficits, and then the Asian crisis – drove an already vulnerable Japan into a serious deflationary situation. The coincidence of a scandal at the Bank of Japan (BoJ) resulting in the appointment of a new Govenor renowned for his strong yen views and zealous in his pursuance of independence for the central bank from the Ministry of Finance (possible under the just passed Bank of Japan law) was unhelpful at the least. What can and should be done about flaws in the Japanese policy-making system – and in the international monetary system – which allowed the yo–yo yen to fluctuate so violently and cause so much damage? This final question is the subject of Chapter 6. Two recipes are discarded – these include turning the clock back to a fixed exchange rate regime and doing nothing. Instead the proposal is put forward of a new constitutional framework for monetary and fiscal policy to accompany a completely free float of the yen. This framework would include contingency arrangements which would come into force if a state of deflation alert were declared. Most probably the framework could have produced better results for the Japanese economy in the recent past and it might well improve prospects in the future, both for the working population and rapidly growing retired population. Yet the actual drama of the yo–yo yen through the 1990s remains troubling. Confidence in international economic cooperation and in skilled use of fiscal and monetary policy tools being capable always of preventing severe global recessions has surely been undermined. International economic institutions such as the International Monetary Fund simply failed to meet the challenges presented by wild fluctuations and serious overvaluation of one of the three key currencies in the world.

1 Historic Roots of the Yo–Yo Yen (1859–1949)

The pre-historical period of the Japanese yen begins and ends with critical decisions made by the USA. The so-called Ansei-Man’en monetary reforms of 1859/60 which accompanied the re-establishment of diplomatic and trade relations between Japan and the Western Powers after more than two centuries of seclusion were largely influenced by US pressures. Less than a century later, in the aftermath of the Pacific War, it was the US Occupation Authorities who relaunched the yen at a rate of 360 to the US dollar as part of the Dodge Plan. The pattern of critical US intervention was to continue into the modern era – including, first, the forced revaluation of the yen in August 1971 under irresistible pressure from the Nixon Administration and second, the Plaza Accord of 1985. In the middle years of the 1990s (1993–7) the Clinton Administration sought to manipulate the yen on a number of occasions. But the violent fluctuations and misalignment of the yen during that Lost Decade for the Japanese economy stemmed also from many important sources inside Japan. Ever since Commander Perry and his black ships sailed into Edo harbour in 1853, there have been winners and losers in Japan from US intervention. The power of Washington to prescribe yen policy has depended – in varying degrees – on cooperation from those within Japan who stood to gain. And so it was with the drastic reforms of 1859/60. The agenda of the USA and other Western Powers (France and Britain were also very involved in the chain of events from the opening of Japan in the mid-1850s to the fall of the feudal Tokugawa regime in 1868) was to create trade links with the almost totally closed island economy (the only opening was via the officially tolerated Dutch colony in Nagasaki). An essential precondition to international trade between Japan and the outside world was the setting of a rate of exchange between Japanese and foreign monies. In Tokugawa Japan money consisted of gold, silver, and copper coins but there was no free market in bullion. A narrow market existed for precious metals bought and sold for non-monetary purposes, but the rate of exchange between gold and silver bore no close relationship to international 5

6 The Yo–Yo Yen

prices (hardly surprising given the absence of trade). Moreover, the silver coinage had been heavily debased during successive ‘reforms’ instituted by the shoguns in need of extra funds. (Shogun was the name given to the military rulers of Japan, all stemming from the Tokugawa family.) The total misalignment of the rate of exchange between silver and gold money inside Japan to that outside Japan (and most of the world was then at least formally on a bimetallic standard based on gold and silver) was the problem which had to be addressed. The demands made by US negotiators and the response by the Tokugawa regime culminated in a period of hyperinflation, which itself played a critical role in undermining the feudal state and bringing about the Meiji restoration (1868) (marked by the end of the shogunate and the assumption of power by a reformist regime legitimised by the ‘restoration’ of power to the Emperor). The hyperinflation was not planned but the income redistribution consequences of the currency changes made to accommodate US demands were foreseeable. Large landowners, bankers, and merchants gained, whilst peasants, urban commoners, and the lower-ranking samurai lost. The key role of inflation in undermining the established social and political order was not a new feature of world history. Silver brought to Europe by Spain from its conquests in South America had been the catalyst for revolutionary change in the sixteenth and seventeenth centuries. The new aspect, in the case of Japan, was the source of the inflation storm – a foreign power dictating exchange rate policy aimed at extracting favourable conditions of trade (albeit without significant success, as the price of the principal Japanese export, silk, jumped to take full account of currency manipulation and access to the international market).

The Ansei-Man’en monetary reforms, 1859–60: a first shock from Washington In 1858, Japan’s metallic money (in contrast to various forms of paper money issued by feudal domains) consisted of 53 per cent gold coin (the ryõ), 40 per cent silver coin (principally the ichibu-gin, equivalent legally to one-quarter of a ryõ) and 7 per cent silver currency by weight (mainly used in western Japan around Osaka). The silver coins (ichibu-gin), valued on the basis of silver content and at the international exchange rate between silver and gold (the ratio of gold to silver prices – each measured for the same unit weight – in the world market was around 15.5 and was anchored in the French bimetallic system), were worth far less than their legal equivalent in terms of gold coin (12–13 ichibu-gin rather than four ichibu-gin would have exchanged for one ryõ). The US negotiators led by Townsend Harris – the US representative resident in Japan since 1854 and described by Allinson (1999) as ‘a patrician Yankee down on his luck’ – took the silver coin (ichibu-gin) as the basis

Historic Roots of the Yo–Yo Yen (1859–1949) 7

for determining an international exchange rate. Silver money, in particular the Mexican silver dollar, was the medium of exchange used in trade by the Western Powers with the Far East (for example, the Dutch East Indies, China and India) and it was natural that Japan should fit into that same system. The USA determined an official exchange rate between the Mexican silver dollar and the ichibu-gin based on the relative silver content of the two coins. (At this time the USA was nominally on a bimetallic standard; but effectively it was on a gold standard, with silver dollars out of circulation, as the ratio of exchange between gold and silver coins as fixed by the Mint Act of 1837 had undervalued silver relative to its international price. Hence the Mexican silver dollar sold at a premium to the US gold dollar.) For official transactions one silver dollar was fixed at three ichibu-gin. At that official rate of exchange, 100 ryõ could be obtained against 133 silver dollars. In fact, rates of exchange for private transactions were freely negotiable, and in the early days the ichibu-gin’s free market value (in dollars) was above its official rate under the influence of the arbitrage transactions described below. Various forms of leakage, however, set a limit to the discrepancy between the free and official rates, even though there was no provision for the free minting of coins (whereby anyone can take bullion to the mint office and have it made into coins at no charge) which in countries on a full metallic standard sets a ceiling to their currency’s value (in terms of other currencies on the same metallic standard). For example, the shogunate could profit when the free market rate of the ichibu-gin was above its official rate by the minting of new coins. Their agents could turn Mexican dollars into ichibu-gins (a process that involved melting down and minting) and then sell the newly created coins in the private market for a greater number of Mexican dollars than to start with. Of course, the operation was only undertaken if the profit margin covered the costs of re-minting. In 1859, immediately following the opening up of trade, there was a huge arbitrage opportunity for foreigners in the form of buying ichibu-gin (either at the official rate or somewhat more expensively in private transactions), exchanging them into ryõ (at the legal tender rate of 4:1), shipping these gold coins back home, and melting them down. The shogunate immediately sought to close the arbitrage opportunity by reforming its silver coinage. A new silver coin, the nishu-gin, was issued, of similar silver content to the debased ichibu-gin, which was to exchange (on the basis of legal tender) against the ryõ at a rate close to the international exchange value of their respective metallic contents (around 13 nishu-gin per gold ryõ). The intention was to withdraw the ichibu-gin from circulation by bringing to an end their legal tender. The exchange of ichibu-gin into nishugin would have imposed a loss on present holders and the overall impact would have been deflationary.

8 The Yo–Yo Yen

However, before the issuance of the new coin had barely got under way, vigorous opposition from the USA brought the operation to a stop. The USA saw the step as a ploy to reduce at one stroke the purchasing power of the Mexican dollar, in terms of Japanese goods, to one-third. Bowing under US pressure, the shogunate switched strategy. The gold ryõ was now to be roughly between one-half and one-third of its previous size. Small new ryõ coins (Man’en) were to replace the old larger ryõ coins (Ansei) at a ratio of slightly less than 3:1. During the three-to-four month interim period until the new coins appeared in circulation the existing coins were ‘called up’ in face value by a multiple of two to three. The implicit rate of exchange for the new coins against the Mexican dollar was still 100 ryõs/133mex$ (using the official rate). The huge increase in the money supply (measured in ryõs) had fully predictable consequences. Within one year, the price level (quoted in ryõs) jumped by 30 per cent and by 1866 was up 400 per cent from pre-trade levels. Peasants and urban commoners, the main holders of silver coin, suffered loss, as did the general wage-earner and the lower-ranking samurai (feudal administrators). By 1865 the real wages of carpenters in Osaka were half of what they had been in the 1840s. Excluding extreme famine periods, peasant riots and urban revolts became more numerous than at any time. The price of the main export, raw silk, soared (up by more than 250 per cent immediately following the opening of trade). There were only fleeting gains for the USA or other Western Powers before price rises had extinguished any benefit (whether for foreign consumers or merchants) from the exchange rate of the ichibu-gin (and by implication the ryõ) having been set so low. Furthermore, there were the once-and-for-all profits made by coin arbitrageurs before monetary reform counter-measures took effect. In summary, the US negotiators had not been very smart. Was the shogunate any more astute? Was there really no alternative to the self-destructive policy of hyperinflation? One possibility would have been for the shogun’s agents to permit and even promote a free market in Japan for gold ryõs against Mexican silver dollars (where the rate of exchange would have reflected closely the relative price of gold and silver in world markets). Notionally one ryõ would have remained equal to four ichibu-gin, but no holder of ryõs would have parted with them at that rate given the alternative of readily exchanging them first into silver dollars in the free market. Silver dollars would have circulated alongside ichibu-gins as a parallel money albeit at a rate of exchange between the two which would have been somewhat variable. The shogunate could have met the increased demand for ichibu-gins (now the main medium of exchange, given the effective withdrawal of gold ryõs from circulation) by minting more of these coins (either out of silver bullion or from first melting down Mexican dollars), so preventing their value from rising substantially above their official price (in terms of Mexican dollars).

Historic Roots of the Yo–Yo Yen (1859–1949) 9

Gold ryõs would simply have ceased to be money but would have remained an important part of private wealth. Some share of the prereform stock of gold ryõs would have been exported in exchange for silver, which would have been minted into an additional stock of ichibu-gins. The ryõ could have remained as the unit of account. But ichibu-gins and to a lesser extent Mexican dollars would have been used for transaction purposes. (Indeed, Mexican silver dollars did circulate to some extent in the years up to the currency reforms undertaken in the mid-1870s under the Meiji Restoration). The price level measured in ryõs (in effect an accounting unit equivalent to four ichibu-gins) would have increased (as the windfall gains in private wealth from the jump in silver value of gold ryõs would have fuelled an increase in spending) and the money supply (consisting mainly of ichibu-gins) would have grown in step. Inflation might well have been less than what actually occurred because the gold ryõs withdrawn from circulation by their owners and hoarded would not have formed part of the money supply. The shogunate could have earned some profit from its arbitrage-type operations and the arbitrage profits made by foreigners (at the expense of Japanese who disposed of their gold coins) in the months before the eventual monetary reform would have been prevented. In time a much bigger silver coin could have been minted to form part of the circulating money without any opposition from the Western Powers. Indeed, that is what occurred a decade later following the Meiji restoration. Another option was for the shogunate to have bargained more effectively with the USA (and the other Western Powers who were negotiating treaties simultaneously). Perhaps the shogun’s representatives could have insisted on the official rate of exchange being fixed in terms of gold ryõs rather than silver (ichibu-gins). (The free market rate of the ryõ could have risen above the official rate unless the shogunate introduced the free minting of gold into gold ryõs.) After all, the USA was itself effectively on gold, Britain was on gold, and France was fully on a bimetallic standard (gold and silver). Or perhaps the Tokugawa regime could have simply said no to the request from the USA that Japan desist from reforming its silver coinage. Indeed the outbreak of the US Civil War was soon to reduce any imminent military threat from Washington to zero and Britain was later apologetic for the whole sorry episode. Were there insiders (in the shogunate), or potential domestic opponents of the Tokugawa regime, who stood to gain from the confused state of US currency policy? Or was the shogunate simply inept in matters of currency policy? The facts presented here are consistent with both hypotheses (which are, in any case, not mutually exclusive) but proof is beyond the subject-matter of this book. The same set of questions, however, reappear frequently in Japanese currency history – particularly in the last three decades of the twentieth century, which form the content of later chapters.

10 The Yo–Yo Yen

The long march from silver to gold, 1868–1897: inflation, deflation and devaluation Soon after the Meiji restoration in 1868 (the term given to the successful rebellion against the shogunate by a group of ‘clans’ in western Japan who took power under the banner of restoring the Emperor as the head of government and who were intent on modernisation as the means of resisting colonisation by foreign powers) the new rulers initiated monetary reform soon after they assumed power in 1868. As a first step the circulation of silver weight currency (prevalent still amongst Osaka merchants) was suspended (leaving ichibu-gins as the only silver element in monetary circulation). Then in 1870 a new silver coin of the same weight and fineness as the Hong Kong trade dollar was minted, with the intention of Japan moving on to the silver standard. A year later, there was a change of course, under the influence of Germany’s adoption of the gold standard (following the Franco-Prussian War) and of early moves in the US Congress towards putting the USA on the gold standard (convertibility of the dollar into gold or silver had been suspended during the Civil War). According to the ‘New Currency Ordinance’ promulgated in 1871, the basic unit of the Japanese currency was fixed as a gold coin called the yen. This was specified as having a weight of 25.72 troy grains and 90 per cent fineness. The new coin was to be round and the decimal system was used (100 sen = 1 yen). (New small silver and copper coins, denominated in multiples of 1 sen, replaced the ichibu-gins and other smaller change.) The traditional gold coin, the ryõ, was declared equivalent to 1 yen. The gold content of the new coin (one yen) was around 25 per cent less than of the old and so the yen gold coin sold for less than the ryõ in terms of foreign currencies. Around 25 per cent fewer Mexican dollars were required to buy 100 yen in 1871 than 100 ryõs in 1860, despite little change so far in the international rate of exchange between gold and silver. The motivation behind the shrinkage of the gold content was concern at the growing amount of paper money and debts redeemable in coins (see below). In effect the ‘New Currency Ordinance’ was a devaluation of Japan’s money (albeit that some holders of the old ryõ coins might have sold them into an international market where they would be priced according to their gold weight rather than using them to effect payments which could be made 1:1 with the new yen coin of lower gold content). For the convenience of trade with Asia a one yen silver coin (much larger in size than the yen gold coin), equivalent in weight to the Mexican dollar, was also minted, but its use restricted to the open ports. A parity of 100 yen in silver equivalent to 101 yen in gold was fixed. In 1875 the weight of the silver coin was increased slightly and the following year gold and silver coins were declared interchangeable (1 yen gold = 1 yen silver). In accordance with the rules of a metallic standard (whether gold, silver or bimetal-

Historic Roots of the Yo–Yo Yen (1859–1949) 11

lic), the coins were freely minted (meaning that silver or gold could be converted into coins at par value on demand). This meant that the yen could not rise significantly higher in the currency markets than the level implied by the lower of its value in silver or gold form. (Note that free minting had not applied previously, even though first the shogunate, and later the Meiji rulers, did effectively set a limit to any potential rise of the yen above silver par value by their plentiful supply of new coins.) Meanwhile, an international slump in the price of silver had set in, caused by huge new discoveries of the metal and the demand for gold following Germany’s shift from a silver to a gold standard. France (and other countries in the Latin Monetary Union) made a first step towards abandoning bimetallism by restricting the free minting of silver, and the USA was progressing further towards adopting the gold standard. (In 1873 Congress passed legislation which excluded silver from future minting operations.) The fall in the price of silver against gold resulted in large-scale exports of gold coins from Japan (arbitrage took the form of importing silver into Japan, having the silver minted into silver yen coins, exchanging into gold yen coins at 1:1, and exporting the gold coins to be melted down and sold). The silver yen became the dominant medium of exchange as gold yen dropped out of circulation (partly due to the arbitrage transactions described and partly due to Japanese hoarding the gold coins rather than parting with them at an undervalued level domestically). In 1878 the authorities recognised the inevitable by officially permitting the unlimited domestic circulation of the silver yen. Though Japan was still legally on a bimetallic gold and silver standard, in practice it had moved on to a silver standard, on which it remained for the next nineteen years. Why did Japan opt for the silver standard rather than following the example of European countries and the USA, which were shifting from bimetallism to gold? In principle, Japan could have suspended the free coinage of silver. The main consideration was that Japan did not have large gold reserves, and the issuance of paper money (which under the gold standard would be redeemable on demand in gold) was growing rapidly as a consequence of the weak state of government finances in the early years of the Meiji restoration (exacerbated by the armed revolt of the samurai in 1877). There was a better chance of anchoring the yen to silver than to gold and the fact that the other main countries in Asia were on silver must have been important. The new instability in the ratio of silver to gold prices in the world market meant that exchange rates between countries on the silver standard and those on the gold standard now became volatile, with the currencies of the silver countries on a falling trend (Figure 1.1). (An exception to the falling trend was a short-lived 25 per cent surge of the silver currencies in 1890 on speculation that the Sherman Act, passed that year by the US Congress, would lead to large official US purchases of silver.) In any case,

12 The Yo–Yo Yen

* Relative price of gold in terms of silver, based on London market prices.

Figure 1.1

Gold–silver parity, 1868–94*

the higher transport costs, relative to value, of silver over gold, meant that exchange rates between silver currencies or between silver and gold currencies could move within wider margins – for any given relative price of silver and gold – than between the gold currencies. By 1879, when the USA effectively went on to the gold standard, the largest area (in terms of economic size) of the world currency map was in a gold bloc (including the USA, Great Britain, France, Germany, and many smaller countries), and there was a smaller area of countries on the silver standard (principally Japan, China, Russia and India). In Russia the convertibility of paper currency into silver had been suspended following periods of war causing the exchange rate of the rouble (in non-metallic form) against the gold standard currencies to be weaker than implied by the relative price of silver and gold. Over the next decade (the 1880s) the fall in the silver price aided the return of rouble notes to their par value. Eventually, in 1893, Russia abandoned the silver standard (suspending the free coinage of silver in the face of a huge influx of the metal, which created an inflation menace). India also moved off the silver standard in the same year. And so when Japan shifted from the silver to gold standard in 1897 the silver area had effectively narrowed to include only China and Hong Kong.

Historic Roots of the Yo–Yo Yen (1859–1949) 13

However, we are rushing too far ahead in our story. Returning to 1878, Japan was already well into a period of paper inflation, in which yen notes fell to a steep discount below silver yen, similar to what had occurred in Russia during the previous two decades. Very early on (1868), the Meiji administration had started issuing ‘gold notes’ (kinsatsu) to finance its budget deficit and soon these were quoted at below par. Nonetheless they gradually came to be accepted as currency (the government helped bring this about by announcing that part would be redeemed in newly minted currency and part with government bonds bearing 6 per cent interest). Throughout the 1870s the plight of the Treasury grew more and more desperate and the government issued paper money in several forms. Following the abolition of the feudal clans, which had held great power in pre-Meiji restoration Japan, all their outstanding notes (1,694 different varieties of paper money called hansatsu) became an obligation of the central government and in 1871 were redeemed with new paper money. The rapid increase in paper money and the sharp rise in prices (inflation was less rapid when measured in terms of silver yen than paper yen) had alarming repercussions on the whole fabric of the economy. Action was finally taken in the early 1880s by Masayoshi Matsukata, who was appointed Finance Minister in October 1881. He pursued a policy of stringent fiscal deflation (cutting government expenditure and increasing taxation), selling public enterprises to private buyers, usually at knock-down prices (amongst the buyers were the ‘political merchants’ who formed the great conglomerates, the so-called zaibatsu), and accumulating silver as the counterpart to an emerging trade surplus (technically, the government lent paper money to exporters against their bills of exchange, then collected the amounts due for the goods in silver). As the reserve ratio of government and bank notes in circulation rose to over 35 per cent (calculated as the value of silver in official reserves as a proportion of paper outstanding), the paper yen rose towards parity with silver yen, which was achieved by end-1885. In modern-day terms the so-called Matsukata deflation was a severe fiscal and monetary deflation following an inflationary boom during which both monetary and fiscal policy had been stimulatory. During the deflation itself (1882–5) the exchange rate between the silver yen and the dollar was on a flat trend, meaning that the paper yen appreciated sharply. In itself the official purchases of silver (equivalent to foreign exchange intervention in the direction of selling yen) dampened the extent of monetary contraction – but the budget surpluses plus sales proceeds of public enterprises far offset the silver purchases and so the overall money supply (including silver coin and paper money) fell, as the net surplus was used to retire note issues. Many of the small and industrial enterprises that had mushroomed in the inflationary period went into bankruptcy. A number of banks had to suspend business whilst many suffered huge losses. Round the corner, however, from 1885 to 1887, lay a 20 per cent depreciation of the yen

14 The Yo–Yo Yen

$

Figure 1.2

y

US$/yen exchange rate, 1880–97

against the dollar and other gold currencies, in line with a sudden sharp fall in the price of silver (Figure 1.2). A new period of prosperity dawned, with the fillip from yen devaluation playing an important role. Indeed, the yen fell substantially further against the dollar and other gold currencies in the period 1891–4, in line with new weakness in the price of silver. This was an early example in Japanese history of devaluation pulling the economy out of a post-bubble depression – an exit door that was to be barred, with severe consequences, a little more than a century later (in the 1990s). With paper yen now back to par with silver yen in 1884, the government published its ‘convertible bank note regulations’ and in May 1885 the Bank of Japan issued its first convertible 10-yen notes, which were followed by 1-yen and 100-yen notes. The Bank had already started operations in 1882 (modelled largely on the Belgian central bank which had been set up in 1850 and thus possessed more elaborate statutes than the British or French central banks), but its privilege of issuing convertible banknotes had so far been withheld. Implementing the privilege did not mean that the Bank of Japan had any real control over monetary developments. Japan was now fully on a silver standard. In the new period of prosperity that started in 1886, Japan’s exports to countries using the gold standard boomed (spurred by devaluation) and the inflow of silver via the trade surplus led to monetary expansion. Overall there was mild inflation (in contrast to the deflation then experienced by the gold standard coun-

Historic Roots of the Yo–Yo Yen (1859–1949) 15

tries which stemmed from a world-wide scarcity of the yellow metal – not relieved until well into the following decade as a result of huge new discoveries). In 1893 the government appointed a Commission to study the problem of inflation, but its report, submitted in July 1895, was inconclusive. The Commission discussed in particular the question of whether to adopt the gold standard, but showed no decisive preference in that direction. However, Masayoshi Matsukata, an advocate of gold, became Prime Minister in September 1896 (holding office until January 1898) whilst retaining the post of Minister of Finance. China was now paying large indemnities in sterling to Japan under the terms of the Treaty of Shimonoseki, which had ended the 1894–5 Sino-Japanese War (Japan also gained Taiwan). The new additions to Japan’s gold and near-gold reserves (sterling was convertible into gold) reduced the apparent risks of shifting to the gold standard (less danger of being forced off by a shortage of bullion during any subsequent financial crisis). In March 1897 a currency law was passed prescribing that the yen was equal to 750mg of gold and that coins of ¥20, ¥10, and ¥5 would be minted. Hence the yen against gold was valued at one-half the level fixed by the 1871 currency reform. The exchange parity against the US dollar corresponding to the new gold value was ¥100 = $49.845. And so the yen had fallen more than 60 per cent against the US dollar since an official exchange rate had first been set in 1859. In October 1897, the new currency law became effective, putting Japan on the gold standard. There followed almost twenty years of exchange rate stability against the US dollar and major European currencies – roughly equal in length to the other main period of stability in the history of the yen from 1950 to 1971 under the Bretton Woods System. Even whilst war raged between Japan and Russia in 1905, the yen remained on gold (as did the Russian rouble). But the monetary experience of the first forty years that followed the opening of trade with the outside world had left currency devaluation and inflation as no strangers to the modernising Japanese economy. Later bouts of enthusiasm for monetary orthodoxy and a strong national currency, whether briefly at the end of the 1920s, or during the lost decade of the 1990s, were not the results of historical conditioning.

Japanese currency policy during the First World War: new problem – how to recycle a huge trade surplus? Japan’s break with the gold standard came during the First World War. In September 1917, the USA (which entered the war in April 1917) prohibited the export of gold, stifling the equilibrating mechanism that kept the yen within tight limits against the US dollar. The yen climbed well above its par value (to the US dollar) in line with a huge surplus which had developed in

16 The Yo–Yo Yen

Japan’s trade balance (as much as 40 per cent of GDP according to some estimates). Japan, an ally of Great Britain, had declared war on Germany at the outbreak of hostilities in 1914, but it played virtually no part in military operations. As a non-belligerent economy, its industries thrived, meeting demand particularly from other Asian countries that had been cut off from traditional European sources of imports. Suddenly Japan, which in the years prior to the First World War had been in substantial trade deficit (normal for a developing economy importing capital from the rest of the world), found itself in the reverse situation. Yen strength did not emerge immediately at the outbreak of war. Indeed, during the early weeks, Japan found itself in a liquidity crisis. The shipment of export bills to the London market via the Trans-Siberian railway was suspended and so the inward flow of foreign exchange fell sharply. The Bank of Japan had to sell gold to prevent payments for imports forcing the yen below its normal floor (set by gold arbitrage) against sterling or the US dollar. Junnosuke Inouye, who alternated roles between Governor of the Bank of Japan and Minister of Finance through the 1920s, wrote that senior officials felt that Japan was well down the road to bankruptcy (meaning a moratorium on international debts) in autumn 1914 and the following winter. By spring 1915 the fog had lifted as orders for arms and munitions began streaming into Japan from the entente governments (mainly France and Great Britain). As military and non-military exports boomed (in volume and in price), Japan faced a new problem that would resurface in a much more enduring form fifty years later. How was it to recycle a huge trade surplus into foreign assets? So long as the dollar and yen were on the gold standard, Japan’s huge trade surplus was largely matched by an inflow of gold, which in turn fuelled monetary growth and inflation. The problem of inflation and what to do about it preoccupied Japanese financial officials, and some of the solutions they came up with bear some resemblance to various policy options discussed or even implemented in the much longer period of surplus during the last three decades of the twentieth century. Most involved the promoting of capital exports. In principle a boost to capital outflows would mean less upward pressure from the trade surplus on the money supply (or on the exchange rate, once this was floating as from 1917). During 1915 and 1916 the Japanese government made a series of domestic debt issues for the purpose of repaying external debts. But this approach came up against the barrier of the No Loan Policy imposed by the government of the day (zero addition to government debt). Then there were the official loans to China (the so-called Nishihara loans made in a spirit of conciliation after initial strong-arm diplomacy). Foreign governments – France, Great Britain, and Russia – made debt issues in Tokyo. And finally, Japanese investors bought a small amount of loans placed in the US market by the British and French governments.

Historic Roots of the Yo–Yo Yen (1859–1949) 17

In general the Japanese public showed no great enthusiasm for foreign investments. According to Inouye, as a contemporary observer, ‘in countries such as England, France, and Germany, the man in the street is a foreign investor. Japan, by contrast, had never been wealthy enough for people here to indulge in such investment. During the war period there was a lot of talk about how we ought to invest abroad, but a nation cannot acquire discrimination in such a matter all at once, and to all intents and purposes no such investments were made by this country.’ Maybe Inouye was making too much of wealth and discrimination as factors in foreign investment. More important were the relatively high interest rates at home typical of the pre-war savings shortage – the counterpart to the trade deficit – and wariness of investment in assets of warring nations. European investors may have had more experience of foreign assets, but the huge losses made by Dutch and Swiss speculators buying German marks during the First World War and beyond hardly testifies to wisdom. The speculators in marks, however, were only a subset of the investment population. Some Dutch and Swiss investors gained from buying US securities when the dollar fell sharply against their own currencies during 1917–18. Indeed, in many respects, the Japanese yen during the First World War fits into the group of neutral currencies – including the Dutch guilder, Swiss franc, and Spanish peseta – rather than to the belligerent currencies, even though Japan was technically a military participant (on the side of the entente powers – Britain, France and Russia). There were, however, some important differences. The flow of gold between the USA on one the hand and Switzerland and the Netherlands on the other was disrupted early on in the conflict, unlike the situation between Japan and the USA (where sealanes between Tokyo and San Francisco remained fully open). Hence emerging balance of payments surpluses for Switzerland or the Netherlands had little automatic offset in the form of gold inflows and had a bigger effect on the exchange rate. Moreover, both Switzerland and the Netherlands were the recipients of huge volumes of capital flight, much of it out of Germany. Japan, by contrast, did not attract refuge capital. On the other hand, Japan did not face the physical constraints on international trade experienced by Switzerland and the Netherlands (the British fleet’s interruption of shipping across the North Sea to check that supplies were not headed for Germany, and German interference with Rhine traffic). During the first three years of the war, the Swiss franc and Dutch guilder fluctuated quite sharply, whilst the Japanese yen remained near its gold parity to the dollar. For example, in the early stages of the war the Swiss franc fell below its gold parity to the dollar on pessimism about the prospects for the Swiss economy, given its high dependence on imports of grain (much of which had come from Russia), energy, meat and wool, and its land-locked position. Also there were some fears about whether Swiss neutrality would be respected, especially for a brief interval following Italy’s

18 The Yo–Yo Yen

entry into the war (May 1915). Into 1916, however, the Swiss franc rose sharply under the influence of growing inflows of refuge funds. By contrast, the Dutch guilder, which had been strong through much of 1915, fell back in 1916 as the Netherlands exporters provided larger credits to their German customers and the British grip over Dutch trade tightened. Spain, unlike the Netherlands and Switzerland, was so far largely free of restrictions on its international trade. As Spain’s agricultural and steel exports boomed, its government took measures similar to those in Japan towards promoting capital exports – repaying foreign loans and providing large credits to France. The Spanish peseta, unlike the Japanese yen, had not been on the gold standard, and rose sharply. The Japanese yen, though on gold, did move sharply against the currency of its number one trade partner, China. In fact, the yen fell steeply against the Chinese currency (the Shanghai tael) and Hong Kong dollar, which were still on the silver standard, as silver prices soared (explained by the use of this metal in the manufacture of explosives). From September 1917, however, it was the movement of the dollar that took centre-stage in Asia. With gold arbitrage operations now fully suspended between the USA and Japan, the yen climbed to over US$52/¥100 (compared to parity of US$49.845 = ¥100). Even so, the extent of that climb can only be described as very modest compared to either the experience of the neutral currencies or to later events (in the last three decades of the twentieth century). For example, the Swiss franc reached a peak level (in June 1918) of more than 30 per cent above its gold parity against the US dollar. One principal difference in the Japanese experience was the huge buying of dollars by the central bank. The Bank of Japan stemmed the rise of the yen by accumulating vast foreign balances (¥1.1 bn in 1920), largely in New York, even though there was no longer any possibility of converting these into gold. These foreign balances were to play a large part in the management of the exchange rate in the post-war years. Already Japan had accumulated huge reserves in gold (until the US embargo on gold exports in September 1917). Financial officials in the Japanese government and the Bank of Japan were not at all happy with the rapid accumulation of foreign balances, partly out of concern at exchange risk (the dollar could fall further against the yen), and partly out of inflation fears (the process of accumulating the balances involved domestic monetary expansion). In May 1918, the Exchange Investigation Committee was appointed to examine the question of currency policy. The issues considered by the Committee would have been only too familiar to currency policy-makers at the end of the twentieth century – possible concerted action by the central banks in Japan and the USA, concerted action between the leading private banks in Japan and the US, limitation of interest on bank deposits, encouragement of foreign investments, and limitation of exports. In fact war came to an end (November 1918) before the Committee reported. If there had

Historic Roots of the Yo–Yo Yen (1859–1949) 19

indeed been a final report it would have been seriously flawed for not considering one key option – letting the yen float freely (no further acquisition by the government of foreign balances), albeit coupled with a clear statement of intent to return to the gold standard as soon as possible after the war ended. The big advantage of a free float, whenever adopted (from summer 1915 onwards), could have been the lowering of inflation pressure. Buoyant demand for Japanese exports would have sent the yen higher. The boom would have been less intense in the export sector, as profits there were cooled by the yen’s ascent. The rate of monetary creation would have slowed with the government (via the Bank of Japan) no longer acquiring foreign balances. The outflow of private capital into foreign investments would have been stronger, as Japanese investors could look forward to a larger currency gain from the eventual fall in the yen once peace came. What were the disadvantages? First, a free float would have been a journey into the unknown. Virtually ever since the Meiji restoration the yen had been on the silver or gold standard. True, there had been experiences elsewhere of floating currencies for limited periods (for example, the Russian rouble in the late nineteenth century between leaving the silver standard and joining the gold standard, or the US dollar in the decade following the Civil War). But their relevance to the Japanese situation during the First World War was dubious. And there was the contemporary experience of sharply fluctuating (and generally appreciating) European neutral currencies to suggest caution. Second, on the eve of the First World War, Japan was still a relatively underdeveloped economy compared to the USA, Great Britain, France and Germany. War brought a big fillip to Japan’s developing industries, which gained not only from booming export demand, but also effective protection (as competitor economies were mobilised for military production). The war was most likely to only last a few years and the acceptance of inflation might be a sacrifice worth making for the one-off benefits of accelerated industrial development. Third, the country’s gold and foreign exchange reserves were small and overall it was a large net debtor. A massive build-up of gold and foreign exchange reserves was consistent with the aim of furthering Japan’s position as a great military power.

The first era of a floating yen, 1919–32 In principle, Japan could have moved back to the gold standard as early as June 1919. That was when the USA lifted its embargo on the export of gold – almost simultaneously with the conclusion of the Versailles Peace Conference. The essential step would have been for Japan to lift its own embargo (introduced in 1917, as reciprocal action to the US embargo

20 The Yo–Yo Yen

imposed two days earlier) on gold exports. That step was not taken finally until a doomed moment in early 1930 when the world economy was in the first phase of its greatest ever depression. Japan’s only response to the lifting of the US embargo in June 1919 was to make important conversions of dollar balances into gold. The hesitation in Tokyo towards restoring the gold standard reflected the huge uncertainty as to how the Japanese economy would perform now that peace had returned and the special elements in its wartime prosperity no longer applied. The price level in Japan had risen rapidly during the First World War – substantially more than in the USA. Fixing the yen prematurely to the dollar at its previous gold parity might mean considerable problems for Japan’s export industries when faced with an expected sharp fall in demand. In addition the war chest of huge gold and dollar reserves could be frittered away. At the Genoa Conference of 1922 the report of experts hinted at the merits of Japan returning to gold at a devalued rate, and a leading economist, Gustav Cassel, calculated the so-called purchasing parity level of the yen against the dollar as between 35 and 40 US$/100 yen. Returning to gold at a devalued rate was not a first time experience in Japanese currency history. That is what happened, after all, when Japan adopted the gold standard in 1897, following more than twenty years on the silver standard. But that was not the path followed in the 1920s, even though several prominent Japanese economists argued the case strongly. Hence the Japanese yen joined the other major currencies of the world in a new era of floating exchange rates following the First World War. There were several important differences between this first era and the second era that started in 1971. First, the US dollar remained fully convertible into gold (both domestically and internationally). Second, there were powerful and persistent expectations about an early return to a fixed exchange rate system (based on gold), albeit that in the case of the French franc eventual return was to be at a devalued gold parity, and the German mark was to expire worthless before its successor currency, the Reichsmark, was launched on a gold basis. Third, the yen of the 1920s was to a considerable extent a commodity currency – with Japan’s principal export, raw silk, having its price determined in dollars on the world market. Fourth, by economic size, the Japanese yen tied for fifth place (with the Italian lira) in the 1920s, rather than occupying second place as by the 1970s. During the first forty years or so of the Meiji restoration (1870–1913), living standards in Japan (GDP/capita) had grown at a similar annual average rate to those in the US and Germany (around 2 per cent p.a.). Overall economic growth had been much faster in the USA (4.6 per cent p.a. compared to 2.4 per cent p.a. in Japan), reflecting the rapid population increase there amidst a great wave of immigration. In the next twenty-five year period, 1913–38, Japanese economic growth (at 3.9 per cent p.a. on average) ran far ahead of that in the USA (1.1 per cent p.a.) or Europe

Historic Roots of the Yo–Yo Yen (1859–1949) 21

(Germany, 1.8 per cent p.a.; Great Britain, 0.7 per cent p.a.). Some economic historians see in that growth spurt for Japan in the quarter century from 1913 the forerunner to the miracle years of 1953–73. But that sweeping overview fails to distinguish some very large variations in economic fortune, both in Japan and in the rest of the world. First there was the great wartime boom in Japan from 1915 to 1919. Economic growth from 1913 to 1919 has been estimated at 6.2 per cent p.a., with investment spending increasing by 8.4 per cent p.a.. Then there was a lost decade of low growth, financial crises, and the Tokyo earthquake. Economic growth during 1919–31 ran at only 1.6 per cent p.a. on average, with investment spending down by 0.7 per cent p.a.. A change in currency policy in 1931 ushered in several years of very rapid growth before the Japanese economy went on to a war footing from 1937 onwards. From 1931 to 1937, the economy grew by 6.2 per cent p.a., with investment up 8.3 per cent p.a.. By contrast, the US economy enjoyed a wave of prosperity through the 1920s, before passing through the Great Depression of 1930–3. Misguided currency policy played a role in the lost decade of the 1920s as it did in the 1990s, albeit that the mistakes stemmed from a quite different combination of circumstances. Later in this volume the question will be posed as to how different the 1990s would have been for Japan if the yen had fallen sharply after the ‘Bubble economy’ burst rather than rising to the sky. In the early 1920s the counterfactual currency question is how the economy would have performed if the yen had been allowed to fall freely (and far) after the business cycle peak of early 1920 and had subsequently been re-pegged to gold at say 35 US$/100 yen rather than at almost 50 US$/100 yen. The counterfactual story would start with the Japanese stock market crisis of March 1920 and would also have to include the real events of the Great Kanto ¯ earthquake in 1923 and Japan’s military advance into Manchuria in autumn 1931. The economy had remained in boom after the First World War ended, right through 1919 and into early 1920. The banks had continued to fuel a build-up of speculative credit. As during the war, the government had remained in large fiscal surplus. Interest rates had remained low throughout the war (reaching in 1917 the lowest level since 1911) and only began to rise in winter 1919/20 as imports boomed and the trade surplus vanished. Suddenly, on 15 March 1920, the bottom fell out of the stock market and panic ensued. The Tokyo stock exchange closed its doors for two days. Later there was a stock exchange holiday from mid-April to late May. The index of stock prices (July 1914=100) fell from 250 in January to 113 in June. There followed two years of economic stagnation as export markets won during the war were lost one after the other, producing a large-scale deficit in the balance of payments. The government and Bank of Japan responded with a policy of bold lending to depressed industries. A slight business recovery got under way in winter 1921/22, but in late 1922 runs on banks (eleven in western Japan failed) led to new confusion.

22 The Yo–Yo Yen

The currency policy that accompanied this set of events was effectively a dirty float – large-scale intervention to prevent the yen falling far. Indeed, the immediate trigger to the Crash of March 1920 had been an unsterilised sale of dollar balances by the government aimed at preventing a fall of the yen as imports outstripped exports (unsterilised means that the yen purchased by the government was taken out of monetary circulation and thereby put upward pressure on interest rates). The dollar balances acquired during the war years became a key determinant of the exchange rate for the yen. In somewhat convoluted language, Inouye described the rate of the yen as ‘artificial – in that the sale of the government’s balances abroad exerts on [the yen] an influence which has been powerful and not natural; the determining factors on which the yen exchange rate depends are the current amount of our balances abroad and our policy in regard to these balances. Their free liquidation means a rate moving towards $49, whilst a refusal to draw on them entails a movement below $40.’ During the depression of spring 1920 to 1922 the government allowed the yen to fall only modestly to a low of US$47/100 yen (Figure 1.3). That was at a time when it was appreciating sharply against the currency of a principal trade partner (albeit now second to the USA) – China. The price of silver (to which the Chinese currency was linked) collapsed in half from its wartime peak until the end of 1920. In late 1922 and early 1923 the Kato government adopted the policy of pushing the yen higher (using the official dollar

$

Figure 1.3

y

US$/yen exchange rate, 1918–25

Historic Roots of the Yo–Yo Yen (1859–1949) 23

balances for this purpose), with the purpose of reducing import prices (which particularly favoured the important cotton spinning industry). By the end of April 1923, the exchange rate had gone to $49, and there was much talk about an early lifting of the embargo on gold exports (meaning that the yen would again return to the gold standard at the pre-war parity). But the government, concerned at the low level to which its foreign balances had declined (depleted by years of intervention to support the yen), hesitated. Then in September 1923, calamity struck as the Great Kanto ¯ earthquake destroyed much of Tokyo. Today, the question is sometimes posed as to whether earthquake disaster could strengthen the yen in the short run by bringing a sea-change in international capital flows. A sudden increase in domestic investment (for reconstruction) and fall in personal savings could trigger a big jump in interest rates and bond yields creating heavy capital inflow rather than outflow (as discussed in a later chapter). But in 1923 there was no ambiguity – the yen came under immediate downward pressure, which was initially countered by heavy official intervention (the government running down its dollar balances) but subsequently led to a sharp fall. The scale of the disaster included 105,000 dead, 554,000 homes destroyed (out of 2.3 million total), and 7 per cent of national wealth destroyed. In Tokyo, in the immediate aftermath of the earthquake, there was an outbreak of social violence, as frenzied mobs attacked Koreans and the police murdered communists, amidst false rumours that Japanese communists and Korean nationalists were trying to set up a revolutionary government. (The news of this violence was hushed up until several weeks after the earthquake.) Why was the currency market so convinced of the negative consequence of the earthquake for the yen in 1923 in contrast to the diversity of opinion that a similar catastrophe would provoke at the beginning of the twenty-first century? A key difference could have been the behaviour of capital flows. Today a jump in Japanese bond yields set off by an earthquake would attract a large amount of foreign capital inflows and would also encourage some Japanese investors to lighten up on their holdings of foreign bonds, reinvesting the proceeds in yen. Back in the 1920s, Japan was not regarded as a high-quality debtor. Foreign exchange reserves had fallen sharply since the war (although large gold reserves had been maintained) and the private sector did not hold a large amount of foreign assets. The earthquake itself lowered the implicit credit-rating of Japan, as US investors in particular (the biggest international lenders in the 1920s) were concerned about the huge trade deficits which were likely to lie ahead. Bonds denominated in yen, still a floating currency unlinked to gold, were not attractive to investors outside of Japan. The idea that a currency could be driven higher by high interest rates despite a large trade deficit was strange to the investment community of the 1920s (in contrast to its familiarity with investors at the end of the century who had much recent experience of currencies floating upwards despite large trade deficits).

24 The Yo–Yo Yen

If Japan had been on the gold standard at a devalued rate (say, US$35/ 100 yen) when the earthquake struck, capital might well have flowed in to finance the widened trade deficit, with just a slight rise in yen interest rates taking place. At the pre-war parity, by contrast, the yen would probably have been toppled off gold. In the world of the 1920s huge flows of capital driven by interest arbitrage did take place between currencies on gold at realistic parities. For example, Germany attracted huge volumes of capital inflows, especially from the USA, in the years 1924–7. The German economy had many admirers in the USA and its central bank (the Reichsbank) was subject to an international treaty (the Dawes Plan) which seemed to guarantee financial stability and a fixed exchange rate (against the US dollar) for the Reichsmark. By contrast, US investor opinion was not friendly to Japan. Washington distrusted the expansionist designs of the Japanese military (even though Tokyo had agreed to limitations on naval armaments following the Washington Conference of 1922). New measures to curb immigration into the US (eventually signed into law in 1924) were viewed in Japan as hostile, considering the tough restrictions applied to ‘Orientals’. On top of these unfavourable factors was the fact that the government and central bank did everything possible to stop interest rates rising in the wake of the earthquake, even though that is what would have happened on the gold standard (or under a modern monetary regime where the central bank targets a stable price level). The authorities’ immediate objective was to prevent any seizing up of liquidity. Beyond that, the aim was to foster a generous supply of credit for the purpose of reconstruction. In early 1924, the Japanese government arranged a series of foreign loan offerings with the declared purpose of preventing a shortage of capital from pushing up rates in the domestic market. In the currency markets, the Japanese authorities battled during the first few months following the earthquake to prevent the yen from falling far by running their dollar balances down further. In January 1924 a new government abandoned the policy of propping up the yen, even though each subsequent decline was heralded by declarations that the rate would not be permitted to go any lower. In the first few months of 1924 the yen fell by around 20 per cent in value to $40/¥100 and by the end of 1924 was down to $38/¥100. An immediate factor behind that decline was the jump in the trade deficit accompanied by the policy of holding down interest rates. The deterioration in the trade balance stemmed from both the underlying increase in investment (reconstruction expenditure) and a fall in savings and temporary bottlenecks in domestic supply. As illustration of the latter factor, there was the need to import timber despite there being forests across Japan. Yes, the raw timber was there all right, but what was not there was any proper plant for sawing it. Japanese domestic architecture used shaped timber (posts and boards), not logs. Such sawmills as there were proved entirely inadequate to cope with the demand for materials suitable for the

Historic Roots of the Yo–Yo Yen (1859–1949) 25

construction of homes on the scale required. Accordingly the quickest and cheapest way out to the difficulty was to import sawn timber from the USA. Moreover, there were practically no factories in Japan equipped for the production of builders’ hardware. In principle, a currency beaten down to a low level by a temporary surge in imports should become attractive to speculative investors. And that is exactly what happened in the case of the yen in early 1925. True, the yen at $38/¥100 was not fundamentally cheap (indeed, still somewhat higher than the purchasing power parity level against the dollar), but given its preearthquake level and the probability of an eventual restoration of the gold standard at the pre-war parity, there were obvious speculative attractions. According to Inouye, the turnaround of the yen originated with heavy demand from speculators in Shanghai. The Chinese currency (and silver) tended to follow a seasonal pattern, reaching its peak at the end of the (Chinese) year when heavy demand for cash to settle accounts created a liquidity shortage. Hence Chinese traders were particularly interested in looking for foreign currency assets at the turn of the year (given the likelihood of a seasonal fall in the Chinese currency during following months). In 1925 the end of the Lunar Year was in the first week of February and a wave of speculation on a yen rise swept Shanghai. By the end of March the exchange rate had risen to $42/¥100. Late in the same year a broad-based advance of the yen got under way on signs of a falling trade deficit and substantial progress in reconstruction. There were hints that Japan might use part of its gold reserves to bolster the yen. Briefly, spring shoots of parliamentary democracy appeared following the elections of 1924, and this may have helped underpin demand for Japanese bond issues in the USA. Into 1926 there was growing speculation on a return of Japan to the gold standard, and the new Finance Minister in September of that year pushed forward preparations for the move. But the plans were interrupted by a severe financial crisis, which erupted in spring 1927, and brought on a crop of bank failures culminating in a three-week moratorium on all financial obligations. An immediate trigger to the crisis was government indecision as to how far to bail out banks which held large amounts of so-called ‘earthquake bills’ (debts which had been frozen in the immediate wake of the earthquake). But the ultimate source of the difficulties were the huge speculative activities in the years 1915–20 and the floundering of the economy since. There is the obvious parallel here with the banking crisis of summer/autumn 1997 which came a full six years after the bursting of the Bubble (of 1987–90) during which time the economy had stagnated. Banking stability was undermined by a combination of original speculative excess and dismal macro-economic performance largely stemming from policy error. Banking crisis (at a national rather than international level) usually goes along with a flow of capital out of the afflicted centre and so the yen weakened in the midst of the 1927 crisis.

26 The Yo–Yo Yen

By 1929, however, speculation was again riding high that Japan would lift its embargo on gold exports (and thereby returning to the gold standard at the pre-war parity). Through the spring, the government (formed from the Seiyu¯kai party) repeatedly denied that a move was imminent, and issued a particularly strong refutation in May 1929. In July, however, a new government (formed from the Minseitõ party) came into office and pledged to lift the embargo. Inouye, the Minister of Finance, pursued fiscal deflation laying the groundwork for the restoration of the gold standard. Loans were arranged with New York banks. The crash of the New York equity market in October 1929 was seen in the market-place (and by Japanese officials) as facilitating an early lifting of the embargo, as credit became available in New York at much lower cost (dollar interest rates fell sharply and competing US domestic demand for margin-related credit plummeted) and as the worldwide flow of capital towards the USA weakened and might even go into reverse. (Foreign capital had piled into New York during 1928 and the first three quarters of 1929 to take advantage of the high call rates stemming from broker demand for funds to finance their clients’ speculation in the equity market.) Before the Wall Street Crash, there was the danger that a lifting of the gold embargo would unleash huge outflows of capital from Japan to the USA to take advantage of the high interest rates there (and so lead to an unsustainable loss of gold or a sharp rise in Japanese interest rates, undesirable given the weak domestic economy). What policy-makers and market opinion failed to see in October 1929 was that a severe US recession lay ahead which would hit the whole world economy, including Japan, making the financial orthodoxy of the new government unsustainable. Anyhow, on 21 November 1929, the government announced the repeal, effective 11 January 1930, of the ordinance prohibiting the export of gold. Already the cold winds of world depression were blowing. Raw-silk exports to the USA slumped and the outflow of funds from Japan into foreign securities increased. The Chinese currency was falling sharply in line with the price of silver. The Japanese authorities made use of their short-term credit facilities in New York, but in July 1931 foreign borrowing became more difficult due to the collapse of the Danat Bank in Germany. Finance Minister Inouye responded by pushing up borrowing costs, but the drain continued. The Manchurian Incident (18 September 1931), in which the Japanese Army launched an offensive towards extending control over that area of north-east China, and Britain’s departure from the gold standard (23 September), aggravated the loss of confidence in the yen. Finally there was dissension within the Cabinet (some call it self-interest – Home Minister Adachi Kenzo¯, who, advocating a coalition with the opposition Seiyu¯kai Party, was later suspected, but never proved, of being an accomplice to a speculator’s ‘plot’) and on 11 December 1931, the Minseitõ government fell. Two days later a new Seiyu ¯kai government, with Korekiyo

Historic Roots of the Yo–Yo Yen (1859–1949) 27

Takahashi as Finance Minister, reimposed the embargo on gold exports. Japan had at last abandoned the gold standard system. Two months later ex-Finance Minister Inouye was assassinated in a growing tide of right-wing nationalist violence. There followed five years of rapid economic growth (until the full-scale invasion of China) during which reflationary monetary and fiscal policies were followed, and the yen fell to a highly competitive level. Already by end1931 the yen was down to US$34.5/100 yen, the rate advocated ten years earlier by economic experts at the League of Nations. By late the following year the yen had collapsed to almost US$20/100 yen despite exchange restrictions introduced that summer (1932) to counter capital flight. An intensification of political violence in Japan and a wave of protectionism against Japanese exports played a part in the rout. As exports (particularly of textiles) boomed, boycotts, discriminatory tariffs and import quotas were imposed on Japanese goods and there were numerous trade disputes. The devaluation of the dollar in 1933–4 under the Roosevelt Administration brought some subsequent recovery of the yen. But the Japanese currency was already well outside the shrinking group of freely tradable currencies.

Postscript: re-fixing the yen, 1949 It is not a purpose here to chart the course of the yen through the calamity of war and its aftermath. In broad terms, inflation during the war, from the invasion of China (1937) until the Surrender in summer 1945, was suppressed by comprehensive controls. Under the early period of the US occupation, hyperinflation caught up with Japan as the massive increases in money balances, that had occurred during previous years and had continued into the defeat, came into balance with a severely shrunken productive capacity of the economy. Measures of the occupation authorities to block large bank deposits and cancel large-denomination notes did not quell the fires of inflation. As US policy towards Japan shifted from March 1947 (under the so-called Truman doctrine reconstruction took over as the priority from demilitarisation and reparations), the focus gradually shifted to monetary and budgetary reform, and exchange rate stabilisation. In December 1948, General MacArthur, in a ‘letter to the Japanese Prime Minister Concerning the Economic Stabilization Program’, spelt out nine principles, including fiscal balance, effective tax collection, limited credit extension to projects contributing to economic recovery, and paving the way for the early establishment of a single general exchange rate. Joseph M. Dodge, a Detroit banker who had previously been associated with the postwar currency reform in Germany, came to Japan in February 1949 as a financial adviser to General MacArthur concerning Japan’s economic stabilisation. The measures he initiated became known as the ‘Dodge Line’.

28 The Yo–Yo Yen

They implied, firstly, a balanced budget applied to all categories – general accounts, special accounts, and agencies connected with the government (for example, government corporations). Secondly, government subsidies and price controls were to be gradually phased out. And thirdly, international trade was to return to private channels rather than being conducted through government agencies. Concerning the exchange rate, a memorandum of 23 April 1949, from the US Occupation Authority directed the Japanese government ‘to take the steps necessary to put into effect at 0001 hours, 25 April 1949, an official foreign exchange rate of 360 Japanese yen to one US dollar. Rates for other currencies will be based on this rate translated into the US dollar values of such currencies as registered with the International Monetary Fund.’ A whole folklore has built up around the choice of stabilisation level for the yen, which brought to an end a system of multiple exchange rates (different products at different rates), and ushered in a fixed rate between the US dollar and yen which was to last for over twenty-two years (until August 1971). According to one popular account, the occupying authorities chose a rate of ¥/$360 because they lacked any better guide than the number of degrees in a circle. In fact during the weeks before the decision, there had been widespread expectations of the rate being stabilised at a rate of between ¥/$330 and ¥/$350. Almost a year before, in May 1948, Ralph Young, a Federal Reserve Board economist, had suggested an exchange rate of ¥/$300 which he thought would undervalue the yen to encourage exports. An October 1948 Ministry of Finance report recommended that exports be priced at ¥/$350. The wholesale price index, which was used in that report for international comparison purposes, did not include black-market prices. Taking account of these, some unofficial calculations put the purchasing power parity value of the exchange rate at over ¥/$400. On balance, the final rate chosen of ¥/$360 was probably well within a normal confidence range for where the purchasing power parity of the exchange rate then lay – but with the yen somewhat expensive rather than cheap. Most hyperinflations, however, end with exchange rate stabilisation at what seems an expensive level – and Japan was no exception to that rule. (A somewhat overvalued exchange rate helps to arrest inflationary expectations, and as demand for money rises strongly in the post-hyperinflation economy, the price level may actually fall back as part of a deflation process, meaning that the initial overvaluation is corrected.) The fact that the purchasing power parity value of the yen in spring 1949 lay near ¥/$360 compared to ¥/$2.70 (US$37/100 yen) as estimated by the League of Nations economists in the early 1920s is a key measure of the extent of hyperinflation in Japan during the war and its aftermath. And it was by no means certain that the new exchange rate would be sustainable. The devaluation of the British pound in September 1949, which countries

Historic Roots of the Yo–Yo Yen (1859–1949) 29

in the sterling area followed, raised new concerns about Japan’s ability to compete in world markets. But those concerns faded away as exports boomed in the Korean War. And as Japan entered an era of rapid growth that transformed the economy, the question of whether the yen had been overvalued in 1949 simply became irrelevant. In any event, from the late 1950s onwards (right through until the late 1980s) the yen was on a strong long-run upwards trend against the US dollar measured relative to its purchasing power parity level. As Japan became more and more expensive (the price of a representative basket of goods and services in Japan climbing relative to that of the same basket in the USA calculated at the given exchange rate) analysts soon saw this as symptomatic of the growing duality in the Japanese economy (rapid productivity growth in the export sectors compared to much slower productivity growth elsewhere) rather than as a threat to trade performance, which surpassed even optimistic expectations.

2 A Brief History of the Modern Yen (1960–87)

It was well into the miracle period of 1953–73, during which Japanese growth averaged near 10 per cent p.a., that the modern history of the yen begins. Only in 1963 did Japan become an ‘Article 8’ member of the International Monetary Fund (meaning Japanese residents could convert yen into foreign currencies for all trade transactions and non-residents could exchange yen deposits freely for whatever purpose) and in the following year a member of the OECD (Organization for Economic Cooperation and Development). Those landmark steps were the culmination of a process originating in 1960 when, in response to international criticism for moving slowly, an outline plan for trade and foreign exchange liberalisation was introduced (90 per cent of imports to be free of quota or other restrictions). 1960 was indeed a seminal year. In mid-June, the US–Japan Treaty had been signed despite a wave of protests in Tokyo including the entry of police into the Diet to disperse rioters. Kishi Nobusuke, the last Prime Minister to have served in a pre-war cabinet, resigned. A strike over huge redundancies in the coal industry faced with the competition of cheap oil ended in complete defeat for the union, ushering in a long period of labour tranquillity. The new Prime Minister, Ikeda Hayata, who survived in that post for a long time by Japanese standards, adopted the famed ‘income doubling plan’ (income doubling in ten years) whose ambitious targets were in fact exceeded, notwithstanding French President de Gaulle’s disparaging remarks about ‘the transistor radio salesman’. Also in 1960, the yen started its long climb, at first only in real (inflation-adjusted) terms, much later (1971) in nominal terms against the US dollar. The climb was far from smooth. The yo–yo yen already made its appearance in the late 1970s. With hindsight the climb ended in the late 1980s (by the time of the Louvre Accord in spring 1987). For the remainder of the twentieth century there were violent swings around a flat trend. In total, the first forty years of the modern yen (1960–2001) can be divided into the thirteen phases described below: 30

A Brief History of the Modern Yen (1960–87) 31

1. First, there was the sharp real appreciation from 1960 to 1965, when the yen remained at a fixed exchange rate to the dollar (360 yen) while the consumer price level in Japan rose by 30 per cent relative to the USA (hence one yen of constant internal purchasing power bought 30 per cent more dollars of constant internal purchasing power in 1965 than in 1960). 2. From 1966 to 1970 the yen was virtually unchanged against the dollar both in nominal and real terms (the yen/dollar exchange rate remained fixed at 360 whilst inflation in Japan and the USA ran at similar levels). 3. The yen revaluation of summer and autumn 1971, which formed the most important component of the dollar devaluation orchestrated by officials in Washington. 4. A long period of the yen/dollar rate on a flat trend against the dollar through to late 1976 at around 300 (an initial period of pegging during the brief life of the Smithsonian Accord from December 1971 to February 1973, followed by a sharp rise of the yen as the dollar tumbled in spring 1973 but then a rapid reversal by early 1974). 5. The sharp appreciation of the yen from late 1976 until autumn 1978 (most of all against the US dollar but also against the DM). 6. The yen fell steeply from its peak of autumn 1978 until late 1979, as the second oil shock erupted, US interest rates rose sharply, and Japan’s trade balance swung into substantial deficit. 7. From 1980 until mid-1985 there was a long period of near stability for the yen in overall real effective exchange rate terms at a level some 10 per cent higher than during the period from spring 1973 to 1976 (the fourth period above) but well below the level of 1978 (Figure 2.1). 8. A near 100 per cent appreciation of the yen against the dollar from the Plaza Accord (September 1985) through to the Louvre Accord (February 1987) and ending in the immediate aftermath of the Wall Street Crash (autumn 1987). Broadly speaking, the main theme was the bursting of the euphoria regarding Reaganomics and a growing optimism about the Japanese economy. 9. A sharp fall of the yen (by over 20 per cent in real effective terms) from late 1988 until early 1990, which accompanied the final stage of the bubble economy in Japan and then the Tokyo equity market crash. The weakness of the yen was evident not just against the dollar but most of all against the DM (which rose during German unification). 10. A 60 per cent overall (real effective) appreciation of the yen from early 1990 until spring 1995. This coincided with a period of dollar weakness, but the yen was much stronger than the DM, and surged ahead on its own during spring and summer 1993 and again, briefly, in early spring 1995.

32 The Yo–Yo Yen

* Calculation based on consumer prices.

Figure 2.1

Real effective exchange rate index of the yen, 1971–2001*

11. The yen plunged in just three years (spring 1995 to summer 1998) by nearly 50 per cent against the US dollar (from a peak of 80 yen/$ to a low of 145 – a level last seen during the Tokyo equity market crash of early 1990). Generally, the US dollar was strong during this period, but less so against the European currencies than against the yen. This plunge, in real effective terms, brought the yen back to around the high level first reached in the early aftermath (one year on) of the Plaza Accord. 12. From autumn 1998 to the end of 1999 a new violent surge occurred, including a near 20 per cent jump in one day, bringing the yen/$ rate back to 100 and the currency in real effective terms to its lofty level of end-1994 (albeit well short of the final summit reached in spring 1995). 13. After some brief stability in early 2000, the yen slid – from around 100 against the dollar in winter 1999/2000 to around 135 two years later. In total there were six episodes of a surging yen or yen jump, three of stability (either against the dollar or in overall effective terms), and four of a plunging yen. From 1960 until 1987–8, the yen was on a clear upward trend (as measured in real effective exchange rate terms). After that there was a long period of remarkable volatility with no clear direction. The yen at the end of 2000 was not significantly higher than in 1987–8 and the turbulence had been so great as to make any judgement of a trend difficult.

A Brief History of the Modern Yen (1960–87) 33

Symptomatically, in the 1990s the yen became the most volatile of the three big currencies (US dollar, DM, and yen), with the standard deviation of monthly change in the yen–dollar and yen–DM exchange rate about 30 per cent larger than for the dollar–DM exchange rate (by contrast, in the 1980s, the US dollar had been the most volatile currency). In this chapter the first eight episodes are reviewed. We will give the final five episodes close attention in Chapters 4 and 5 after considering, in Chapter Three, some general principles to be derived from the story up to the end of 1987.

The first two episodes, 1960–71 At the start of this period, Japan was in the middle of the so-called Iwato boom (1959–61), the second phenomenal burst of investment-led expansion (the first was the Jimmu boom of 1956-7) which marked the far-fromeven progress of the economy through its miracle two decades. The Japanese economy had made huge advances since 1953, when output had first regained its pre-war peak level (though in income per capita terms, Japan in 1953 compared unfavourably with Brazil), but still ranked well below Germany and the UK in overall size (the Federal Republic had overtaken the UK in 1959). By the time President Nixon finally scuppered the Bretton Woods System in August 1971, Japan had become the second largest economy in the world (overtaking Germany in 1966), even though real GDP per person employed there was at the lower limit of the range observed in developed Western countries. In terms of GDP per hour worked, Japan was even less well placed, given the unusually long hours of work in what had become Asia’s ‘new giant’. The years 1960 and 1965 are dividing lines not just in the currency history of the yen, but also in the economic history of Japan. Some of the watershed political economic events have already been described. In addition, 1960 was when Japan entered a long period of fairly high inflation (CPI up 1.5 per cent p.a. in 1955–60, 6.2 per cent p.a. in 1960–65 and 5.5 per cent in 1965–70). The outbreak of inflation in Japan pre-dated that in the USA by more than five years, meaning that nominal exchange rate stability between the yen and dollar at the 360 parity (set under the Dodge Plan in 1949) required a sharp real appreciation of the yen (in the years from 1960 to 1965). In the second half of the 1960s, inflation was at a similar pace in Japan and the USA, so real appreciation of the yen halted. At the level of the real economy, 1965 was a break year in that it marked the most severe recession to date during the miracle years (Figure 2.2) (recession is used here to describe periods of sharply slower growth, including only rarely a quarter of negative growth; there were seven such recessions during the period 1953–73, all accompanied by a dip in at least one

34 The Yo–Yo Yen

–

Figure 2.2

Japan vs. Germany economic growth in the 1960s

key component of investment spending). The previous recession of December 1961 to October 1962 had been mild. By contrast, in the recession of October 1964 to October 1965 (which became evident soon after the Olympic Games in Tokyo) there was unusual pessimism, aggravated by three big corporate bankruptcies (Yamaichi Securities, Sanyo Special Steel and Sun Wave Cabinet Making). The preceding boom had been unusually short and during the first half of the 1960s the growth of business investment spending slowed (compared to the second half of the 1950s). There was talk that the miracle years had ended. In this climate, one of the pillars of the ‘economic constitution’ put in place by the Dodge Plan began to weaken. The balanced budget rule (according to which the central government should not borrow from the Bank of Japan or issue marketable bonds) was revoked in favour of two new weaker conditions – that government bond issues should never exceed the amount spent on construction and that bond issues should never be sold directly to the Bank of Japan but issued in the open market, as the government of the day turned to Keynesian demand management to tackle the recession. In practice, the stance of fiscal policy hardly changed when account was taken of government spending financed via the parallel budget (outside the central government accounts). But the change in the constitutional position was to have important consequences for fiscal policy from the early 1970s onwards.

A Brief History of the Modern Yen (1960–87) 35

In fact the immediate pessimism of 1965 proved to be misplaced. By early 1966 the economy had emerged into a powerful new expansion which was to last through until summer 1970. Growth was even higher than during the years 1955–64 and capital spending was racing ahead. Productivity growth accelerated, and inflation (CPI measure) actually fell to 4.2 per cent p.a. in 1967 from its peak of 6.4 per cent p.a. in 1965 (subsequently to accelerate to 6.7 per cent in 1969 and 7.2 per cent in 1970). This was a period of rapid development in the consumer durables industries (the ‘three Cs’ – cars, colour televisions, and air conditioners) where Japan achieved considerable competitive advantage. And domestic costs were no longer running ahead much faster in Japan than in the USA, as had been the case in the first half of the 1960s, thereby exerting some restraint on profits growth in the export industries and so ultimately on exports. Correspondingly, by the late 1960s Japan was moving into large current account surplus, in sharp contrast to the situation of near current account balance through most of the previous two decades, broken by periodic deficits near the peak of each cycle (the appearance of a deficit triggered monetary policy tightening in each case). A big current account surplus in the midst of an investment spending boom with no evident domestic savings surplus was not an equilibrium situation. (A current account surplus is sustainable in the long run only if the economy has an inherent tendency to generate more savings in total – public and private – than can be absorbed by domestic investment opportunity.) Exiting the disequilibrium situation depended on a resumed (including a catch-up) real appreciation of the yen or stimulating domestic savings (and removing controls in the way of their flowing out as capital exports). A real appreciation could be achieved either via an acceleration of domestic inflation or an upward revaluation of the yen–dollar parity, or some combination of the two. In practice the route followed started with revaluation and later included a powerful dose of inflation. An intriguing question of counterfactual history is to consider an alternative route out of disequilibrium. Suppose in the late 1960s Japanese economic policy-makers had realised that since US inflation had accelerated to the same level as in Japan (meaning no further real appreciation of the yen so long as its exchange rate against the dollar remained fixed (Figure 2.3)) a large external surplus was likely to emerge, which might provoke calls from Washington for yen revaluation (or dollar devaluation). They could have deliberately stoked up domestic inflation. Or they could have tightened fiscal policy sharply, driving the budget into large surplus (or, equivalently, cut the deficit in the parallel budget through which public investment was financed directly from savings placed in government financial institutions). Then an underlying domestic savings surplus (private and public sector combined) would have matched the current account surplus and have

36 The Yo–Yo Yen

Figure 2.3

Real appreciation of the yen vs. dollar, 1960–71

flowed out as capital exports (providing that exchange controls were lifted on Japanese investors buying foreign assets), meaning no disequilibrium in the balance of payments. In practice there was no grand plan even on the shelf as to how to salvage the fixed parity of the yen against the dollar. In September 1969 the Bank of Japan (closely controlled by the Ministry of Finance), concerned at the rise in inflation, tightened policy sharply (using both interest rates and direct controls). This was a fateful decision that was to set a bomb ticking under the fixed dollar–yen parity. Early the following year (1970), Arthur Burns, newly appointed as Federal Reserve Chairman by President Nixon in the midst of a severe economic slowdown (Figure 2.4) (which had just developed into an actual recession), delivered on his promise (to the President) and demanded at his first meeting of the Federal Reserve Open Market Committee (FOMC) an immediate aggressive easing of monetary policy despite still high inflation. Nonetheless, the Bank of Japan persisted with its tough anti-inflation policy right through until the summer (1970). The chances of an exchange rate crisis for the yen had become very high. But that is running ahead of our story. A missing part of the 1960s narrative is a discussion of why Japanese policy-makers tolerated an around 6 per cent p.a. inflation rate in the first half of the decade and then balked at a further acceleration to say 10 per cent p.a. in the second half. The overriding concern of policy-makers throughout this period was to sustain rapid

A Brief History of the Modern Yen (1960–87) 37 15

10

5

0 Japan GDP (real, YoY) US GDP (real, YoY) –5 65

66

Figure 2.4

67

68

69

70

71

72

73

74

75

76

Japan vs. US economic growth, 1965–76

growth of exports, which was seen as essential to a continuing economic miracle. Stability (rather than increases) in export prices was consistent with that objective. Given the especially rapid rate of productivity increase (including product improvement) in the export sector, stable export prices meant inflation elsewhere in the economy. As wage increases accelerated in the early 1960s (led by strong demand for labour by the big export companies together with shrinking supply from the agricultural sector), the authorities took no action to resist the trend so long as the export industries could absorb the costs without problem, even though it meant substantial inflation overall. The policy of no resistance to inflation so long as export prices remained stable did not have any natural evolutionary trait whereby it would develop into a policy of promoting still higher inflation when US inflation picked up, thereby underpinning the fixed exchange rate between the dollar and yen. In any case, even the 5–6 per cent p.a. inflation rate of the early 1960s had not been popular, but it was somehow accepted as an uncomfortable side-effect of rapid growth. The Bank of Japan had had considerable experience during the 1950s and early 1960s of tightening policy in the boom phase of the economic cycle so as to prevent the current account of the balance of payments going deeply into the red and undermining the yen–dollar parity. But the Bank had no knowledge or experience of how to deliberately let a current account surplus in a boom phase

38 The Yo–Yo Yen

of the cycle stimulate monetary growth and inflation and thereby pre-empt irresistible international pressures for a revaluation of the yen.

Dollar devaluation, and then a return to yen–dollar stability, 1971–6 The third and fourth episodes span five years in total, from the so-called US closing of the gold window in August 1971 until summer 1976. In overview, the yen was at an embryonic stage of international development. In some respects it was still an open question whether the yen would remain effectively linked to the US dollar even though the old international monetary order of Bretton Woods had broken down irreparably. In contrast to the yen, the DM had made a clear break from its dollar-linked past and there was no inclination amongst German policy-makers, most importantly at the Bundesbank, to turn back. Indeed, Germany (and the Netherlands) had already abandoned the dollar standard in spring 1971, well before the Nixon Administration’s final coup (August 1971) against the Bretton Woods international monetary system. In the face of huge money inflows from the USA, where the Federal Reserve under Chairman Arthur Burns was pursuing an aggressively easy policy (aimed at jump-starting the economy out of its hesitant recovery from the recession of 1970 and, thereby, aiding President Nixon’s chances of re-election in 1972), Bonn had allowed the Deutsche mark to float rather than run the risk of importing inflation. Switzerland had simultaneously revalued its currency (the first change in the franc’s official dollar exchange rate since 1936). Thus the twin pillars of the Bretton Woods System – first, a dollar standard under which all currencies were pegged to the US currency, and second, convertibility of dollars into gold at the official price of $35 per ounce (the US Treasury in effect standing ready to supply gold at that price) – were already tottering before the Nixon Administration delivered its fatal blows. Back in 1968, in the midst of a worldwide scramble out of dollars into gold, the convertibility of dollars into gold at the official price had been suspended except for transactions between central banks; in effect, a free market in gold at a fluctuating price existed for all private transactions. Indeed it was the remnants of the gold–dollar link that triggered Nixon to call a summit meeting of his economic advisers at Camp David during the weekend of 14–15 August. On 12 August, the British government had asked the USA to ‘cover’ or guarantee (in terms of gold) US$750m of its dollar reserves. The message from London was garbled and the US Treasury believed that the British wanted Washington to cover a much larger amount. US acquiescence was likely to set off a scramble by other countries to get the US government to either guarantee their dollar holdings or to convert them into dollars.

A Brief History of the Modern Yen (1960–87) 39

As is often the case, the trigger to the summit was not the main topic on the summit agenda. The priority, albeit not spelt out, was how to assure that the US economy would be in a boom by Presidential election time. The sharp easing of monetary policy effected by Chairman Burns immediately following his appointment in early 1970 had so far failed to propel the economy into a strong economic expansion. Yet inflation remained obstinately high, at more than 5 per cent p.a. In retrospect, monetary critics could argue that it would have been better if the FOMC had persevered with tight money well into 1970, albeit at the risk of serious recession, so as to kill off inflation. But the FOMC could hardly reverse course now and Chairman Burns never gave any indication of regretting earlier monetary decisions. Instead, his inclination was to blame stagflation on monopoly power on the part of both corporations and labour unions. Already in summer 1970 he had started to advocate an incomes policy, for which there was much support in Congress, especially amongst the Democrats. At Camp David, a hitherto reluctant Administration accepted a prices and incomes policy – initially a 100-day freeze – as a key component of the programme for electoral (and economic) success. The second major plank of the economic package for re-election of the President was an aggressive trade policy. The charge made was that the rest of the world had stolen competitive advantage from the USA by maintaining undervalued currencies. Now it was time for the USA to repair the damage and seek an immediate revaluation of the major foreign currencies. The instrument of policy was to be an emergency 10 per cent tariff on imports to the USA, to be repealed only once an agreement had been reached on new exchange rate levels for the dollar. The policy of devaluation was sure to be supported in Congress. Just the week before, a Congressional Sub-Committee had warned that Europe, but more particularly Japan, were gaining at the expense of the USA, as a result of their currencies being undervalued against the US dollar. Perhaps the most amazing aspect of the Camp David discussions was how 100 per cent unanimity prevailed amongst the participants regarding the adoption of this neo-mercantilist exchange rate policy (see Wells, 1994). Even Paul Volcker, who had spent much of his working life fighting in one international meeting after another to defend the status quo of the US dollar, voted for the emergency import tariff. Yet the economic argument in favour of overall dollar devaluation at this time was weak. The top European currency (the DM) was already at a free market level and had been substantially revalued over recent years. And what was so wrong with a US trade deficit? So long as the rest of the world had excess demand for US assets, then the USA was bound to run a deficit on its current account. That was a matter of simple economic arithmetic. With US inflation a problem, surely a devaluation of the dollar would only make

40 The Yo–Yo Yen

matters worse? True the new big surplus country, Japan, had yet to remove barriers in the way of its citizens accumulating foreign (most probably US) assets. But under some gentle prodding from Washington, Tokyo would surely oblige and scrap its exchange controls. The case against deliberate devaluation of the dollar, spearheaded by an emergency import tariff, was lost by default at Camp David and also in the public discussion that followed. Powerful trade lobbies had gained sway for the moment over US currency policy – a take-over that was to be repeated at various points of economic weakness over the next three decades. The special interests of the automobile producers (Detroit), steel makers and others at the front line fighting the onslaught of Japanese competition counted for much more (in Washington) than fears amongst a few nonmainstream economists about the inflationary consequences of dollar depreciation. Was there anything that Tokyo could have done immediately following the bombshell of 16 August 1971 to make the US Administration reverse course? Probably not. In any event, the path that the Japanese authorities trod in the immediate aftermath of the announcements from Washington was doomed to failure. For ten days, the Bank of Japan bought massive quantities of US dollars against yen. Large-scale intervention in the currency markets had fended off revaluation pressure on the yen in May 1971, in the wake of the DM’s revaluation. But now, the imposition of the import tariff made the pressure irresistible. Japan was hardly in a position to say no to the whole world. The only counter-strategy which Tokyo could have adopted with any chance of even small success would have been to persuade Washington to rescind the import tariff in exchange for an immediate unilateral sweeping aside of all import tariffs and quotas, abolition of all controls on capital exports, and a new dose of monetary expansion. The Bank of Japan had only started to ease monetary policy in August 1970, and very gradually (even though the decline in business activity which had peaked in July 1970 continued through 1971) – in sharp contrast to the aggressive easing of US monetary policy under way since January 1970. If Tokyo were serious about maintaining the yen on the dollar standard, then Japanese monetary policy had a lot of catching up to do. In reality there is no evidence of Japanese policy-makers considering a last-ditch macro-economic and commercial deal with the USA to avoid a yen revaluation. Instead, on 27 August, the yen was floated, with its maximum appreciation set at 8 per cent from previous parity. Did the closing of the gold window (announced together with the rest of the new economic policy on 16 August) have any bearing on that outcome? There is no evidence of any direct link. Contemporary Japanese policy-makers had never demonstrated any special affection for gold and the fact that dollar reserves in future were purely paper (rather than having

A Brief History of the Modern Yen (1960–87) 41

a metallic link) was not a serious deterrent to Japan staying on the dollar standard. Indeed, the closing of the gold window was a small help to Japan in its battle to resist yen revaluation. France, long a protagonist of gold rather than the dollar being at the centre of the international monetary system, became a ‘co-belligerent’ against Washington’s currency policy. If President Nixon had heeded the lone voice of Arthur Burns at Camp David in support of maintaining the dollar’s gold link (the voice was not all that strong! – the chairman argued the window could be closed later if the new economic policy did not bring a return of confidence in the dollar as expected), then France might well have agreed to an immediate revaluation of its franc. Instead France fought a four-month battle with an armoury of exchange restrictions (instituting in effect a dual exchange market, where financial transactions occurred at a free rate whilst current transactions still took place at near the unchanged official parity against the dollar) to block a revaluation of the franc until Washington changed its policy on gold. The value, however, of France as a co-belligerent to Japan should not be exaggerated. Paris backed down in mid-December 1971 and agreed to a revaluation of the French franc when Washington conceded a virtually meaningless rise in the official price of gold (but no reopening of the gold window). In the few days between Paris’s withdrawal from combat and the Smithsonian Agreement the yen rose by around 4 per cent against the US dollar. That must be the maximum of any estimate of French usefulness to Tokyo in resisting a large revaluation of the yen. Throughout the period from the closing of the gold window in mid-August to the Smithsonian Agreement, Tokyo’s best chance of limiting revaluation lay in its own hands. In fact a sharp easing of Japanese monetary policy was ultimately to follow the appreciation of the yen. The counterfactual historian might speculate whether even half of that policy adjustments (ideally combined with trade liberalisation) offered up front, in summer and autumn 1971, might have substantially diminished the extent of revaluation which Tokyo finally had to concede as part of the Smithsonian Agreement. In reality, the 8 per cent limit to yen appreciation announced by Tokyo on 27 August had a short life (Figure 2.5). At the Smithsonian Agreement (18 December 1971) a new parity was fixed for the yen against the dollar of 308 with 2.25 per cent bands of fluctuation permitted on either side. A huge miscalculation by Japanese economic policy-makers was to follow. Their premise was that the revaluation of the yen would have a powerful deflationary influence on the economy, which had to be offset by equally powerful monetary and fiscal stimulus. To some degree, the monetary stimulus occurred passively, as waves of speculative funds came into Japan on expectations of a further revaluation of the yen. These expectations were due in part to the rise in Japan’s current account surplus, albeit that this was more than entirely attributable to the so-called J-curve effect

42 The Yo–Yo Yen

Figure 2.5

Yen exchange rate vs. US$ and DM, 1971–9

(revaluation brings an immediate fall in import prices), with the trade surplus in volume terms already narrowing. Throughout 1972 the Japanese monetary authorities pursued an aggressively easy monetary policy despite accumulating evidence (from spring 1972) of economic recovery having taken root. With regard to fiscal policy, the yen revaluation and the perceived need to provide an offsetting stimulus was an important catalyst to implementation of the Tanaka government’s ambitious spending programme entitled ‘Plan for Re-Building the Archipelago’. The normally cautious Ministry of Finance was won over – marking the first time that currency policy set by Washington played into the hand of big spenders in Japan’s ruling party (Figure 2.6). The Plan, which assumed 10 per cent p.a. economic growth through until 1985, envisaged eliminating regional inequities by relocating in the interior and on the Japan Sea coast industries which had been concentrated on the Pacific Coast belt, and linking together the entire country by constructing a 9000 km Bullet Train, 10,000 km of superhighway, and 7,500 km of oil pipeline. Modern cities with populations of around a quarter of a million were to be built across the nation. Tanaka Kakuei had become Prime Minister in July 1972, following a leadership election in the ruling Liberal Democratic Party (LDP). Tanaka, a populist, had been chosen as the candidate most likely to bring victory for the LDP in looming general elections (for the Lower House of the Diet).

A Brief History of the Modern Yen (1960–87) 43

–

–

–

–

Figure 2.6

Japan budget deficit (% of GDP), 1960–2000

Many in the LDP were concerned at growing disaffection amongst the urban electorate and voted for Tanaka as their potential saviour. A very stimulative budget for fiscal year 1972 (April 1972 to March 1973) had already been passed when the economy was still perceived to be in recession. In May, August, and October (1972) there were further packages of fiscal reflation. The budget for fiscal year 1973 (published in late 1972) was again highly stimulatory and played its part in the re-election of the Tanaka government that December (1972). The election campaigns of Richard Nixon in the USA and of Tanaka Kakuei in Japan were, in effect, macro-economic extravaganzas for which the bills started to appear as soon as January 1973. Arthur Burns had been in charge of Nixon’s extravaganza even though he never recognised his particular role either at the time or subsequently. Burns had allowed a rapid rate of monetary growth to occur in the second half of 1972 – against considerable misgivings of several FOMC members and Federal Reserve economists – arguing that unemployment was still too high at 5 per cent and that big interest rate hikes would jeopardise the prices and wages policy. At the start of 1973, however, the prices and wages policy virtually lapsed (moving into a voluntary phase three), and concerns about rising US inflation brought about a new dollar crisis. According to a commentary from the New York Federal Reserve (published March 1973), the ‘atmosphere’ for the dollar had already begun to

44 The Yo–Yo Yen

deteriorate in mid-January 1973 as US inflation risks increased and US equity prices fell sharply. On 22 January, the Swiss franc was floated in response to a huge inflow of funds, largely from Italy where the lira was under attack. In the following few weeks outflows from the dollar gained momentum, fuelled in part by adverse trade news (US current account deficit in 1972, Japanese and German current account surpluses – all very modest by later standards, measured relative to economic size, but enough at the time to cause concern in the marketplace that Washington might press for a further devaluation of the dollar). On Tuesday, 13 February, following an emergency meeting of international financial officials from Japan, the EU, and the USA, the Japanese yen was floated whilst the dollar was devalued by 10 per cent against the EU currencies. A month later (12 March) the EU currencies jointly floated against the US dollar. The yen reached a brief peak of 248 against the dollar (compared to Smithsonian parity of 308). This was the turning point for the Japanese currency, though not yet for the DM. In the following few weeks the yen fell back to around 260, at which level the Japanese authorities effectively supported the currency until late in the year, intervening heavily at times (selling dollars and buying yen). Then during winter 1973/4, in the midst of the Great Oil Shock, the yen fell back to its Smithsonian level of around 300, where it remained until late 1976. What brought about the turn of the yen? The most fundamental cause was the rampant monetary expansion in Japan culminating in an outbreak of severe inflation. The Tanaka bubble economy was in full swing (Figure 2.7). The nationwide land price index for urban property increased by more than 50 per cent from 1972 to 1974 (surveyed in March of each year at 1614, 1821, 2286 and 2812 in 1971–4 respectively). Even before the increase in oil prices in October, inflation had become virulent. Wage rates were rising at an annual rate of 16.5 per cent, consumer prices at 18 per cent, and wholesale prices at 26 per cent. From January (1973) the Bank of Japan had started pushing up money interest rates, and from the spring, the government had made a succession of cutbacks in its ambitious spending plans. The run-up of inflation in 1973 was, of course, a worldwide phenomenon, but amongst the G-3 countries it was most acute in Japan. Also in early 1973 Federal Reserve Chairman Burns became alarmed at rising inflation and at last acknowledged that monetary policy must play a critical role in restoring stability. He had considered the further devaluation of the dollar in February and March as ‘unavoidable’ but he did not like it. ‘I cannot emphasise too much or too often that as far as I am concerned this is the last devaluation.’ Wholesale prices in the USA increased by 21 per cent p.a. in the first quarter (of 1973) whilst consumer prices were up by 8 per cent p.a.. The Federal funds rate was pushed up progressively from 5 per cent in the fourth quarter of 1972 to 10.5 per cent in the third quarter

A Brief History of the Modern Yen (1960–87) 45 25 20 15 10 5 0 –5 Japan GDP (real, QoQ annualised) –10

US GDP (real, QoQ annualised)

–15 65

66

Figure 2.7

67

68

69

70

71

72

73

74

75

76

Japan vs. US business cycles, 1965–76

of 1973. But Arthur Burns leant against the wind of rising rates. He was concerned about their influence on wage negotiations and he cajoled New York bankers into not raising prime rate fully in line with market rates. By contrast, in Germany the Bundesbank was now following a tough monetarist policy against inflation, similar to that adopted by the Federal Reserve five-and-a-half years later under Paul Volcker. Average three-month money market rates in Frankfurt rose from 8.75 per cent p.a. in March 1973 to 14.25 per cent in July. Day-to-day rates reached as high as 30 per cent in early summer. The Bundesbank was targeting the monetary base and accepting the cost of violent fluctuations in short-term rates, unlike the Federal Reserve, which was still targeting interest rates. Three-month eurodollar rates rose by less than one percentage point between March and June 1973. Consistent with the Bundesbank’s tough policy, the DM rose sharply against the dollar, from DM/$2.75 in early May (the same level as in midMarch) to a peak of 2.25 in early July. That was a turning point for the dollar against the DM, as the Federal Reserve allowed US money market rates to rise by 200 basis points (bp) by end-August and the USA intervened (in support of the dollar against the DM) in the foreign exchange markets. The yen, still being stabilised at around 260 against the dollar, recovered in step against the DM (Figure 2.5). The Japanese authorities were also toughening up their anti-inflationary policies in autumn 1973. Interest rates rose sharply and credit restrictions

46 The Yo–Yo Yen

Figure 2.8

Japan interest rates, 1970–80

were applied to all financial institutions (Figure 2.8). Further budget cutbacks were announced. The Tanaka Cabinet temporarily – and in the event permanently – abandoned its plans for ‘Re-building the Archipelago’ and made reining in inflation its top economic priority. In the exchange markets, the Bank of Japan supported the yen to prevent any depreciation against the dollar. The support was withdrawn once the oil crisis erupted. On 18 October 1973, in the midst of the Arab-Israeli war, Saudi Arabia cut its oil production by 10 per cent. As the oil crisis deepened in November and December, the dollar powered higher against both the DM and yen (more against the DM at first as the Bank of Japan tried for a time to prevent the yen depreciating beyond 280 to the dollar but then more against the yen when, in early January 1974, the Bank allowed a fall to the 300 level). Alarm about rising inflation in the USA and the end of capital export controls there brought a brief correction (down) of the dollar in spring 1974, most of all against the DM but also against the yen. But then a decisive further tightening of monetary policy by Chairman Burns, who was now fighting inflation with rare single-mindedness (while President Nixon was increasingly immersed in the Watergate affair), brought a recovery of the Greenback, with the yen returning to around 300 to the US dollar. Thus by summer 1974 the yen re-stabilised against the dollar at a level some 35 per cent higher in real terms than in the mid-1960s (Figure 2.9).

A Brief History of the Modern Yen (1960–87) 47

* Calculated on the basis of consumer prices.

Figure 2.9

Real exchange rate index of the dollar against yen,* 1970–2000

That result, broadly similar to the amount of real appreciation between 1960 and 1965, was achieved by a combination of a cumulative appreciation by around 20 per cent of the yen against the dollar in the foreign exchange markets together with a faster rate of inflation in Japan than in the USA through 1973–4 (US consumer prices had risen by 18 per cent compared to 39 per cent for Japan). The sudden descent of the US economy into recession in late 1974 brought a relapse of the US dollar, initially just against the DM but also against the yen in early 1975 (as the Japanese authorities allowed the yen to move through its unofficial peg of 300 towards 285). By summer (1975) the yen was back to 300 as the USA entered a strong economic recovery much sooner than generally expected. The fall-back of the yen against the dollar was much less than that of the DM. Japan, like the USA, was emerging decisively from recession (mining and manufacturing production had fallen almost 20 per cent from the fourth quarter of 1973 to the first quarter of 1975). From the second half of 1975 Japan’s exports began to climb steeply (automobiles and colour televisions were at the front of the export boom). Export strength compensated for weak domestic demand. Business investment did not recover to the vigorous growth path of previous economic expansions and public investment was held back in line with the intent of improving public finances after the ravages of the recession.

48 The Yo–Yo Yen

In fact the Japanese economy that emerged from the 1974–5 recession had changed mode from the pre-recession high growth era. Corporations and households had scaled back their expectations from rapid to slow growth and entered a process which economist Takafusa Nakamura describes as ‘Operation Scale-Down’. No doubt this process would have gradually got under way even without the recession, as the growth of Japanese economic productive potential slowed from the miracle period, but the adjustment would have been more gradual. Businesses, typically highly levered on the eve of the recession, were determined to improve their financial ratios and became much more cautious in their capital budgeting than during the high-growth era of the 1950s and 60s. Households had raised their savings rates, having experienced the ravages of high inflation and falling asset values, now aware of increased risks of employment, and no longer able to count on rapid income growth to provide for their pensions (Figure 2.10). As we shall discuss in much more detail in Chapter 3, a swing of an economy into large private sector savings surplus at a time when the fiscal balance is being held in check tends to go along with a rising current account surplus. In effect the savings surplus is exported in the form of capital outflows to the rest of the world. It is likely that the national currency would fall in international value as part of the process of macroeconomic adjustment, unless there are powerful offsetting influences.

Figure 2.10

Japan business investment and saving (% of GDP), 1960–80

A Brief History of the Modern Yen (1960–87) 49

And indeed during late 1975 and 1976 Japan appeared to be following this route, although restrictions on capital exports were a handicap. True the yen was stable rather than weakening, but Operation Scale-Down was leading to big efficiency gains in the export sector. Japan’s current account was moving into modest surplus again despite the huge oil bills that had to be paid to OPEC. But unknown or unrecognisable to contemporary observers Washington was about to deliver a new shock, emanating first from the Federal Reserve under Chairman Burns (who had been reappointed for four years in January 1974), which was to blow the Japanese economy and the yen off course. Arthur Burns had been relieved at the US economy’s exit from recession in spring 1975 – an exit which he had confidently predicted against a chorus of pessimism from consensus economists in Washington and on Wall Street. But he was concerned at the continuation of the high inflation rate (underlying inflation rate was close to 6 per cent p.a. that year). His monetary strategy called for a relatively slow recovery in which economic slack in the form of idle capacity and unemployment (at around 8 per cent) would bear down on inflation. By the first half of 1976 his strategy appeared to be working well. The economy grew by an impressive 8.5 per cent p.a. rate in the first quarter and a still strong 5 per cent p.a. in the second while consumer prices increased at ‘only’ 5 per cent p.a. But in the summer quarter (1976) there was a deterioration – the economy seemed to be slowing. Unemployment crept up to near 8 per cent in the second half of 1976. Chairman Burns argued that temporary pauses were not uncommon during periods of economic expansion, but the looming Presidential contest complicated policy decisions. In response to some slowdown in monetary growth, the FOMC allowed money rates to fall, with the prime rate declining from 7.25 per cent in June to 6.25 per cent in December. (Even so, President Ford, with whom Burns had formed a good working relationship, lost the election to Jimmy Carter.) The easing of US monetary policy, coinciding with the swing of the Japanese trade balance into significant surplus, brought some upward pressure on the yen, which in late summer/early autumn 1976 briefly broke below 290 yen/$. The yen advanced more rapidly than the DM. For the first time under the floating exchange rate regime (dating back to the start of 1973), the yen was the focal point in currency markets, moving at the opposite end of the pole to the US dollar with the DM in between. Until this point, the yen had either moved in strict parallel with the DM versus the dollar, or had been in between the DM and dollar – rising against one and falling against the other; never had the yen moved on its own with the DM and dollar stable against each other or at the opposite end of the pole to the DM or US dollar. Beyond early autumn, the yen fell back to near 300 as the Bank of Japan itself eased monetary policy in response to the faltering economic recovery. By contrast, the DM continued its rise against the

50 The Yo–Yo Yen

US dollar, and so the yen found itself at the opposite end of the pole to the DM, with the dollar moving in-between.

The yo–yo yen is born, 1977–80 The return of the yen to near its unofficial parity of around 300, which had broadly been in place since spring 1974, was brief. The election victory of Jimmy Carter (in November 1976), expected to be more interventionist in international economic policy than his predecessor, was the catalyst of the first unilateral rise of the yen against both the US dollar and DM under the post-1973 floating exchange rate regime. In the three months following the election the yen moved to 275 against the dollar whilst the DM/dollar rate remained virtually stable. This modest but solo move marked the birth of the yo–yo yen which in its first huge oscillation went to 180 against the dollar and 90 against the DM by summer 1978 (from 290 and 125 respectively in late 1976), and then reversed violently to 240 and 145 by winter 1979/80 (Figure 2.5). The rise of the yen against the dollar to its peak of 180 in summer 1978 occurred in the context of a general decline of the US dollar. But that decline was much greater against the yen (and the Swiss franc) than against the DM. During the subsequent fall of the yen through to winter 1979/80, the DM/dollar rate remained largely stable. Thus at the end of its first big fluctuation, the yen was much lower (worth less) against the DM than at the start. Overall, in real effective terms the yen started the 1980s at a level similar to that just before the start of its ascent in late 1976. What were the driving forces behind the climb of the yen to its summer 1978 summit and its subsequent startling descent? US monetary policy played a lead role in the decline of the dollar to its lowpoint in the third quarter of 1978 but not directly in the much greater rise of the yen than the DM. The US economic pause in the second half of 1976 gave way to rapid growth and a jump of inflation in the first half of 1977 (headline CPI rose by 10 per cent p.a. and 8.1 per cent p.a. respectively in the first and second quarters, albeit exacerbated by a surge in food prices). The White House cut back its planned fiscal stimulus, of which so much had been made during the election campaign, and even began to talk about balancing the Federal budget by 1981. The Federal Reserve still under Arthur Burns started to raise rates – the Federal funds rate, which had fallen to around 4.75 per cent during the previous election quarter (1976Q4), edged up to 5.5 per cent by summer 1977. But that could hardly be called an anti-inflation monetary policy! It was no wonder that the currency markets became gripped by a crisis of confidence in the dollar. Burns was concerned about the weakness of the dollar, seeing it as a dangerous development for inflation, but did not

A Brief History of the Modern Yen (1960–87) 51

recognise it as a symptom of monetary policy being far too easy. Instead he gave verbal support to measures designed to cut back petroleum imports and urged action to make US companies more competitive (for example a cut in corporate taxes). Declining headline inflation in the second half of the year, fresh anxiety within the Administration about whether the economy was slowing and the looming reappointment decision regarding the Federal Reserve Chairman all acted against any bold tightening of monetary policy in the second half of 1977 (nonetheless the Federal Funds rate did rise 100bp to 6.5 per cent by the fourth quarter) and the dollar continued to fall. In the event, President Carter decided against reappointing Arthur Burns. In early 1978 Burns left the Federal Reserve, to be replaced by William G. Miller, the president of Textron Corporation. The appointment got the thumbs-down in the markets. History has been more severe on Arthur Burns than his contemporaries were. They saw the chairman as a fighter against inflation in the face of overwhelming counter-forces, including a very hostile Congress (which was always demanding higher growth and the taking of less recession risk) and an aggressive White House (first, President Nixon in the years 1970–2 and subsequently President Carter in 1977) that demanded monetary stimulus and fretted at any counter-inflationary move. Contemporaries viewed William Miller as a lightweight who could put up no fight against rising prices and the experience of spring through autumn 1978 when the Federal Reserve acted tamely in the face of rising inflation did not prove them wrong. US inflation and Federal Reserve ineptitude were only two factors in the decline of the dollar during 1977–8. International investor concern about US inflation tended to have its biggest impact on the Swiss franc followed by the DM. Thus when the crisis of confidence in US monetary policy was at its worst, in autumn 1978, the Swiss franc soared and the DM was also strong. By contrast, the Japanese yen hardly rose (against the dollar) from the peak it reached earlier in the summer (1978). The DM and Swiss franc had more appeal than the yen to international investors seeking a safe haven against monetary disorder in the USA. The yen had historically been a relatively high inflation currency and 1978 was the first year in which Japanese inflation was below that in the USA (since the start of the history of the modern yen presented in this chapter) (Figure 2.11). Another key factor in the decline of the US dollar through 1977–8 was concern about the widening US trade deficit. This factor had its biggest impact on the yen. Rapidly rising Japanese exports to the USA were an obvious (albeit misguided!) issue for officials in Washington to raise when seeking cures for the perceived trade deficit problem. Furthermore, they viewed yen and to a lesser extent Deutsche mark appreciation as part of the solution. Markets were influenced by opinion in Washington, not least because the Nixon shock (summer 1971) had demonstrated that the USA

52 The Yo–Yo Yen

Figure 2.11

Japan vs. US inflation, 1971–9

was ready, on occasion, to take forceful action to implement its exchange rate policy. The US trade deficit, which had totalled about $10 billion in 1976 more than tripled in 1977 as oil imports rose sharply, manufactured imports surged, and export growth was weak. The rising energy deficit was blamed on inappropriate price controls on domestic production, whilst the non-oil deficit seemed (to Washington observers) to reflect a lack of US competitiveness and the failure of European nations and Japan to take sufficient action to reflate their economies. At an international conference in June 1977, US Treasury Secretary Blumenthal tried to put pressure on the Japanese and German governments by hinting that the USA wanted the yen and DM to appreciate. Japan was in the front line of criticism not just because its export performance was most striking but also because its recovery effort (from the recession of the mid-1970s) appeared to be the most inadequate (Figure 2.12). The IMF, for example, in the highly provocative ‘Witteveen paper’ issued in spring 1978, called for Japan to grow at 7.5 per cent p.a. annually over the next three years and pressed both Tokyo and Bonn to take further measures of fiscal reflation. IMF officials at that time simply had not seized the new fact that Japan’s miracle years had ended – possibly already by 1970 but certainly by the mid-1970s (the reflation of 1971–2 produced a huge inflation boom because productive potential growth had already slowed unbeknownst to Japanese economic policy-makers). The suggestion

A Brief History of the Modern Yen (1960–87) 53

– – Figure 2.12

Japan vs. US economic growth, 1976–90

that Japan could reattain high growth by Keynesian demand-side stimulation was implausible. Nonetheless, under the weight of US pressure (which mattered much more than the European accompaniments), Tokyo substantially eased fiscal policy through 1977–8. For example, the Fukuda Cabinet announced in December 1977 that it was aiming for 7 per cent economic growth in the next fiscal year and towards that end unveiled ambitious public spending plans. In principle, if Washington’s chief concern in economic policy relations with Tokyo was to get faster domestic demand growth in Japan, it would have been indifferent between monetary or fiscal policy being used to that end. A striking feature of the policy ‘debate’ between the US Treasury, IMF, and Tokyo (as on several later occasions, particularly the early 1990s) was an implicit silence on both sides about the monetary options. Japanese reticence was understandable – after all, Japan had just recently emerged from a severe inflationary period, and even in 1977 average CPI inflation had declined to only around 7 per cent. The Bank of Japan was following a quasi money supply target (implicitly) and was not prepared to jettison its price stability policy by again subjugating everything to exchange rate policy as it had done in the early 1970s. Also understandable was the keenness of LDP politicians to use pressure from Washington in their battle against the Ministry of Finance’s attempts to limit public spending. The US

54 The Yo–Yo Yen

Treasury was silent on potential monetary expansion in Japan as its preference was for a stronger yen – and thereby increased competitiveness for US manufacturers – which could accompany fiscal expansion but was unlikely to co-exist with monetary reflation. Barely had Japan embarked on a major easing of fiscal policy in spring 1978, than the upward pressures on the yen began to abate. The US trade deficit peaked in the first quarter and then started to fall sharply. Japan’s own trade surplus reached its peak around the same time and then remained on a plateau before falling sharply from the fourth quarter onwards. As US inflation rose amidst general evidence that the US economy was now overheating it became untenable for Carter Administration officials to continue repeating the mantra that Japan and Germany were exporting unemployment to the USA. In Japan, the Ministry of Finance was rapidly easing restrictions on capital exports so that these could play a role in offsetting upward pressure on the yen from the trade surplus. The fact that US bond yields had now risen well above Japanese yields was helpful (Figure 2.13). Obstacles were removed to the issuance of foreign bonds in Tokyo, Japanese insurance companies were encouraged (by the Ministry of Finance) to buy foreign bonds, and banks entered the rapidly growing market for syndicated loans to the developing countries (in some cases having access to cheap funds directly from the Bank of Japan which

Figure 2.13

Japan vs. US government bond yields, 1975–80

A Brief History of the Modern Yen (1960–87) 55

re-lent dollars purchased in the foreign exchange market to the Japanese banks under swap arrangements designed to stem the yen’s rise). Indeed, the restrictions on capital exports and the unfamiliarity of Japanese investors with foreign assets, or foreign borrowers with the yen, had all played a part in the extraordinary rise of the yen under the influence of the current account surplus (during 1977 and the first half of 1978). The normal mechanism of capital outflows absorbing a current account surplus had not been fully operational. To some extent the decline of the yen late in 1978 can be seen as symptomatic of the relief to an overheated currency from opening the tap of capital exports. A significant tightening of US monetary policy in November 1978 as part of a package of dollar–defence measures announced by the Carter Administration (indicating that Washington no longer wanted a weaker dollar or stronger yen) played a role in the yen’s downturn. A further factor was the Iranian revolution and associated surge in energy prices, which the Japanese economy was viewed in markets as particularly vulnerable to. Into the second half of 1979, Japan’s current account balance had swung into large deficit (around 2 per cent of GDP), reflecting not just the oil price shock but also a boom in domestic demand (spurred in part by the fiscal reflation of the previous year) (Figure 2.14).

– – – Figure 2.14

Japan current account balance, 1970–80

56 The Yo–Yo Yen

Almost six years of overall near-stability, 1980–5, and then the Plaza ‘shock’ By contrast to the yen, the DM in 1979 kept broadly level with the US dollar, buoyed by an increase in international investor demand in the wake of Washington’s order freezing Iranian deposits with US banks. In overall real effective exchange rate terms (Figure 2.9) the yen had already fallen back to its level of late 1976 before Paul Volcker unleashed the monetary shock of Saturday night, 6 October 1979 (the recently appointed Federal Reserve Chairman, replacing his predecessor William Miller, set the stage for sharp rises in US money rates by adopting a direct target for monetary base growth). The yen was then at around 240 to the US dollar – the same level as just prior to the Plaza Accord almost six years later. But in the interval there was to be a further throw of the yo–yo yen, although much smaller than the violent episode which had just occurred (from 1977 to 1979). In real effective terms the yen was broadly stable from winter 1979/80 until the Plaza Accord (September 1985). The yen rose from its lows of late 1979 as the Japanese current account balance swung back into surplus in 1980 and exports boomed. However, this climb was terminated by the election victory of Ronald Reagan (November 1980) and a subsequent surge in US interest rates (in part related to the rebound of the US economy from the recession of January–August 1980, the Volcker Federal Reserve taking the opportunity to complete its anti-inflation mandate and, in part, to the fiscal expansion associated with Reaganomics). By summer 1981 the yen had fallen back to 240 against the dollar having almost touched 200 in late 1980 (Figure 2.15). Next came a brief but sharp lurch of the yen to 280 by autumn 1982 as the US economy passed through the second and most serious recession of the Volcker years. The recovery of the yen against the dollar was even more violent once the recession ended to 240 yen/US$ by the end of 1982. There followed almost two years (until Plaza) of the yen oscillating by ±5 per cent around 245 yen/US$. There were several factors behind the overall stability (in real effective exchange rate terms) of the yen during the first half of the 1980s. First, except for 1980 and 1982, the yen was not centre-stage in the currency markets. It was the DM rather than the yen that was at the opposite end of the pole to the US dollar during the great anti-inflation battles of the Volcker Federal Reserve and then the Reaganomics boom (the latter coincided with a first episode of acute Euro-pessimism). Second, currency politics was anathema to the first Reagan Administration (1980–4). Markets did not have to reckon with the risk of a Nixon-type shock in which Washington would seek to devalue the dollar and revalue the yen in order to promote economic recovery. Indeed, during the deep US recession of late 1981 and 1982 (first three quarters) the yen was generally weak, as a normal response to concerns about the impact of

A Brief History of the Modern Yen (1960–87) 57

Figure 2.15

Exchange rates: yen/DM and yen/US$, 1979–87

weak US demand on Japanese exports and profits. If markets had feared that the Reagan Administration would talk down the dollar during recession the yen would have followed a quite different path. Third, with no pressure from Washington on Tokyo regarding fiscal policy, the Ministry of Finance (in Japan) took the opportunity to institute a bold consolidation with the aim of returning the public finances into surplus. Fiscal deflation in Japan kept downward pressure on yen interest rates and helped stimulate capital outflows. In turn, strong capital exports meant that the emergence of a trade surplus no longer meant a rise of the yen (as in the late 1970s). Finally, at the end of 1980 the Ministry of Finance had lifted most of the remaining controls on capital outflows from Japan. In the next few years Japanese investment institutions became huge buyers of high-yielding foreign bonds, mainly in US dollar denomination. Indeed, Ministry of Finance officials, keenly aware of the importance of promoting capital exports to avoid a rising trade surplus that would put new upward pressure on the yen, gave strong hints to the Japanese insurance industry that earthquake risk meant it was prudent to maintain substantial holdings of foreign assets. As Japan’s current account surplus rose steadily to over 3 per cent of GDP in 1984 and 4 per cent in 1985, the yen remained steady (at around 240) against the US dollar (Figure 2.16). It seemed like a golden age in which

58 The Yo–Yo Yen

Figure 2.16

Japan current account balance, 1981–90

huge flows of capital would move across the globe to equalise rates of return in the face of differential investment opportunity and varying national savings rates. Trade balances would be a statistic on the back page of the financial press rather than the focus of Finance Ministers’ attention (including, most prominently, a US Treasury Secretary following a neomercantilist agenda). A giant US trade deficit was of no consequence if it was the by-product of booming investment opportunity unleashed by Reaganomics, and large Japanese trade surpluses were simply a reflection of the high savings rate in Japan, not a plot of Tokyo to knock out US competition and take over the world. Events were soon to show, however, that celebration was premature. Growing trade protectionism in the US Congress and gestures of appeasement by the Reagan Administration were ominous. Could another Nixon shock be in the making that would set back the stabilising role of international capital flows for years to come? Just months after coming to office the Reagan Administration had worked towards a voluntary agreement to restrain Japanese automobile exports. In 1983–4 the so-called ‘yen–dollar’ talks had culminated in agreed measures for opening up the Tokyo financial markets to some foreign participation (in particular US investment houses). Treasury Secretary Regan had made clear that he expected the measures would bolster the yen via making domestic asset markets more attractive (in terms of say liquidity and sophistication) to Japanese investors who would otherwise favour US

A Brief History of the Modern Yen (1960–87) 59

assets. In January 1985, Washington proposed a new set of MarketOriented Sector-Specific (MOSS) talks with the Japanese aimed at removing a wide range of barriers to foreign access in four sectors (telecommunications, medical equipment, forest products and electronics). But even as the Administration was attempting to reclaim the initiative, congressional demands for a more aggressive trade policy were reaching new heights. During 1985 more than 300 trade bills were introduced as members of Congress, faced with mounting pressure from industry and labour, rushed to introduce harshly worded resolutions and protectionist bills. One resolution, passed 92–0 by the Senate in March 1985, blasted Japan for its unfair trading practices and urged retaliation unless the nation significantly increased its imports from the USA. The most notorious of the legislative initiatives was the Gephardt Amendment, based on legislation first introduced by Senator Lloyd Bentsen (subsequently the Treasury Secretary in the first Clinton Administration) and Representatives Gephardt and Rostenkowski in summer 1985, under which Japan and other surplus countries would have had to reduce their surpluses by 10 per cent per annum or else face sanctions. The table was turned on the trade protectionists when the Reagan Administration reluctantly abandoned the position that the dollar should be determined in the free market, and embraced, at Plaza (September 1985), the idea of concerted central bank intervention, accompanied by monetary policy shifts, to lower the dollar’s international value. By promoting a smaller trade deficit, a weaker dollar was supposed to keep protectionism at bay. The depreciation of the dollar from 240 against the yen just before Plaza to 150 a year later (autumn 1986) was certainly far beyond what anyone envisaged at the meeting. Indeed, in testimony before the Diet in July 1987, the Finance Minister Kiichi Miyazawa disclosed that the Plaza Agreement was based on a target of around 220 yen/US$. Miyazawa maintained that the ‘concerned countries judged that reducing the dollar’s value by about 10 per cent before the International Monetary Fund’s annual general meeting in Seoul two weeks later would help the success of the meeting’. It is very difficult to blame Plaza (and thereby the Reagan Administration) for more than a small part of the huge losses that Japanese investors were to make on their first big foray into foreign currency assets. These losses were to become part of the folklore explaining the extraordinarily sluggish capital outflow from Japan on various occasions during the next fifteen years. Rather, Japanese (and European) investors had embraced far too optimistic scenarios for the US economy over the following years – scenarios where extraordinarily high interest rates could co-exist with economic prosperity. By spring 1985 it was evident that the Reaganomic boom was drawing to a close, and by the time of the Plaza Accord, the US economy was almost certainly in a growth-recession (period of well below

60 The Yo–Yo Yen

trend growth) that, with the benefit of many years of hindsight, is now dated as running from late 1984 to early 1987. Between mid-1985 and mid1986, ten-year US T-bond yields fell almost 300bp while the Federal Funds rate dropped by 150bp (Figures 2.17 and 2.18). In many respects Plaza was indeed an empty agreement. Finance ministers and central bankers can talk about preferred exchange rate levels and threaten large-scale intervention but why should anyone in markets sit up and take notice? Intervention is widely seen as futile if not accompanied by a substantial shift in monetary policy. The only shift that explicitly followed Plaza was a bizarre short-lived tightening of monetary policy by the Bank of Japan. Short-term money rates in Tokyo jumped by almost 150bp and JGB yields by almost 100bp in the immediate aftermath and, correspondingly, the yen shot up against both the US dollar and DM in a few weeks following the agreement, from 240 to 215 against the dollar and from 85 to 80 against the DM (Figure 2.15). But there was no basis for tighter monetary policy in Japan at this point. Perhaps an easing of fiscal policy would have provided cause (for tighter money). But significantly, at Plaza, Washington did not (as on many previous or later occasions) press for budget reflation and the Ministry of Finance was, in any case, totally opposed to reversing its hard-won gains on the road to budget balance. By early 1986, the Bank of Japan had reversed the tightening of policy effected following Plaza and until year-end the yen now rose less in total

12 10yr JGB yield 10yr T-bond yield 10

8

6

4 Jan-85

Apr-85

Figure 2.17

Jul-85

Oct-85

Jan-86

Apr-86

Jul-86

Japan vs. US government bond yields, 1985–6

Oct-86

A Brief History of the Modern Yen (1960–87) 61

Figure 2.18

Japan vs. US money market rates, 1985–6

than the DM against a generally weakening dollar. Fear amongst economic policy-makers in Tokyo that the tumble of the dollar would send the economy into a recession lay behind a further aggressive easing of monetary policy that has subsequently been blamed for sowing the seeds of the great bubble economy in Japan during the late 1980s. Apparently enhanced domestic investment opportunity in Japan went along with a slower momentum of capital exports bringing soon further gains for the yen. After some temporary stability at around 160 to the dollar during late 1986, the yen surged towards 140 in early 1987 (Figure 3.14). Overall the dollar’s fall against the DM since Plaza had been almost equal to that against the yen, and Washington now agreed, at the so-called Louvre Accord (February 1987), to help prevent a further decline. There was the usual burst of foreign exchange market intervention by the Federal Reserve, Bank of Japan, and Bundesbank, but then the Wall Street Crash of October 1987 brought a decline of the dollar to 120 against the yen by the end of 1987. The yen made substantial gains against the DM through the first half of 1988 whilst returning to 130–140 against the dollar by the summer (1988), as the US economy continued upwards despite the Crash and the Japanese economic boom (bubble) was now in full swing. By contrast there was still lingering pessimism about European economic prospects.

62 The Yo–Yo Yen

In summary, after the golden stability of the early 1980s, the new violent swing (upwards) of the yo–yo yen in two or three years which followed the Plaza Agreement may have had much less to do with Washington than popular legend claims. Rather, fading optimism about Reaganomics and then a sudden outbreak of euphoria about investment opportunities in Japan (which in part may have been stimulated by policy-makers in Tokyo out of fear of currency-led deflation, over-easing monetary policy and even helping to stimulate a huge wave of real estate speculation) were pulling the string of the yo–yo yen.

3 Who Pulls the String of the Yo–Yo Yen?

Does Washington or Tokyo pull the string of the yo–yo yen? That is the outstanding question from the history of the years 1971–87 covered in Chapter 2. Suppose there had been no buzz of concern from Washington about the size of Japan’s trade surplus, would the yen have pursued a much more stable path? The question is even more pertinent to the experience of 1988–2000, through the Bubble and into the Lost Decade, to be considered in the next two chapters. The search for who pulls the string should start with the origins of the trade and current account surpluses, which were to become the periodic focus of currency markets and the apparent catalyst on several occasions to currency instability. Was it inevitable that the surpluses would fuel the yo–yo behaviour of the Japanese currency? The discussion of inevitability involves some counterfactual historical analysis. As a final point (to this chapter), how do we measure the swings of the yo–yo yen in a three-currency world? Although much of the narrative about the yo–yo yen is in terms of the yen–dollar rate, to understand and measure the phenomenon we have to distinguish how far the yen is moving on its own as opposed to simply being carried along by the US dollar or the euro (and previously the DM).

Origins of Japan’s surplus ‘problem’ It is an identity of economic arithmetic that the current account surplus in the balance of payments equals the excess of domestic savings over investment spending. A country whose residents are big savers and where domestic investment opportunity is poor runs a large current account surplus matched by equal net capital exports. As an extreme illustration take an oil rich nation populated by a small number of sheikhs. Most of the oil revenues are saved and invested in foreign assets. The trade surplus is very large relative to the size of the economy. A less extreme example is a 63

64 The Yo–Yo Yen

country whose working population is ageing and saving hard for retirement but where domestic outlets for investment do not grow in step. An example is Switzerland at the end of the twentieth century, whose current account (and savings surplus) had grown to around 13 per cent of GDP. Japan in the 1970s started to show symptoms of savings surplus – savings running ahead of domestic investment opportunities. The miracle era of double-digit growth came to a sudden end with the recession of 1974–5. From the 1960s onwards, economists had predicted a gradual rather than sudden fading of the miracle. As we saw in the previous chapter, some contemporary economists erroneously diagnosed the beginnings of the end of the miracle as early as the mid-1960s. But in reality the miracle came to an end with a bubble-and-bust sequence – the Tanaka boom of 1972–3 followed by the subsequent crash. The wide amplitude of the economic fluctuations in the mid-1970s meant it was some considerable time before a final verdict could be given on the passing of the economic miracle. As the miracle faded, investment opportunities contracted. No longer was there the seemingly boundless scope for profit from chasing the levels of technology and capital per head found in the advanced industrial economies. An indicator of the change in opportunity set was the decline in business investment as a proportion of GDP (Tables 3.1, 3.2, 3.3 and Table 3.1

Japan savings–investment balance, 1960–72 (% of national income) 1960

1965

1968

1970

1972

Saving (gross) Household Corporate Government Total saving (S)

14.2 14.6 6.7 35.5

14.9 13.7 6.1 34.7

15.1 17.9 6.5 39.5

15.1 20.0 7.5 42.6

16.2 17.2 6.8 40.2

Investment Household Corporate Government Total investment (I)

4.2 24.0 7.5 35.7

6.0 19.0 9.1 34.1

6.6 23.8 8.8 39.2

6.8 26.0 8.6 41.4

7.3 20.1 10.1 37.5

Savings surplus (S-I)

–0.2

0.6

0.3

1.2

2.7

0.4

1.1

0.8

1.1

2.3

–0.8 0.6 10.0 –9.4

–3.0 3.6 8.9 –5.3

–2.3 2.6 8.5 –5.9

–1.1 2.3 8.3 –6.0

–3.3 6.0 8.9 –2.9

Current account (balance of payments) Savings surplus by sector Government Private Household Corporate

Who Pulls the String of the Yo–Yo Yen? 65 Table 3.2

Japan savings–investment balance 1974–82 (% of national income) 1974

1975

1978

1980

1982

Saving (gross) Household Corporate Government Total saving (S)

20.8 10.2 7.3 38.3

21.6 8.1 4.1 33.8

20.4 11.4 2.3 34.1

18.1 11.3 3.7 33.1

16.4 10.9 3.9 31.2

Investment Household Corporate Government Total investment (I)

7.9 22.1 9.4 39.4

7.3 17.6 9.5 34.4

7.2 15.1 10.4 32.7

6.8 17.3 10.1 34.2

5.7 15.7 9.1 30.5

Savings surplus (S-I)

-1.1

-0.6

1.4

-1.1

0.7

Current account (balance of payments)

–0.9

–0.1

1.8

–0.9

0.8

–2.1 1.0 12.9 –11.9

–5.4 4.8 14.3 –9.5

–8.1 9.5 13.2 –3.7

–6.4 5.3 11.3 –6.0

–5.2 5.9 10.7 –4.8

Savings surplus by sector Government Private Household Corporate

3.4). At the cyclical peaks of 1962 and 1970, the investment proportion had reached around 25 per cent. In 1973 the proportion had reached a somewhat lower 23 per cent. But in the late 1970s and early/mid-1980s the peaks were at 15–16 per cent only. Further ahead, in the speculative frenzy of the Great Bubble, the investment ratio touched 20 per cent (in 1990) but subsequently fell back to around 15 per cent on average during the Lost Decade (1990s). Investment by the household sector (mainly residential construction) also fell as a trend – by around 2 per cent of GDP – between the 1960s and 1990s. Household savings, however (measured as a percentage of GDP), showed no tendency to move down in step with business investment. Indeed during the early 1970s the savings rate jumped amidst high inflation and economic uncertainty. There was a decline during the late 1970s bringing the net savings ratio (household savings, after deducting annual depreciation of the capital stock – mainly homes – held by the household sector, as a proportion of GDP) in the first half of the 1980s to around 12 per cent, up from around 10 per cent in the 1960s. Subsequently a dip occurred during the period of the bubble economy, but in the 1990s the savings ratio steadied at around 9 per cent of GDP, just marginally below the

66 The Yo–Yo Yen Table 3.3

Japan savings–investment balance 1984–9 (% of national income) 1984

1985

1987

1989

Saving (gross) Household Corporate Government Total saving (S)

16.3 12.1 4.5 32.9

15.9 12.3 5.9 34.1

14.4 13.4 6.5 34.3

13.5 13.0 8.4 34.9

Investment Household Corporate Government Total investment (I)

5.0 16.7 8.2 29.9

4.9 17.9 7.2 30.0

6.0 17.3 7.3 30.6

6.2 20.4 6.9 33.5

Savings surplus (S-I)

3.0

4.1

3.7

1.4

Current account (balance of payments)

3.1

4.0

4.0

2.3

–3.7 6.7 11.3 –4.6

–1.3 5.4 11.0 –5.6

–0.8 4.5 8.4 –3.9

1.5 –0.1 7.3 –7.4

Savings surplus by sector Government Private Household Corporate

1960s. The corporate sector savings rate (corporate savings, roughly equivalent to retained profits plus depreciation allowances, measured as a proportion of GDP) did fall, but only slightly, between the early/mid-1960s and the 1980s/1990s. There are several plausible hypotheses (not mutually exclusive) as to why Japan’s private sector savings remained high despite declining investment opportunity, and, of course, each explanation varies in importance through the three decades. First, the period of explosive growth meant that employees retiring in the 1980s would not have saved sufficiently during their early working years to provide income near the level of their late working years. Second, the inflation and recessionary storms of the mid-1970s together with the sudden end of the miracle encouraged some greater caution on the part of households regarding their spending plans. Third, high land prices meant that young households had to save hard to buy living accommodation. Fourth, there was a bulge in the proportion of middle-age workers providing hard for their retirement against the background of scepticism

Who Pulls the String of the Yo–Yo Yen? 67 Table 3.4

Japan savings–investment balance, 1990–9 (% of national income) 1990

1993

1997

1999

Saving (gross) Household Corporate Government Total saving (S)

12.7 13.5 9.5 35.7

13.8 14.4 6.5 34.7

14.0 15.1 3.1 32.2

14.3 14.3 1.2 29.8

Investment Household Corporate Government Total investment (I)

5.6 21.1 7.0 33.7

5.2 17.0 8.3 30.5

4.5 17.6 8.3 30.4

4.5 15.1 8.9 28.5

Savings surplus (S-I)

2.0

4.2

1.8

1.3

Current account (balance of payments)

1.5

3.1

2.3

2.7

2.5 –0.5 7.1 –7.6

–1.8 6.0 8.6 –2.6

–5.2 7.0 9.5 –2.5

–7.7 9.0 9.8 –0.8

Savings surplus by sector Government Private Household Corporate

regarding the ability of public and private pension funds to meet their commitments. Fifth, and most relevant in the late 1990s and beyond, public concern about huge government deficits and the likelihood of increased taxation in the future encouraged precautionary saving. Corresponding to the pattern of private sector savings surpluses and business investment described, the private sector savings surplus in the Japanese economy rose from around 2 per cent of GDP in the 1960s to almost 10 per cent in the late 1970s. It fell back to around 5–6 per cent through the early and mid-1980s, dipping to virtually zero at the peak of the bubble economy (1989–90), and then rose back to 9 per cent by the end of the 1990s. These recorded surpluses, however, may understate the underlying imbalances between private savings and investment, as they were generated at interest rates that, for much of the period (late 1970s to end of the century), were below foreign rates (especially US). If there had been no exchange risk and international capital perfectly mobile (as under the gold standard regime prior to the First World War) then Japanese and US rates would have been much closer together and the private sector savings surplus in Japan even larger.

68 The Yo–Yo Yen

The implications of the private savings surpluses for the balance of payments depend in part on the position of the public sector. It is the total savings surplus, private and public combined, which is equal to the current account surplus. In the late 1970s an aggressive easing of fiscal policy offset a build-up of the private sector savings surplus, so that the current account surplus was only small. Again, in the 1990s, a progressively more expansionary fiscal policy diluted the impact of a huge private sector savings surplus on the current account balance. (Public and private sector savings are not wholly independent of each other. If Ricardian equivalence held, households would increase their savings when budget deficits appeared by enough to service the issues of government debt – including repayment. But in practice only partial Ricardian equivalence has been found in empirical studies – and so expansionary fiscal policy would reduce the overall savings rate in an economy.) The size of Japan’s overall savings and current account surpluses recorded through the 1980s and 1990s was hardly large by historic or contemporary standards. Expansionary fiscal policy and increasing aversion of Japanese investors to bearing foreign exchange risk (meaning lower than otherwise bond yields and interest rates in Japan) kept a lid on the surpluses. By contrast, in the twenty years before the First World War the comparatively mature British economy (which had led the industrial revolution) ran current account surpluses of around 10 per cent of GDP annually. In the 1980s and 90s, Switzerland ran ever larger current account surpluses reaching as high as 13–14 per cent of GDP (Figure 3.1). The Swiss current account surpluses corresponded to a bulge in household savings spurred by generous fiscal incentives for building up nest-eggs for retirement coupled with sluggish domestic investment opportunities (Table 3.5). The Swiss example does have interesting comparisons with Japan. As discussed further in the next chapter, the Swiss economy was subject to a land bubble and burst also in the late 1980s and early 1990s. As in Japan the bursting of the bubble was at first accompanied by a bizarre strengthening of the national currency and a big fiscal expansion which contributed towards Switzerland suffering a lost three-quarters decade. But the extent of the damage was less in the case of Switzerland – in considerable part because the reversal of course in the mid-1990s (the exchange rate falling and the budget deficit being reduced) which occurred in both countries was sustained (unlike the situation in Japan, as discussed in Chapter 5). The Netherlands ran a current account surplus of 6–7 per cent of GDP through much of the 1990s, reflecting a high personal savings rate coupled with a much-improved budgetary situation. In Singapore the current account surplus reached almost 30 per cent of GDP at the end of the 1990s. It is striking that all the examples of large surpluses have gone hand-inhand with a propensity for domestic residents to invest abroad and for foreigners to borrow the currency of the given country. British investors

Who Pulls the String of the Yo–Yo Yen? 69 105

14 12

Swiss current account balance (% GDP)

10

Swiss franc real effective exchange rate (RHS)

100

95 8 90

6 4

85

2 80 0 –2

75 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00

Figure 3.1 Switzerland current account balance vs. real effective exchange rate, 1980–2000

before the First World War played a large part in financing the development of North and South America. Swiss portfolio investors in the 1980s and 1990s were avid buyers of higher-yielding paper denominated in foreign currency and Swiss corporations were at the forefront of a take-over boom in both the EU and North America. The low interest rate Swiss franc has been popular with international borrowers. In the case of the Netherlands, corporations there have greatly increased their international presence. The stock of Japanese investment abroad did grow rapidly through the 1980s and 1990s. But the yo–yo behaviour of the yen was an impediment to an even greater outflow of capital. Investors who lost very heavily on their acquisition of foreign bonds in the early 1980s as the yen shot upwards in the late part of that decade were reluctant to re-engage in ‘interest arbitrage’. Later, the foreign borrowers who ran up yen liabilities as part of the hugely popular carry trade in the years 1995–8 were so sore at the huge losses inflicted by the yen’s jump of late 1998 that they would surely not re-enter a similar line of activity for a long time to come. The yo–yo yen, by dampening the force of potentially stabilising international capital flows, imposed an economic burden on the Japanese economy. Arguing that the yo–yo yen was costly for Japan is not the same as nostalgically advocating a return to fixed exchange rates. As a practical matter,

70 The Yo–Yo Yen Table 3.5

Switzerland savings–investment balance, 1990–7 (% of national income) 1990

1992

1994

1996

1997

Saving (gross) Household1 Corporate2 Social assurance Government Total saving (S)

10.0 11.2 9.8 2.6 33.6

11.7 8.1 9.2 0.1 29.1

10.1 9.0 8.1 1.0 28.2

11.2 8.6 8.2 1.1 29.1

13.5 8.5 7.4 1.2 30.6

Investment Household Corporate Government Total investment (I)

9.0 14.9 3.8 27.7

7.5 12.2 3.8 23.5

7.8 10.9 3.5 22.2

7.2 10.7 3.0 20.9

7.1 10.3 2.9 20.3

Savings surplus (S-I)

5.9

5.6

6.0

8.2

10.3

Current account (balance of payments)

3.9

6.5

7.0

7.7

9.2

–1.2 7.1 10.8 –3.7

–3.7 9.3 13.4 –4.1

–2.5 8.5 10.4 –1.9

–1.9 10.1 12.2 –2.1

–1.7 12.0 13.8 –1.8

Savings surplus by sector Government Private Household Corporate 1 2

Includes financial intermediaries. Non-financial corporations only.

the conditions were never present for an exchange rate treaty to be agreed in Washington and Tokyo. As a matter of principle, normal exchange risk where there is no fear of sudden shocks caused by currency policy changes in Washington and Tokyo would not have been a serious impediment to intensive and equilibrating international capital flows. The politics of the yen – both its US and Japanese dimension – not floating exchange rates in themselves were to blame for the waste of economic resources. The waste took the form of too low a level of foreign investment and excess investment in domestic public sector projects with more obvious political than economic benefit. On the US side, Administrations in Washington pressed for fiscal expansion as a way of stimulating the Japanese economy, reducing the Japanese savings and current account surpluses and fostering a stronger yen – the latter development being clearly welcome to important industrial lobbies. In Tokyo, big spenders in the Liberal Democratic Party (LDP) (the party

Who Pulls the String of the Yo–Yo Yen? 71

which has been in power throughout the modern history of the yen except briefly during 1993–4) could take their cue from Washington in breaking down opposition to budget deficits from the conservative Ministry of Finance. Anti-reformers in the LDP (who in some cases were also big spenders) were quite happy to offer Washington a stronger yen as a way of dulling the periodic demands for greater access of US firms to Japanese markets (especially in finance, insurance and telecommunications). Japanese manufacturers were tolerant of the bouts of yen strength given the possibilities of transplanting production to other cheaper labour Asian economies and official help was provided for the move. In the Foreign Ministry and the Ministry of International Trade and Industry (MITI) there was a strong undercurrent of support for the closer Asian involvement fostered thereby as furthering Japan’s long-run geo-political interests.

Big surplus, strong currency myth An idea that has plagued economic policy debate – both domestic (within Japan) and internationally – is that the large Japanese current account surplus implies that the yen should be a continuous candidate for appreciation. The view is built on seemingly common sense evidence – after all, a current account surplus means trade demand for the given country’s currency is greater than supply. In fact the imbalance between savings and investment that lies behind the current account surplus also propels capital exports. Hence, far from there being overall excess demand for the currency, there could be excess supply (if net demand for foreign assets, measured as a flow, rises by more than the trade surplus in the short turn). Indeed, the emergence of a current account surplus due to an autonomous rise in savings relative to investment should normally generate a downward shift of the exchange rate (the currency of the country or monetary area under discussion falls in value relative to other currencies). The extent and nature of exchange rate adjustment depends on the currency regime. In a system of totally fixed nominal exchange rates, the downward shift would be in real terms only (lower inflation in the country with increased savings than in other countries). To demonstrate these points, consider a sudden sharp rise in the private sector savings surplus, as occurred in Japan after the bursting of the Tanaka bubble economy of 1973, for example, or later in the aftermath of the bubble economy of 1987–9. Investment spending falls sharply from the peak levels when euphoria was widespread, whilst households, no longer confident about job security and ever-rising incomes, cut back their spending. Suppose first, for illustration purposes, that the shock occurs in the context of a fixed exchange rate system where there is near zero exchange risk (as would be the case under a well-established gold standard). A rise in

72 The Yo–Yo Yen

the private savings surplus would go along with a fall in domestic demand (or the near-term growth of domestic demand). A new equilibrium would be reached in which the domestic price level would have fallen relative to price levels abroad, whilst interest rates would still be at the international level, which for the purpose of this example is not affected by events in the country in question (with virtually no exchange risk, capital would be perfectly mobile internationally and interest rates would be nearly identical on similar quality assets in different countries). The export surplus would rise by the same amount as the shock increase in the private sector savings surplus. A real depreciation of the currency (a fall in domestic prices relative to foreign, at an unchanged nominal exchange rate) would be the immediate force behind the increase in exports and decrease in imports which brings the economy back to its productive potential level of output despite the fall in domestic demand. (For illustration purposes, the bubble-bursting occurs only in one country. In practice, several countries may be experiencing at the same time a sudden rise in savings – a point we return to in the next chapter when discussing the simultaneous occurrence of US and Japanese asset deflation in 1990–2.) The entire shock increase in the savings surplus would flow out as capital exports (in the new equilibrium). If the price level is sticky downwards, then adjustment may involve a prolonged recession or depression. Second, consider a floating exchange rate system, with varying amounts of exchange risk. The shock rise in the private savings surplus would go along with a fall in the natural rate of interest for the given economy. (The natural rate of interest is the level of the interest rate in real terms at which, given present savings propensities and investment opportunity, overall demand would equal the economy’s productive potential.) The exchange rate of the national currency would fall (probably to a level from which some recovery would be expected over the long run), reflecting the decline in the domestic interest rate. Given the existence of trend exchange rate expectations (of some eventual recovery of the national currency – see below) and exchange risk there is considerable scope for interest rates to fall relative to those abroad. Unlike in the previous example, where in effect a big induced increase in net export demand means that the natural rate of interest does not change in the long run, here it falls. For example, where Japanese interest rates fall far below US rates, the gap between the two in part matches expectations of a recovery of the yen in the long run and in part provides a reward to investors and borrowers for taking the risk of crossing the yen–dollar frontier (Japanese investors buying dollar assets or foreigners borrowing yen to finance investments outside Japan). The widening of the rate spread (in favour of foreign currencies) as described goes along with an increased net capital outflow (given the increase in reward for risk) which in turn matches a rise in the current account surplus. The national currency falls to below the pre-shock

Who Pulls the String of the Yo–Yo Yen? 73

level, helping to bring about an increase in the trade surplus. In the new equilibrium the size of the current account surplus (and the savings surplus) is likely to be smaller than in the gold standard case, in that the fall of the domestic interest rate has mitigated the initial shock rise in the savings surplus. If perceptions of exchange risk are minimal (or aversion to exchange risk is low), then the currency could fall substantially, but by less than the real exchange rate depreciation under the hypothetical gold standard regime. As illustration, suppose the shock rise in the savings surplus were around 5 per cent of GDP (for example, capital spending intentions falling by 4 per cent of GDP, savings rising by 1 per cent of GDP). Interest rates in the given country, say Japan, might fall to, say, 3 per cent below those abroad (principally in the USA). The currency (yen) might fall by around 20 per cent from the level at the peak of the boom. In the eventual equilibrium ‘solution’ the rise in the savings surplus (trimmed by the fall in interest rates) could be around 3 per cent of GDP, and the exchange rate depreciation would be sufficient to bring about (in combination with other adjustments) a similar increase in the current account surplus. There would be strong expectations of the currency (yen) appreciating as a trend over, say, the next ten years – in part due to rising investment income from abroad (on the increasing total of foreign assets) and in part to a return of economic confidence meaning that investment spending would rise and the personal savings rate fall. The investor in our hypothetical example who forecast a significant recovery of the yen over the next decade could earn a small risk premium (equal to cumulative gain in interest income less exchange loss) from being in foreign currency assets rather than domestic. If exchange rate risk and aversion to bearing that risk is high, then the fall in the currency that accompanies the shock rise in the savings surplus could be very small. The fall in the domestic interest rate triggers little capital outflow. The adjustment to the rise in the savings surplus principally takes the form of declining interest rates. Rather than falling 3 per cent as in the previous illustration, interest rates may fall by, say, 6 per cent. In the new equilibrium there is only a small increase in the net export of capital and similarly in the eventual ‘steady state’ savings surplus. Foreign currencies are very attractive in terms of their income advantage, but investors are simply too scared to make bold transfers into them. In practice, the adjustment described could be blocked by a central bank lacking the courage to make the necessary bold cuts in nominal interest rates (meaning that actual money rates lag far behind the fall in the natural rate of interest). And by the time it does effect a cumulative large cut the economy may already be in a deflationary situation where the price level is falling. Then it may be impossible for real interest rates to fall far, given that nominal interest rates under any conventional monetary regime cannot reach sub-zero levels.

74 The Yo–Yo Yen

In this last case the fall in the savings surplus from its shock high would be limited and the matching current account surplus would remain substantial. Capital exports would be too feeble to absorb the current account surplus. In this unstable situation the currency (yen) would jump to a level where speculators were willing to enter the so-called carry trade (borrowing low interest yen and buying higher interest rate foreign currencies) in anticipation of a subsequent narrowing of the current account surplus (as trade flows respond to the yen jump) relieving the currency shortage. This is perhaps the scenario some commentators, particularly in the 1990s, have had in mind when they argue that a current account surplus has put upward pressure on the yen. During some parts of that decade the equilibrium rate of interest in Japan might well have been below zero, as we shall see in the next two chapters, and the aversion to bearing exchange risk with respect to the yen has been very high. It is hardly plausible to blame the entirety of the yen’s extraordinary path, especially during the first half of the 1990s, on the impossibility of nominal interest rates falling below zero (Figure 3.2). In the early 1990s, the actual level of yen rates was well above zero. They could have been cut aggressively but were not. And why was exchange risk then perceived to be so high (by Japanese investors in foreign assets)? As we shall see, Bank of Japan officials played no small part in inflaming risk perceptions.

Figure 3.2

US Federal funds rate vs. Japan unsecured overnight call rate, 1991–5

Who Pulls the String of the Yo–Yo Yen? 75

In the narrative of the next two chapters, the yen’s sharp rise from 1990 through to early 1995 had much to do with misguided Bank of Japan policy – interest rates held too high for too long. If interest rates had already been cut to near zero in the second half of 1992 rather than being held above contemporary US rates, then the yen might well have fallen in response to the jump in Japan’s savings surplus – especially once the US economy pulled out of the recessionary or slow growth period of the early 1990s. The Bank of Japan Governor himself spoke in favour of a strong yen, seeing this as promoting economic restructuring. And he aired in public poorly based opinions about the trade surplus being a reason for the yen to go higher. It is hardly surprising that the yen went into a debilitating (from the viewpoint of economy) upward spiral. What role did Washington play in building up expectations of a stronger yen? As we have already seen, in 1977–8 and 1985–6 (Chapter 2), the Carter Administration and later the second Reagan Administration let markets know their preference for a weaker dollar, particularly against the yen. The first Clinton Administration was to act similarly in 1993–4. But the power of Washington to talk up the yen should not be exaggerated. Just because the US President and Treasury Secretary speak in favour of a stronger yen does not mean that markets adjust to fulfil their hopes. And an increased risk of economic policy confrontation between Tokyo and Washington does not mean inevitably a stronger yen. In the final analysis, if Washington were to slap tariffs on Japanese imports and the Japanese economy were to flounder further as a result, that could be bad news for the yen. Some economic commentators – including Ronald McKinnon and Kenichi Ohno (1997) – tell a story steeped in psychology in which unnerved foreign exchange dealers, for whom the Nixon shock of 1971 and Plaza shock of 1985 are deep in their subconsciousness, bid the yen higher on US trade threats. Japanese holders of dollar assets similarly take fright and rush to repatriate their capital. But the logic behind that chain of events has not been written down. Reports in the financial media about contemporary talk in the foreign currency markets during certain episodes of a strongly rising yen (see Chapters 4 and 5 for early 1993 and early 1994 examples) do indeed suggest that the Nixon shock of 1971 and the Plaza Accord (1985) continued to haunt participants. They believed that somehow Tokyo might engineer a yen revaluation if ultimately necessary to prevent protectionist action by Washington. But what was the tool that Tokyo policy-makers could pull out of the black bag? Market reports gave no indication of what the feared tool might be. In principle it could have been easier Japanese fiscal policy, or much less plausibly direct action to slow capital exports from Japan or encouraging some withdrawal of capital by Japanese investors from US markets. The possible existence of such tools could justify an increase in Japanese risk aversion towards foreign assets at

76 The Yo–Yo Yen

times of tension in economic relations between Tokyo and Washington – capable in itself of bringing about a stronger yen. In fact, the most persuasive link between US policy and the yen does indeed involve Japanese fiscal policy. Bigger budget deficits in Japan meant that more of the private sector savings surplus there would be absorbed domestically rather than via capital exports, meaning a higher yen – and officials in both Washington and Tokyo were well aware of that connection (indeed in the so-called Strategic Initiative talks, discussed in Chapter 4, an explicit demand of the US side was increased public spending). A succession of US Administrations have pressured Tokyo to reflate via fiscal policy rather than monetary policy. Their lecturing on this issue has been music to the ears of big spenders in the Liberal Democratic Party who would otherwise have been constrained by the orthodoxy of the Ministry of Finance. Yes, in principle Japan could have said no to US demands for easier fiscal policy and implicitly a stronger yen, but as we have already seen, there was a powerful coalition of interests against such a course (LDP big spenders, anti-reformers, foreign office pro-Asian officials). And on the US side, some groups (for example insurers, retailers) may have preferred a harder line being taken by Washington on their behalf, but they could not prevail when many industrial lobbies were quite satisfied with a stronger yen on its own (without changes in competitive practice in the other areas mentioned). Of course any discussion of the role of fiscal policy in promoting a strong yen should acknowledge the influence of other developments, including concurrent shifts in the balance between savings and investment outside Japan. We have already referred to how the US private sector savings surplus was rising at the same time as the Japanese in the early 1990s (albeit less sharply) (Tables 3.6 and 3.7), so curbing the fall in the equilibrium value of the yen at that time. The tightening of US fiscal policy in the early years of the Clinton Administration at the same time as Japanese fiscal policy was being eased helped to counter fundamental downward pressure on the yen. In the late 1990s as Japanese fiscal expansion reached a new crescendo, the euro-area embarked on a major fiscal contraction as the EMU candidate countries sought to attain the Maastricht targets for budget deficits. Indeed the story of the weak euro in 1999 and strong yen could have been, in part, a reflection of the EMU-induced rise in euro-area savings surplus (as budget deficits shrank) and aggressive fiscal expansion in Japan (Table 3.8). But before returning to that topic (in Chapter 5) it is necessary to gain some understanding of how to analyse the movement of the yen in a tri-polar currency world.

The situation of the yen in currency geography The yo–yo behaviour of the yen has not occurred in otherwise calm currency markets. Some of the big moves of the yen have been integrally

Who Pulls the String of the Yo–Yo Yen? 77 Table 3.6

US savings–investment balance, 1982–90 (% of national income) 1982

1984

1986

1987

1990

Saving (gross) Household Corporate Government Total saving (S)

12.9 9.9 –1.8 21.0

12.3 10.9 –1.5 21.7

10.3 9.7 –1.8 18.2

9.6 10.0 –0.7 18.9

9.9 9.4 –0.7 18.6

Investment Household Corporate Government Total investment (I)

3.6 13.7 3.8 21.1

5.0 15.3 3.9 24.2

5.5 13.1 4.4 23.0

5.4 12.8 4.4 22.6

4.2 12.2 4.2 20.6

Savings surplus (S-I)

–0.1

–2.5

–4.8

–3.8

–2.0

0.0

–2.5

–3.5

–3.6

–1.3

–5.6 5.5 9.5 –4.0

–5.4 2.9 7.5 –4.6

–6.2 1.3 4.9 –3.6

–5.1 1.3 4.3 –3.0

–4.9 2.9 5.9 –3.0

Current account (balance of payments) Savings surplus by sector Government Private Household Corporate

related to simultaneous fluctuations of the European currencies against the dollar. Therefore, in tracing the path of the yen, it is important to have a reference framework in which its specific turbulence can be disentangled from what is happening elsewhere in the exchange markets. Conceptually the currency world is not round but triangular. The US dollar, the euro (the DM prior to 1999) and the Japanese yen are at the three corners. Most other currencies are either satellite to the US dollar or the euro (there are many more dollar satellites than euro satellites) or are subject to a powerful pull from both currencies (the dollar and euro). A very small number of currencies (all in Asia) are subject to powerful pulls from both the dollar and yen. Thus the dollar, euro, and yen, can be described as currency poles or as possessing polar power. There are two basic types of exchange rate fluctuation within the US dollar–euro–yen triangle. The first can be described as solo movement, where one of the currencies is moving against the other two, which are broadly stable against each other. The second can be described as axis movement, where two of the currencies are at the opposite end of the axis and the third in-between. Thus the third currency is rising against one and falling against the other currency,

78 The Yo–Yo Yen Table 3.7

US savings–investment balance 1992–9 (% of national income) 1992

1993

1995

1997

1999

Saving (gross) Household Corporate Government Total saving (S)

10.9 9.5 -2.7 17.7

9.3 9.7 -2.0 17.0

7.8 10.5 -0.1 18.2

6.8 11.1 2.1 20.0

5.1 10.8 4.1 20.0

Investment Household Corporate Government Total investment (I)

3.9 11.0 3.8 18.7

4.1 11.5 3.3 18.9

4.2 12.6 3.5 20.3

4.3 13.8 3.4 21.5

4.7 14.1 3.4 22.2

Savings surplus (S-I)

–1.0

–1.9

–2.1

–1.5

–2.2

Current account (balance of payments)

–0.6

–1.2

–1.4

–1.6

–3.8

Savings surplus by sector Government Private Household Corporate

–6.5 5.5 7.0 –1.5

–5.3 3.4 5.2 –1.8

–3.6 1.5 3.6 –2.1

–1.3 –0.2 2.5 –2.7

0.7 –2.9 0.4 –3.3

whilst at the end of the axis the given currency moves in the same direction (albeit by different amounts) against the other two. Corresponding to these two categories of exchange rate fluctuation there are six different types of motion possible within the dollar–euro–yen triangle: • Solo yen. The yen moves unilaterally against the euro and the US dollar, which are broadly stable against each other. For example, the yen may be in a powerful upswing whilst the euro–dollar rate is following a flat trend. • Dollar–yen axis dominant. The euro moves in an opposite direction against the US dollar and yen. The euro is the ‘in-between’ currency. By contrast, the US dollar moves in the same direction against the euro and yen (more against the yen than euro), whilst the yen moves in the same (opposite to US dollar) direction against the euro and US dollar (more against the dollar than euro). • Yen–euro axis dominant. The US dollar moves in an opposite direction against the yen and euro. The dollar is the ‘in-between’ currency. By contrast, the yen moves in the same direction against the US dollar and euro (more against the euro than the dollar) whilst the euro moves in the same (opposite to the yen) direction against the US dollar and yen (more against the yen than the dollar).

Who Pulls the String of the Yo–Yo Yen? 79 Table 3.8

Euro-area savings–investment balance 1991–8 (% of national income) 1991

1993

1995

1997

1998

Saving (gross) Household Corporate & Other Government Total saving (S)

12.1 9.8 0.0 21.9

11.5 10.6 –1.4 20.7

10.8 11.8 –1.1 21.5

9.4 11.8 0.5 21.7

8.8 11.8 1.4 22.0

Investment Household Corporate Government Total investment (I)

3.9 14.3 4.8 23.0

3.2 12.3 4.7 20.2

3.0 12.7 4.5 20.2

3.6 12.1 3.7 19.4

3.5 12.1 3.8 19.4

Savings surplus (S-I)

–1.1

0.5

1.3

2.3

2.6

Current account (balance of payments)

–1.3

0.5

0.5

1.5

1.1

Savings surplus by sector Government Private Household Corporate

–4.8 3.7 8.2 –4.5

–6.1 6.6 8.3 –1.7

–5.6 6.9 7.8 –0.9

–3.2 5.5 5.8 –0.3

–2.4 5.0 5.3 –0.3

• Solo euro. The euro moves unilaterally against the US dollar and yen, which are broadly stable against each other. For example, the euro may be in a sharp downswing whilst the dollar–yen rate is following a flat trend. • Dollar–euro axis dominant. The yen moves in an opposite direction against the US dollar and euro. The yen is the ‘in-between’ currency. By contrast, the US dollar moves in the same direction against the euro and yen (more against the euro than the yen), whilst the euro moves in the same (opposite to the US dollar) direction against the yen and US dollar (more against the dollar than the yen). • Solo US Dollar. The US dollar moves unilaterally against the euro and yen, which are broadly stable against each other. For example, the US dollar may be in a powerful upswing, whilst the yen–euro rate is on a flat trend. It is of course easier to distinguish the six possible types of motion in retrospect than contemporaneously or in a forecast. Indeed some efficient market theorists would argue that classification can only be a historic exercise – that from the viewpoint of the present there is no basis for expecting an exchange rate to follow a strong trend (a mild trend in line with interest rate differentials would be consistent with the efficient market hypothesis – but this is likely to be swamped by random fluctuations). Retrospective

80 The Yo–Yo Yen

identification involves examining two sets of exchange rate charts at each corner of the exchange rate triangle – the euro/US$ and yen/US$ rates at the US$ corner, the yen/euro and US$/euro rates at the euro corner, and the yen/euro and yen/US$ rates at the yen corner. Identification of each type of motion is made as below, with illustrations drawn from a complete set of charts (Figures 3.3 to 3.23) for exchange rate history since 1973. The euro is put at one corner of the triangle throughout even though it came into existence only in January 1999. Before then our notional euro is an accounting unit equal to a fixed amount of German money – DM 1.95583 – the rate at which the Deutsche mark was converted into euros at the start of EMU: Solo yen (identified in the charts by line segments with the number one). At the US$ corner, the yen/US$ rate moves substantially whilst the euro/US$ rate remains broadly flat. At the euro-corner, the yen/euro rate moves substantially, whilst the US$/euro rate is broadly flat. At the yen corner, the yen/euro and yen/US$ rates move closely in parallel. For example, in the first half of 1998, the yen was falling sharply whilst the DM was broadly stable against the US dollar. Consistent with solo yen motion within the US dollar–euro–yen triangle at the US$ corner (Fig. 3.22), the yen/dollar rate is rising steeply whilst the euro(DM)/US$ rate is flat; at the euro corner (Fig. 3.21) the yen/euro rate rises sharply whilst the US$/euro rate is flat; at the yen corner (Fig. 3.23) both the yen/US$ and the yen/euro rates are rising sharply. The economic story behind the solo fall of the yen in early 1998 was the deep recession in Japan coupled with widespread concern about the stability of its banking system and the contraction of many Asian economies following the previous autumn’s financial crisis. Yen–Dollar axis (identified in the charts by line segments with the number two). Dominance of this axis is seen most clearly at the euro corner, where the yen/euro and US$/euro rates move in opposite directions. At the yen corner, both the yen/US$ and yen/euro rates move in the same direction (the yen/US$ rate movement is sharper). At the US$ corner, both the yen/US$ and the euro/US$ rates move in the same direction (the yen/US$ movement is sharper than the euro/US$). For example in spring 1996 the dollar was generally strong and the yen generally weak, with the euro in-between. At the euro corner (Fig. 3.18), the yen/euro rate is rising, whilst the US$/euro rate is falling; at the US$ corner (Fig. 3.19), both the euro/US$ and yen/US$ rates are rising (the yen/US$ rate by more than the euro/US$ rate); at the Japanese yen corner (Fig. 3.20), the yen/US$ and yen/euro rates are rising (the yen/US$ rate by more than the yen/euro rate). The economic story behind the yen–dollar axis in spring 1996 was the US economy entering a strong upturn coupled with a rising momentum of capital outflow from Japan (including the growing popularity of the so-called carry trade whereby borrowers worldwide financed themselves in low-interest rate yen). Yen–Euro axis (identified in the charts by line segments with the number three). Dominance of this axis is seen most clearly at the US dollar corner, where

Figure 3.3

Euro corner, 1973–7

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

81

Figure 3.4

USD corner, 1973–7

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

82

Figure 3.5

JPY corner, 1973–7

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

83

Figure 3.6

Euro corner, 1978–81

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

84

Figure 3.7

USD corner, 1978–81

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

No trend in any of the three corners of the triangle.

*

Overall stability*

0

Key to currency corner charts

85

Figure 3.8

JPY corner, 1978–81

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

86

Figure 3.9

Euro corner, 1982–5

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

No trend in any of the three corners of the triangle.

*

Overall stability*

0

Key to currency corner charts

87

Figure 3.10

USD corner, 1982–5

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

88

Figure 3.11

JPY corner, 1982–5

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

89

Figure 3.12

Euro corner, 1986–90

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

90

Figure 3.13

USD corner, 1986–90

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

91

Figure 3.14

JPY corner, 1986–90

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

92

Figure 3.15

Euro corner, 1991–4

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

No trend in any of the three corners of the triangle.

*

Overall stability*

0

Key to currency corner charts

93

Figure 3.16

USD corner, 1991–4

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

94

Figure 3.17

JPY corner, 1991–4

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

95

Figure 3.18

Euro corner, 1995–7

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

96

Figure 3.19

USD corner, 1995–7

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

97

Figure 3.20

JPY corner, 1995–7

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

No trend in any of the three corners of the triangle.

*

Overall stability*

0

Key to currency corner charts

98

Figure 3.21

Euro corner, 1998–2001

USD/EURO(RHS) 0.8

0.9

1.0

1.1

1.2

1.3

1.4

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

99

Figure 3.22

USD corner, 1998–2001

Solo Yen USD–Yen axis dominates Yen–Euro axis dominates Solo Euro USD–Euro axis dominates Solo USD

1 2 3 4 5 6

* No trend in any of the three corners of the triangle.

Overall stability*

0

Key to currency corner charts

100

1

Figure 3.23

90 Jan 98

100

110

120

130

140

150

160

1

Jan 99

5 2

1

Jul 99

JPY corner, 1998–2001

Jul 98

JPY/USD JPY/EURO

6 3

1 6

Jan 00

2

Jul 00

4 5 6 2

Jan 01

3 3

5

Jul 01

1

Solo USD * No trend in any of the three corners of the triangle.

6

USD–Euro axis dominates

Yen–Euro axis dominates

3

Solo Euro

USD–Yen axis dominates

2

5

Solo Yen

1

4

Overall stability*

0

Key to currency corner charts

101

102 The Yo–Yo Yen

the yen/US$ and euro/US$ rates move in opposite directions. At the yen corner, the yen/US$ and yen/euro rates move in the same direction (the yen/euro rate move is sharper than for the yen/US$). At the euro corner, the yen/euro and US$/euro rates move in the same direction (the yen/euro rate move is greater than for the US$/euro). For example, in autumn 2000 the yen was generally weak whilst the euro was staging a recovery from a long spell of crisis. At the US dollar corner (Fig. 3.22), the euro/US$ rate is falling whilst the yen/US$ rate is rising; at the euro corner (Fig. 3.21), the yen/euro and US$/euro rates are both rising, the yen by more than the US dollar; at the yen corner (Figure 3.23), the yen/euro and yen/US$ rates are both rising, the euro rate by more than the dollar rate (of the yen). The economic story behind the yen–euro axis in late 2000 was the sudden realisation that the US economy had slowed sharply, with a spill-over to the Asian economies, coupled to a rising tide of capital outflow from Japan as economic optimism there faded and the arrival of the Bush Administration in Washington alleviated any fear of the yen becoming a football in trade confrontation between the world’s top two economies (even before coming into office, senior Bush officials made clear that Washington would not lecture Tokyo on economic policy). Solo euro (identified in the charts by line segments with the number four). At the US$ corner, the euro/US$ rate moves substantially, whilst the yen/US$ rate is broadly flat. At the yen corner, the yen/euro rate moves substantially, whilst the yen/US$ rate is broadly flat. At the euro corner, the yen/euro and US$/euro rates move closely in parallel. For example in summer 2000, the euro rebounded then sank deeply again (by more than the rebound), whilst the Japanese yen was broadly unchanged against the US dollar. Consistent with solo euro motion within the US dollar–euro–yen triangle, at the US$ corner (Figure 3.22) the euro/US$ rate is falling then rising sharply, whilst the yen/US$ rate is flat; at the yen corner (Figure 3.23), the yen/euro rate rises then falls sharply, whilst at the euro corner (Figure 3.21) the yen/euro and US$/euro rates move closely in parallel (rising and then falling together). The economic story behind the solo ride of the euro in summer 2000 was, firstly, expectations of serious monetary tightening by the European Central Bank in response to rising inflation risks and, secondly, disappointment of those expectations. Dollar–Euro axis (identified in the charts by line segments with the number five). Dominance of this axis is seen most clearly at the yen corner, where the yen/US$ and yen/euro rates move in opposite directions. At the US$ corner, both the euro/US$ and yen/US$ rates move in the same direction (the euro to a greater extent than the yen against the dollar). At the euro corner, both the US$/euro and yen/euro rates move in the same direction (the US$ to a greater extent than the yen against the euro). For example in winter 1998/9 (and into) early spring 1999, the dollar was generally strong and the euro generally weak, with the yen in-between. At the yen corner

Who Pulls the String of the Yo–Yo Yen? 103

(Figure 3.23), the yen/US$ rate is rising whilst the yen/euro rate is falling. At the US$ corner (Figure 3.22), the yen/US$ and euro/US$ rates are rising, but the latter by more than the former. At the euro corner (Figure 3.21), the US$/euro and yen/euro rates are falling, but the US dollar by more than the yen rate of the euro. The economic story behind the dollar–euro axis in early 1999 was the unexpected booming of the US economy (despite the financial crisis of late 1998) and the sudden slowing of European growth together with disillusionment regarding European Monetary Union. Solo US dollar (identified in the charts by line segment six). At the euro corner, the US$/euro rate moves substantially whilst the yen/euro rate is broadly flat. At the yen corner, the yen/US$ rate moves substantially whilst the yen/euro rate is broadly flat. At the US dollar corner, the yen/US$ and euro/US$ rates move closely in parallel. For example, in early winter 2000/1 there was a solo rise of the dollar. At the euro corner (Figure 3.21), the US$/euro rate falls sharply, whilst the yen/euro rate is broadly flat. At the yen corner (Figure 3.23), the yen/US$ rate rises sharply whilst the yen/euro rate is broadly flat. At the US$ corner (Figure 3.22), the euro/US$ rate and the yen/US$ rate rise closely in parallel. The economic story behind the solo rise of the dollar at that time was the unexpectedly strong and rapid transmission of the US economic slowdown (already recognised in late autumn 2000) to Europe and Japan. We can say that during all periods when the yen was moving solo or the yen was at one end of a dominant axis (either the yen–US$ axis or the yen–euro axis) the yen was in the limelight in the currency market-place. All such periods are shaded in grey tones in the currency charts. It was not until summer 1976 that the yen first moved into the limelight. But since then the yen has ‘enjoyed’ considerable prominence (albeit somewhat less than the other two major currencies, the US$ and the euro (DM). Length of

Table 3.9

Solo and axis movement in the US$–euro–yen triangle: how frequent?

Duration (mths)

1973–81 1982–90 1991–00* Total Episodes 1973–81 1982–90 1991–00* Total

0

1

2

Motion 3

4

5

6

9 0 0 9

9 8 15 32

16 29 21 66

24 5 8 37

14 13 19 46

21 33 37 91

15 20 8 43

1 0 0 1

3 3 7 13

4 8 9 21

3 2 5 10

4 3 7 14

4 6 10 20

3 3 5 11

104 The Yo–Yo Yen Table 3.10 US$, euro and yen: how long has each been in the limelight? Duration (mths) Yen

Currency USD

euro

1973–81 1982–90 1991–00* Total

49 42 44 135

52 82 66 200

59 51 64 174

Episodes 1973–81 1982–90 1991–00* Total

10 13 21 44

11 17 23 51

11 11 22 44

*Data multiplied by 9/10 to equalise time periods

time and frequency of each major currency in the limelight are summarised in Tables 3.9 and 3.10. Over the period 1973–2000 as a whole, the yen has been in the limelight around 42 per cent of the time (solo yen, yen–dollar axis dominant, or yen–euro(DM) axis dominant). In the decade 1991–2000 the yen was slightly less in the limelight than in the years 1973–81, but similar to 1982–90. Though the 1990s were a time of exceptional yen volatility (as we shall see in the next two chapters), there was plenty happening to the other major currencies. The yen has never been the most in the limelight in any of the sub-periods (1973–81, 1982–90, or 1991–2000) as a whole. The euro has been in the limelight 54 per cent of the time during the whole period 1973–2000 (solo euro(DM) , euro(DM)–dollar axis dominant, or yen–euro(DM) axis dominant). It was in the decade of 1991–2000 that the euro was most in the limelight, almost as much as the US dollar – hardly surprising given that the decade started with German unification and ended with European Monetary Union. (Note that the percentage of time that each currency is in the limelight adds up to more than 100 per cent because two currencies – but not three! – can be in the limelight at the same time.) The US dollar has been in the limelight more than the other two currencies at almost 60 per cent of the time for the total period 1973–2000. That is consistent with the premier position of the US economy and the often asymmetric influence of events there on Japan and Europe. It was during the years 1982–90 that the dollar was most in the limelight (around 76 per

Who Pulls the String of the Yo–Yo Yen? 105

cent of the time) – hardly surprising given that this period included the Great Dollar Bubble of 1983–5 and its subsequent bursting. Around 25 per cent of the time in the limelight for each of the currencies during the whole period 1973–2000 has been as a solo-mover – the rest of the time has been in combination with another currency with both at the opposite ends of the dominant axis. But time out of the limelight corresponds more often to a period of solo motion by one of the two other currencies than to axis motion (where each of the other two are at opposite ends of the axis). As an example, when the dollar is out of the limelight, it is more frequently coupled with yen or euro solo motion, rather than dominance of the yen–euro axis. In total, solo motion (by the US dollar, euro, or yen) accounts for just less than 40 per cent of the total time (over the years 1973–2000 as a whole). The euro has been in solo motion for around 16 per cent of the total period, while the US dollar has been the solo-star for 13 per cent and the yen for around 11 per cent. Amongst the three types of axis dominance, the most common (in terms of cumulative duration over the period 1973–2000 as a whole) is the euro(DM)–US$ axis (motion 5) (26 per cent of the total time), followed by the yen–US$ axis (motion 2) (19 per cent). The least common is the euro(DM)–yen axis (motion 3) (12 per cent). In overall terms, euro(DM)–US$ axis dominance is the most common form of any type of motion (solo or axis) in the US$–euro–yen triangle, followed by yen-US$ axis dominance. Solo motion by either the euro or US dollar, or yen–euro axis dominance are all of about equal total duration (measured over the whole period). The least common type of motion is solo yen. Many of the episodes of particular types of currency motion are quite short-lived. In any historical account it is the long or acute episodes which are the most interesting to examine. In terms of the history of the yen, for the years already covered in this volume (1973–88), such episodes include the following: Early spring 1977 to late autumn 1977: yen–dollar axis dominant (see Figures 3.3, 3.4, and 3.5). The US dollar was generally weak as the Carter Administration pressed Japan and Europe to take reflationary action, the US current account balance swung into large deficit and the Federal Reserve underestimated the building inflation momentum. The yen was subject to greater upward pressure than the DM since US criticism of Japanese policy was particularly sharp, Japanese export growth was particularly strong, and the yen was beginning to encounter strong demand as an international investment (especially from OPEC nations) whilst foreign borrowing of yen remained restricted (as did Japanese capital outflows). Late 1978 to late 1979: yen–euro axis dominant (see Figures 3.6, 3.7 and 3.8). This period encompassed the second oil shock (following the Iranian

106 The Yo–Yo Yen

Revolution) and the US imposition of an asset freeze on Iran, which stimulated a shift of international funds into the DM from the US dollar. The jump in world oil prices and increasing risk of US recession went along with downward pressure on the yen. Thus the underlying trend was a strong mark and weak yen with the US dollar in between. Summer and autumn 1980: yen–euro axis dominant (see Figures 3.6, 3.7 and 3.8). As the US economy bounced back unexpectedly from the recession of early 1980 and the outlook for the Japanese economy improved, the yen rose sharply whilst the DM fell back, and the dollar moved in-between the two. Also buoying the yen was a big improvement in Japan’s export performance (gaining from the steep depreciation over the previous year). Winter 1981/2 until autumn 1982 (inclusive): yen–dollar axis dominant (see Figures 3.9, 3.10 and 3.11). This period includes the severe recession of late 1981 until third quarter 1982 and the dawning of the subsequent long US economic expansion. The dollar–mark rate followed the interest rate lead – with the dollar rising as rate spreads in favour of the dollar widened despite the progress of recession (US interest rates reached exceptionally high levels as the Volcker Federal Reserve acted resolutely to squeeze inflation out of the system), and then turning downwards (in autumn 1982) as the Latin American debt crisis and falling US inflation triggered Federal Reserve easing. The yen swung by a greater amplitude than the DM against the dollar – falling sharply as US recession first emerged (mirroring pessimism on Japanese exports and a falling Tokyo equity market) and then rising sharply with recovery prospects (optimism on US exports and a surge of foreign demand for Japanese equities). Early autumn 1985: Plaza Accord shock: yen–dollar axis dominant (see Figures 3.9, 3.10 and 3.11). The dollar bubble of the early/mid-1980s started to burst at the beginning of 1985. But at first it was the DM rather than the yen that led the bounce-back (against the dollar). Then in early autumn came the sudden change in exchange rate policy by the Reagan Administration (away from benign neglect to pushing the dollar down so as to diffuse growing protectionist pressure in Congress), signalled by the so-called Plaza Accord. Although, in principle, the agreement at Plaza was multilateral between all G-7 Finance Ministers, the focus of US policy was on obtaining an appreciation of the yen. That is what happened in the immediate aftermath as the Bank of Japan tightened monetary policy to accompany yen purchases (and dollar sales) in the foreign exchange markets. Spring 1986: yen–dollar axis dominant (see Figures 3.12, 3.13 and 3.14). This was a period of continuing dollar weakness, but unlike that of late 1985 and early 1986 when the dollar was declining at an equal pace against both the DM and yen, the fall now quickened against the yen (relative to the DM). The powerful economic expansion in Japan, which was eventually to culminate in the bubble of 1988–90, had already taken root and this was reflected in the currency markets.

Who Pulls the String of the Yo–Yo Yen? 107

Early spring 1987: yen solo (see Figures 3.12, 3.13 and 3.14). At the Louvre Accord in early 1987 the G-7 Finance Ministers agreed to stabilise the dollar after its period of sharp fall in the previous two years. Stabilisation was somewhat more successful with respect to the DM/US$ rate than the yen/US$ rate against background speculation about the Federal Reserve pursuing a somewhat tighter-than-otherwise policy so as to prevent a new decline of the dollar. The DM had tended to stabilise already in late 1986 and early 1987 without G-7 intervention.

The US dollar–euro–yen triangle: why dominant? There are six main independently floating currencies in the contemporary world (ranked in order of country or area economic size) – US dollar, euro, Japanese yen, British pound, Canadian dollar and Swiss franc. Why in the currency geography just outlined is the Japanese yen fitted into a triangle with the US dollar and euro, rather than all six currencies being mapped as a hexagon or as a complex set of intersecting triangles? The common sense answer is that the dollar, euro, and yen are so much larger in economic size than the other three currencies. Geography of trade patterns and financial flows also play a role. These influences can be demonstrated as buttresses of the dominant triangle by looking at the British pound and Swiss franc in particular. First take the British pound. It makes no sense to consider a quadrilateral joining the US dollar, euro, yen and pound. The exchange rate between the pound and the US dollar or the pound and the euro is not in any significant way affected by events in Japan. And the exchange rates between the non-pound currencies (for example, US$–euro, US$–yen, and yen–euro) are not significantly influenced by events in the UK. It is useful to join currencies together into a geometric shape only if there is mutual interdependence between the currencies at each corner. For example, in the US dollar–euro–yen triangle already described, any given exchange rate can be influenced by the currency not forming part of that particular pair. Illustratively, the yen–euro rate can be affected by a US shock – for example, an unexpected recession in the US economy often sends the yen down and the euro up (on the basis of Japan’s especially high exposure to US economic risks). The dollar–euro rate can be influenced by, for example, a change in the direction of Japanese portfolio capital flows. Liquidation of euro-assets by Japanese insurance companies during much of 1999 and 2000 (scared by growing losses on huge purchases made in late 1998 ahead of the launch of the euro) were a factor in the weakness of the euro against the dollar. The strong demand for dollar assets from Tokyo in early 2001 helped to limit the weakness of the dollar against the euro in the face of a surprise downturn of the US economy and aggressive easing of

108 The Yo–Yo Yen

Federal Reserve policy. The yen–US dollar rate can be sensitive to European events. For example, an economic boom in the euro-area might push the euro up against the US dollar (as the current of capital flows across the Atlantic moved in the European direction) by more than against the Japanese yen (as Japanese capital flow to Europe was affected to a lesser extent than trans-Atlantic flows by the euro-area boom; a euro-area boom might also boost Japanese export prospects more than US in relation to economic size and this would be reflected in an upward move of the yen against the dollar). A triangle formed out of the British pound, euro, and US dollar at each of its respective corners would not make much economic sense either. The euro–US dollar rate is not sensitive to events in the UK. And though motion could be distinguished in analogous fashion to in the dollar–yen–euro triangle, the categories would in most cases not be meaningful without redefinition. Some types of motion, though possible in principle, would not occur in practice. For example, solo US dollar movement (dollar moving whilst pound–euro rate unchanged) would be better described as the pound being a satellite of the euro. (The dollar is not in practice moving on its own unless the yen–euro rate is steady also; if, rather, the dollar–yen rate is steady, it is misleading to describe the dollar as moving unilaterally, given the importance of financial and trade links between Japan and the USA.) Similarly, solo euro movement (euro moving whilst the dollar–pound rate remains unchanged) would be better described as the pound being a satellite of the dollar. (The small size of the UK economy relative to that of the US or euro-area makes the description ‘satellite’ appropriate. By contrast in the case of the yen, for example, when moving together with the US dollar, it would be inappropriate to describe the yen as a satellite, given that the Japanese economy is over 30 per cent of the size of the US economy.) The pound can move in a solo fashion (when it fluctuates sharply whilst the euro–US$ rate is broadly stable). But in practice solo movement is much rarer for the pound within the ‘pseudo’ exchange rate triangle formed from the euro, US dollar, and pound, than for any of the currencies within the euro–US dollar–yen triangle since the UK is a small open economy highly interdependent with the euro-area and the USA (the degree of interdependence with each varies over time – sometimes the UK economy is in a similar business cycle to that of the USA and at other times to that of the euro-area). In the late 1990s periods of solo movement for the pound usually corresponded to short-lived bursts of speculation as to whether the UK might become a member of the European Monetary Union. Axis dominance within the ‘pseudo’ US dollar–euro–pound triangle is fairly frequent with the pound moving between the US dollar and euro (up against one and down against the other). It is not very helpful however to describe this as euro–US dollar axis dominance as it may well be a time

Who Pulls the String of the Yo–Yo Yen? 109

when that same axis is not dominant in the real US dollar–euro–pound triangle. The frequency of the pound’s in-between movement (with respect to the dollar and euro) can be explained by the almost equal importance of dollar-related economies and the euro-area in the UK’s trade, and the almost equal degree of interdependence on average over time of the UK economy with the euro-area and dollar-related economies (of which the most important, of course, is the US). Other types of in-between motion within the US dollar–euro–pound triangle rarely occur in practice and would not correspond to any economic story. For example, for the pound to be at an opposite end of a pole to the euro (with the US dollar ‘in between’) or to the US dollar (with the euro ‘in between’) would require a powerful countering of the forces which tend to put the pound in-between. And it is not possible to put forward a plausible economic hypothesis under which the same factor responsible for putting the pound at the opposite end of the pole to say the dollar (euro) was also responsible for putting the euro (dollar) in-between. The UK economy is too small relative to the size of the euro-area or US economy to exert significant influence on them (or their currencies). If the pound were indeed mostly between the dollar and euro then it could be described as rotating around a dollar–euro axis. And if further the pound tended to be closer in its in-between motion to the dollar than to the euro (fluctuations against the dollar less than against the euro in the opposite direction) – and periods of satellite behaviour to the dollar were its next most usual form of motion (with satellite behaviour to the euro or solo motion being quite rare) – then it could be described as part of the dollar zone or even as a dollar currency. Membership of the euro-zone can be defined in analogous fashion (most of the time the pound would be either in-between the dollar and euro but closer to the euro or satellite to the euro with hardly any solo-behaviour evident). In practice, during the years 1995–2000 (see Figure 3.24), the pound could be described as a member of the dollar zone, with most of the period being characterised either by the pound behaving as a dollar satellite or moving in-between the euro and dollar but closer to the dollar than the euro. Could the yen be described in any sense as rotating around a dollar–euro axis albeit in a wide orbit or as an outer member of the dollar zone? In the early and mid-1970s it was just about possible to hypothesise such a geographical position for the yen. But subsequent history has provided strong evidence against the validity of that description. It is true that within the US dollar–euro–yen triangle the total length of periods of euro–US$ axis dominance (yen between euro and US dollar) since 1973 (to 2000) has been greater than of yen–US$ axis dominance (euro in between) but only modestly so (91 months versus 66 months out a total period of 324 months) (Table 3.9). And the considerable length of the total periods during which the US dollar has been in-between the euro and Japanese yen or during

Figure 3.24

Sterling, 1995–2001

Solo move by £ £ in-between USD and Euro £ satellite to USD £ satellite to Euro

1 2 3 4

110

Who Pulls the String of the Yo–Yo Yen? 111

which the yen itself has been in solo motion jars with the description of the yen normally rotating around a dollar–euro axis or as an outer member of the dollar zone. The same type of distinction can be made between a pseudo and real triangle in the case of the Swiss franc–euro–US dollar relationship. Interdependence does not exist between each corner, in the sense that events in Switzerland are not, in general, capable of having a significant influence on the euro–dollar exchange rate. (Very occasionally there have been instances of a Swiss event being the initial trigger to a more general move in the currency markets affecting the DM or euro against the US dollar – for example a tightening of monetary policy by the Swiss National Bank might be seen as the beginning of a general rise of European interest rates, bolstering the DM (or euro) versus the dollar; but these instances are of very short duration, and depend on Swiss events being a lead indicator of euro-area developments. It is the latter which are crucial to the initial movement of the euro–US$ rate in response to Swiss news being sustained.) Solo-movement by the Swiss franc has been roughly as frequent as by the British pound (but less than for any of the currencies in the US dollar–euro–yen triangle) (Figure 3.25). This may have something to do with large investment flows relative to economic size in the case of Switzerland and because the Swiss franc has certain unique features as a refuge. On the other hand, the Swiss franc has been between the euro and US dollar less often than the pound has been. This is because Switzerland’s trade with the euro-area is much more concentrated than the UK’s. Correspondingly, the Swiss franc has been a satellite of the euro (or previously the DM) for extended periods (meaning that the Swiss franc and euro move together against the US dollar). There have been periods of pseudo Swiss franc–US dollar dominance, with the euro (or DM) between – albeit closer to the Swiss franc than the US dollar (but never periods of pseudo Swiss franc–euro dominance with the US dollar between – that would indeed be extraordinary given the strong economic interdependence between the euro-area and Switzerland). The Swiss franc in such periods can be described as highly geared on the euro, or in the language of modern finance theory as a high-Beta euro. For example at a time when there is a worldwide shift of funds out of the dollar, the Swiss franc might gain a disproportionate amount because new demand (for the franc) is especially large relative to economic size (in the case of Switzerland); thus the euro would rise, but the Swiss franc would rise even more. The Swiss franc can be described as rotating around the euro–US$ axis but in an area close to the euro end. Its exact position changes across different episodes – sometimes the franc is between the euro and US dollar (as for example on occasions in 1999–2000 when the euro was under intense downward pressure); at other times the franc can be considered as

Figure 3.25

Swiss franc, 1995–2001

SF in-between USD and Euro SF satellite to USD SF satellite to Euro SF as high beta Euro*

2 3 4 5

Swings by more than euro against USD, but not an independent move.

*

Solo move by SF

1

112

Who Pulls the String of the Yo–Yo Yen? 113

an add-on beyond the euro end of the axis (as when behaving as a highBeta euro or DM). Sometimes (not often) the Swiss franc is doing its own thing (solo-movement). Does this description of the Swiss franc or sterling (in terms of their position with respect to the euro–dollar axis) have a counterpart in the case of the yen–dollar? Can we form pseudo triangles between say the Korean won, Japanese yen, and US dollar, or the Singapore dollar, yen and US dollar, or the Taiwan dollar, yen, and US dollar? Unlike the British pound and Swiss franc the currencies of these advanced small economies in Asia (South Korea, Singapore, and Taiwan) are not freely floating. Their exchange rate behaviour depends heavily on policies followed by their respective governments (or central banks). In determining the target bands for their exchange rates these authorities do pay some attention to the yen (hence when the yen is weak against the dollar they might lower the dollar bands for their currency). It is possible in the case of the Singapore dollar and Taiwan dollar to map out episodes during recent years of to and fro motion between the US dollar and yen, satellite behaviour with respect to the dollar (and, rarely, with respect to the yen), and occasional solo-behaviour (notably during the Asian crisis of late 1997) (Figures 3.26 and 3.27). The Korean won, however, does not fit into any obvious relationship to the yen–dollar axis.

Figure 3.26

Singapore dollar, 1992–2001

Solo move by SGD SGD in between USD and yen SGD satellite to USD SGD satellite to yen

1 2 3 4

114

Figure 3.27

Taiwanese dollar, 1992–2001

Solo move by TWD TWD in between USD and yen TWD satellite to USD TWD satellite to yen TWD geared on yen vs. USD

1 2 3 4 5

115

4 From Bubble Economy to Yen Bubble (1988–93)

It is quite possible to tell the story of the Japanese economy’s Lost Decade (1990s) as one of high speculative drama. Indeed, when recounted with skill, speculative panics and crashes make popular history, as J.K. Galbraith (1975) and C.P. Kindleberger (1977) found out in their respective volumes ‘The Great Crash 1929’ and ‘Manias, Panics and Crashes’. Surely, as the dust settles on the Lost Decade, an exciting historical narrative in the same spirit will emerge. The story would start with the fantastic bubble in the equity and real estate markets during 1987–90, continue with the equity market crash of 1990 and the long-drawn-out collapse of real estate prices. But that would not be all. There is the bubble of the yen that at its peak in early 1995 was at a fantastic level of 80 against the US dollar. In turn, the incredible appreciation of the yen was a catalyst to the huge direct investment into Asia by Japanese enterprises, the so-called hollowing out of Japanese industry, and in turn a huge speculative bubble in the Asian host countries. The inevitable bursting of the yen bubble was a key event leading up to the Asian crisis of summer 1997, as Japanese direct investment in East and South East Asia slowed and profits on exports from there (which had swollen due in part to the competitive advantage bestowed by the superexpensive yen) shrank. When the Asian bubble (summer 1997) burst the Japanese economy was whiplashed (1997–8) by a sharp decline in exports just at a time when its banking system was imploding under the weight of bad debts accumulated as a consequence of the real estate market slump and deep depression in the construction sector. The Japanese economy slid into its second major recession of the Lost Decade. In this recession, monetary policy was largely ineffective, as the years of the super-strong yen (1992–5) had helped turn Japan into a land of falling prices. Nominal interest rates could not fall below zero, and so real interest rates could not reach the negative level suitable for an economy in depression. The best hope for economic revival came from the exchange rate – the continuing slide of the yen providing a stimulus to the export sector. 116

From Bubble Economy to Yen Bubble (1988–93) 117

The next speculative shock came in autumn 1998, when there was a global liquidity crisis in the wake of Russia’s debt default. US hedge funds which had been major players in the so-called carry trade (borrowing yen to finance holdings of high interest foreign currency assets, mainly in US dollars) suddenly had to unwind their positions. The yen shot up almost 20 per cent in twenty-four hours – a bizarre event for the currency of the second largest economy in the world. But then, amongst all the gloom, suddenly the skies brightened over the Japanese economy. The fantastic bubble developing in the worldwide market in hi-tech equities, led by the National Association of Securities Dealers Automated Quotations (NASDAQ), pulled the Tokyo equity market sharply higher, reflecting Japan’s role as a major manufacturer of hardware for the so-called new economy. Indeed, Tokyo equities could even have been described as being in a new bubble in 1999. Japanese exports also experienced rising demand from another main beneficiary of the new economy boom in the US – the Asian ex-tigers and ex-cubs. When the NASDAQ bubble burst in late 2000 the second Tokyo equity market bubble in a decade burst and the Japanese economy slid into a new downturn. This last cycle of the Japanese economy – slump of late 1997 and 1998, recovery of 1999 and 2000, and downturn of 2001 – all occurred in the context of continuing price deflation, which could have been as much as –2 per cent p.a. if full account is taken of falling prices in the new economy. The severe deflation is the clue to one major missing ingredient in the attempt to discount Japan’s Lost Decade as a purely speculative epic. Substantial deflation is the result of extraordinary monetary conditions not necessarily in the present but at some time in the recent past. And for Japan the monetary origins of the deflation can readily be identified in the period 1990–5. The importance of money in explaining the Lost Decade carries us back to a well-known point made by Milton Friedman in the 1960s. The starting point of Friedman’s comment is a quote from J.S. Mill, the famous Scottish political economist of the early nineteenth century: ‘There cannot be intrinsically a more insignificant thing, in the economy of society, than money. It is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it; and like many other machines it only exerts a distinct and independent influence of its own when it gets out of order.’ Friedman then comments ‘But money has one feature that these other machines do not share. Because it is so pervasive, when it gets out of order it throws a monkey wrench into the operation of all the other machines. The Great Contraction (USA, 1929–33) is the most dramatic example, but not the only one.’ If the example had been to hand, Milton Friedman would doubtless have cited the Japanese Lost Decade of the 1990s. And in doing so he would

118 The Yo–Yo Yen

have poured cold water on the various bubble hypotheses, just as he was sceptical of explanations attributing the Great Contraction to the Wall Street Crash of 1929. But before considering the 1990s in greater detail, and in particular the specific contribution of the yo–yo yen, it is useful to set a few markers to the discussion. First, the Lost Decade was not a disaster on anything like the scale of the Great Contraction. Indeed in the first half of the decade, the average rate of increase in GDP per capita in Japan – at around 1.0 per cent p.a. – was broadly similar to the US and euro-area (Figure 4.1). It was in the second half of the 1990s that Japan seriously under-performed, with GDP per capita rising by 1 per cent p.a., compared to 2 per cent p.a. in the EU, and 3 per cent p.a. in the USA (Figure 4.2). The lost decade was a series of lost opportunities, not a period of actual economic decline. Second, in an open economy, when the money machine gets out of order, so does the currency machine. Specifically, serious errors in monetary policy are likely to set the stage for currency instability and an associated impairment of mechanisms that usually promote stabilising international flows of capital. In the case of Japan, extreme tightness of monetary policy in the early 1990s, coupled with a bizarre surge of the yen so inflamed perceptions of exchange risk held by Japanese investors that the huge private sector savings surplus could not flow smoothly into foreign investments.

Figure 4.1

Japan, US and euro-area GDP per capita (real, normalised), 1990–5

From Bubble Economy to Yen Bubble (1988–93) 119

Figure 4.2

Japan, US and euro-area GDP per capita (real, normalised), 1995–2000

Japanese economic policy-makers failed to realise the scale of the damage and its consequences. And, indeed, two out of three Bank of Japan governors (during the 1990s) made the problem worse by fuelling investor concerns about the risk of foreign exchange losses. They repeatedly extolled the benefits for Japan of a strong yen and indicated that large current account surpluses could result in the yen rising further. Instead, the governors, and other Japanese economic officials, should have been trumpeting the message worldwide, and particularly in Washington, that Japan’s huge private sector savings surplus should flow into foreign assets and this would mean a weak not strong yen. Third, bubbles make an exciting narrative. But as actual phenomena they are elusive. Indeed, some fans of the so-called market efficiency doctrine maintain that bubbles never exist. With hindsight, investors’ expectations may have been over-optimistic – but at the time of the ‘bubble’ there was always a rational story to tell which could justify prices. Some economisthistorians have even gone so far as to say that the tulip-bulb ‘mania’ in seventeenth-century Holland was indeed rational, as was the South Sea Bubble. Of course a rational explanation can always be found for any market movement, including a bubble – a bit like Voltaire’s Candide managing to square any event, however terrible, with ‘all being for the best in the best of all possible worlds’. But the key question is whether the rational investor would have given the hypothesis used in rationalisation after the event sub-

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stantial significance (indeed approaching certainty) before the event. For example, US equity prices in summer 1929, just prior to the Crash, were not expensive if you believed for certain that the good times of the 1920s would continue – rapid economic growth and rapid profits growth included, driven by rapid technological change. Similarly, technology shares at the height of the NASDAQ boom, in early 2000, were not overvalued if you believed that the US economic miracle had many more years to run. But in both cases there were alternative possible scenarios on which a normally cautious investor should surely have put substantial probabilities of occurrence. Failure of the market to do so implied either a weakness of imagination (inability to assemble from present facts a set of scenarios about the future which did indeed span the broad range of future possible realities) or faulty judgement (faulty estimation of each scenario’s likelihood). In this chapter, the narrative starts with the Japanese economic boom of the late 1980s. This period of Japan’s economic history is now labelled as the bubble economy. The aim is to trace the links between the bubble and, subsequently, bust in the real-estate and equity markets on the one hand and the emerging bubble of the yen on the other. Bank of Japan policy (including statements by its Governor) is a crucial element in the story which runs here through to summer 1993. In the next chapter the story continues with the bubble of the yen reaching its maximum size in early 1995, its subsequent bursting, and the violent fluctuations in the currency market which followed during the next half-decade.

Japan’s economic boom, 1988–90: in search of irrational exuberance In the late 1980s the Japanese economy was in a powerful economic boom (around 6 per cent year-on-year GDP growth through 1988–9). Contemporaries attributed the good times to a number of causes: (i) the easy monetary policy pursued by the Bank of Japan (which after a few months of higher rates following the Plaza Accord had cut rates sharply and allowed monetary growth to accelerate as an offset to deflationary pressures from the huge jump in the yen); (ii) money and capital market liberalisation (banks were now free to compete for deposits – meaning their profit margins were under pressure and yet at the same time they were losing their big loan customers to the capital market, and real-estate related lending promised to be a cheap and profitable way of expanding their balance sheets, and credit growth picked up swiftly); (iii) rapid growth in business investment both in construction and elsewhere in the economy was being fuelled by a low cost of capital in a buoyant equity market; (iv) the ageing of the population and increasing leisure time was inducing a big increase in demand for leisure activities and this presented exciting new investment opportunities; and (v) Japanese business management of manufacturing processes had become the best in the world and increasing capital

From Bubble Economy to Yen Bubble (1988–93) 121

intensity of production was going along with rapid productivity growth. Despite fast economic growth, inflation remained very low, held down in considerable part by the huge rise of the yen from 1985–8 so businesses had no reason to expect an early policy-induced end to boom conditions. There were a few distant clouds on the horizon, but they might well disperse rather than get larger as the economy moved forward. One concern was the visible amount of speculative activity in real estate and equity markets. But this was not the first time that the modern Japanese economy was experiencing a real-estate boom. There had been two episodes of price explosion during the miracle years – in 1960–1 and 1973–4 – and then a further boom in the years around 1980. As regards commercial real estate in the Tokyo area, the nominal price explosion of the late 1980s (measured cumulatively over the years 1985–90) was smaller than the first (1960–1), comparable to the second (1973–4), and of a larger size than the third (which was dominated by residential real estate). The first explosion was ratified by a subsequent decade of economic miracle. The second explosion was reversed in real terms by the inflation surge of the mid-1970s. The explosion of the late 1980s had a quite different denouement – huge falls in the price of real estate, rather than economic miracle or high inflation. But that is running ahead of our narrative. From the viewpoint of the late 1980s, the current boom in Japanese land prices was similar, if not milder, than that which was occurring simultaneously in the UK or in Scandinavia. Furthermore, there was some basis in economic fact for a powerful rise in real-estate prices in Japan at this time. The real-estate boom had started in the greater Tokyo area, particularly in commercial districts, back in 1986 and 1987, a tendency which spread then to residential areas and then to the provinces. The Bank of Japan, in a study published in April 1990, put considerable emphasis on the increase in real demand for land caused by the growing concentration of economic functions in the greater Tokyo area (whilst not playing down a variety of speculative factors). Commercial rents were rising in line with land prices, indicating the considerable strength of underlying demand for space. In particular the hollowing out of the Japanese economy triggered by the huge appreciation of the yen meant a decrease in the share of industrial production and an increased importance for the service sector. This lay behind an increase in demand for commercial space in the big cities. In fact, before the Plaza Accord and the subsequent run-up of the yen, demand for space in Tokyo had been growing rapidly with office space utilisation reaching virtually 100 per cent. The insurance, financial and information industries were the most aggressive bidders for space. It was indeed plausible that the real-estate boom would burn itself out. In 1988 there was a mini-downturn in Tokyo. Overall price indices for the Tokyo real-estate market stalled. In fact there were areas in the suburbs of Tokyo in which land prices after a sharp rise in 1986–7 declined as much as

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20–30 per cent in 1988. This passing weakness in Tokyo real-estate prices appeared to be related in part to the Wall Street Crash of October 1987 and a related retrenchment of international financial institutions. It was also plausible that the equity market bubble would eventually burst from within. The fantastic valuations could just about be defended by analysts who were 100 per cent certain that the Japanese economy would continue to grow at 6 per cent p.a. with productivity rising at 4–5 per cent p.a. (as recorded in 1988) (Figure 4.3). But surely there was a substantial likelihood that recent strong productivity growth was a cyclical phenomenon – a surge in demand when labour markets are already tight can foster efficiency gains at first until the scope for these are exhausted, after which unit labour costs rise and profits growth slows. If reality indeed turned out to be worse than the euphoric consensus would have it, then a big fall would occur in Tokyo equity market values. The idea that speculative bubbles burst of their own accord and that monetary policy-makers should largely ignore them, focusing instead on the overall level of prices for goods and services, has a strong following amongst monetary economists. Milton Friedman and Anna Schwarz (1963) put forward the doctrine first as one conclusion to their Monetary History of the United States. They found that the Federal Reserve of the late 1920s tightened monetary conditions excessively out of concern at the amount of speculation in the US equity market. In consequence the US economy

–

Figure 4.3

Japan productivity growth, 1985–90

From Bubble Economy to Yen Bubble (1988–93) 123

entered an unusually steep contraction in the third quarter of 1929 – in advance of the Wall Street Crash. In the late 1990s, the Federal Reserve under Chairman Greenspan largely followed the advice of Friedman and Schwarz, reformulated in the so-called ‘Blinder doctrine’ (ignore the bubble; but when it bursts follow a policy of aggressive ease as needed to avoid financial crisis). Some critics argue, indeed, that the Greenspan Federal Reserve made the opposite error to the Federal Reserve of the late 1920s. Whilst Alan Greenspan warned of irrational exuberance at the beginning of the boom, by the end he and his colleagues had become cheer-leaders for the new economy. In the late 1980s, the Bank of Japan under Governor Sumita also followed the advice of Friedman and Schwarz and ignored the bubbles in the land and equity markets (tolerance stemmed in part from concern at the huge rise of the yen since the Plaza Accord and the damage that this might inflict on the Japanese economy). Unlike Alan Greenspan, Governor Sumita did not engage in any substantial commentary to either restrain or justify the exuberance at large. Some window guidance was given to banks with respect to reining back their lending to the property sector, but this was largely circumvented by routing loans via financial subsidiaries. The Bank (operating in conjunction with the Ministry of Finance, which at that time still had a voice in monetary policy-making) only started to tighten monetary policy in 1989 out of anxiety about incipient inflation pressures. Before 1989 the inflationary climate was indeed wholly benign, in large part due to the huge appreciation of the yen through 1985–7, but also to the surge of productivity in 1988. Even as late as March 1989, there seemed to be no inflation problem, though some concern existed about the possible impact on inflation expectations of a new consumer tax to be introduced in April 1989 (and which could push the price level up by as much as 2 per cent). The Bank of Japan, in a research paper (Special Paper No. 174) published in March 1989, described the virtuous circle in the Japanese economy in which rapid growth and price stability were co-existing. Favourable influences cited were the decrease in import costs, a decline in unit labour costs, subdued inflation expectations, and an increase in cheaper imports, reflecting structural changes in the economy brought about by the appreciation of the yen. Nonetheless, the paper concluded ‘pressures will inevitably mount, albeit gradually, which might undermine present price stability. It is vital to keep a close eye on prices, so that the foundation of price stability will not be eroded. On the macro-economic policy level, the Bank of Japan intends to act promptly and appropriately should it be necessary.’ Inflation did indeed start to rise from spring 1989, but only to a modest extent, especially when the consumption tax effect is excluded (a tax increase should form no part of core inflation measurement). Measured by the private consumption deflator, year-on-year inflation in Japan in the

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final quarter of 1989 (including the consumption tax effect) had increased to 3 per cent (around 2 per cent without the tax effect?), compared to 1.5 per cent at the end of 1988 (Figure 4.4). In 1990–91 the same measure of inflation peaked at just below 3.5 per cent (equivalent to around 3 per cent p.a. without a delayed tax effect?). Inflation then fell steeply through the recession of 1992/3. An inflation rate reaching around 3 per cent at the peak of a boom would be acceptable to most central banks following a price stability target (usually meaning inflation of below 2.5 per cent on average over the course of the cycle as a whole). Given the usual lags between monetary policy and its influence on inflation, the Bank of Japan could be criticised for not having tightened policy somewhat sooner (in 1988). Earlier monetary tightening would have allowed the Bank to avoid being confronted later with the dilemma as to whether it should enter into monetary overkill (to prevent a wage–price spiral developing) or to sit it out with a moderate tightening only on the basis of forecasts that inflation would fall as the economy slowed. In practice, the Bank of Japan under Governor Sumita did tighten monetary policy significantly through 1989, partly in response to the actual rise in inflation, and also pre-emptively so as to prevent a further acceleration into 1990–1. By the time Satoshi Sumita retired in December (1989), call money rates had moved up 200bp from the start of the year to around 6 per cent. There was a respectable case to be made for arguing that was

– – – Figure 4.4

Japan inflation, 1987–94

From Bubble Economy to Yen Bubble (1988–93) 125

enough, especially as the US economy was slowing sharply (Figure 4.21), and given the considerable possibility that a further deflationary influence could come at any time from an autonomous bursting of the real-estate and equity market bubbles. True, money supply growth was still rapid, but it had slowed to less than 10 per cent year-on-year (from 12 per cent p.a. in late 1988) (Figure 4.5). There was also considerable doubt about the significance of the data in a period of money market liberalisation (new money market certificates which banks could now issue were competing with other forms of savings outside the monetary aggregates). Some monetary economists have applied the technical criticism that the so-called Taylor rule suggested considerable further tightening was indeed necessary in 1990 (see McCallum, 1999). But that line of criticism is unconvincing. The Taylor rule is not prescriptive. It is an equation that describes how central banks typically respond (in terms of their setting of short-term interest rates) to deviations of an economy away from productive potential and to inflation away from target. There is nothing in the rule about how central banks should or do respond to the forming or bursting of asset bubbles or more generally how to take account of possible shifts in the natural rate of interest (at which savings and investment – including net capital exports – balance at a level of economic output equal to productive potential). And application of the rule requires estimates to be made of the economy’s productive potential, the average real rate of interest and

– Figure 4.5

Japan money supply, 1988–94

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inflation expectations, which in Japan of 1989/90 could hardly be made with great confidence.

Yasushi Mieno becomes Bank of Japan Governor, December 1989: Makes false diagnosis of yen weakness At this point a change occurred at the top of the Bank of Japan which was to prove full of consequence for monetary policy, the yen, and the economy. Yasushi Mieno replaced the retiring Satoshi Sumita as Governor of the Bank of Japan. The Economist magazine in a lead article described the outgoing governor as an ‘urbane Francophile’ who had been an outsider to the Bank of Japan – a former vice-minister from the Ministry of Finance. The 65-year-old Mieno had joined the Bank in 1947. His father had been a banker in Manchuria before the war from where the family had returned impoverished. As a youth he sold soap and lived in a sumo stable – ‘few jobs are more humbling than serving vats of sukiyaki and playing valet to sumo wrestlers’ – to work his way through high school, then went on to the elite Tokyo University. Yasushi Mieno’s career at the Bank of Japan had taken him through the ranks and upwards to the positions of head of the personnel department, the general affairs department, and the business bureau, and during the previous five years he had been deputy governor to Sumita. From 1958 to 1960 he had worked in New York. In 1965 he had played a key role within the Bank in the rescue of Yamaichi Securities. In the 1970s he had been a personal aide to Governor Tadashi Sasaki, a Bank of Japan careerist derided for buckling under pressure from one of Japan’s most powerful post-war prime ministers, Kakuei Tanaka, and thereby bearing responsibility for the inflation surge of the mid-1970s. After the Plaza Accord he had played an important technical part in effecting the foreign exchange market intervention aimed at driving down the dollar. The Nihon Keizai Shimbun commented that the new governor had attended many international meetings and made friends with overseas financial officials. The newspaper continued, ‘Mieno often goes to art museums, and enjoys shopping with his wife on holidays. These shopping trips, Mieno’s neighbours say, are Mr. Mieno inspecting consumer prices.’ These inspections would reveal eventually a phenomenon in Japan not seen since the 1920s. As Governor, Yasushi Mieno was to follow policies that had as their consequence not just the arresting of inflation but finally deflation (i.e., falling prices). Looking at the conduct of Japanese monetary policy under Bank of Japan Governor Mieno several points stand out. First, he was a ‘Bank of Japan man’ – determined to wrest more power for his institution and to decrease any constraints from outside, particularly from the Ministry of Finance.

From Bubble Economy to Yen Bubble (1988–93) 127

Second, there was a complete disdain for policy rules of any sort – whether money supply targets or inflation targets. If from the start there had been an inflation target of say 2.5 per cent p.a. (averaged over the business cycle as a whole) and the central bank had set monetary policy so as to achieve the target over the medium term (allowing for the normal lags), then policy should not have been nearly as tight as it was. The march towards deflation was unannounced, unintended, and unsignposted. Third, Governor Mieno had a socio-political mission, which clouded his judgement about appropriate monetary policies. He saw the speculative fervour that had grabbed Japan in the late 1980s as a disease that had to be eradicated, not least because of its criminal dimensions (the involvement of the Japanese underworld). In his view, economic pain was acceptable and indeed an inevitable part of accomplishing that mission. Fourth, Yasushi Mieno was a strong yen enthusiast – he saw currency strength as a catalyst to economic reform (cheap imports would help overcome various barriers within the Japanese economy and spur efficiency). And he considered a central part of his mandate to be the almost continuous expressing of views on the yen and its appropriate level, even though legally it was the Ministry of Finance, not the Bank of Japan, which oversaw foreign exchange intervention policy. In analysing equilibrium exchange rates his focus was largely on the current account of the balance of payments. A large current account surplus for Japan, in his view, meant that the yen had to be strong. More ‘modern’ ideas about capital flows, driven by divergences between savings rates and investment opportunities playing an important role in exchange rate determination, found no place in his public remarks. These four characteristics of Yasushi Mieno’s governorship emerge as the vicious circle of monetary error, and destabilising exchange rate fluctuations unfolded through the early 1990s. But before starting the narrative, there is the general point to consider of how important any one person can be in monetary or exchange rate drama. Certainly there have been colourful histories (for example, Hetzel, 1998; Wells, 1994) of how Arthur Burns, Chairman of the Federal Reserve during 1970–7, bore much responsibility for high inflation in the USA through the 1970s, and of how Paul Volcker restored stability. But could Burns have overridden strong opposition from his colleagues on the FOMC and in Congress? Probably not – responsibility of the central bank chief must be tempered by the failure of those in powerful positions around him or her to articulate concerns and try to steer an alternative course. In the case of Yasushi Mieno, here was a man who had been an official all his working life, hardly a great publicist in the image of Arthur Burns. We must assume that Yasushi Mieno’s decisions on monetary policy reflected a considerable consensus among senior Bank of Japan officials at that time and from elsewhere in the economic policy-making establishment. There was a ‘failure of the system’ to generate a strong alter-

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native view on appropriate monetary policy or to correct the fallacies in the Governor’s analysis. The story starts with a 0.5 per cent hike in the Bank of Japan’s discount rate to 4.25 per cent (Figure 4.6) (note that at this time the discount rate was well below money market rates) just a week after Mieno took office (17 December 1989). There had been strong rumours in the days up to the rate hike about impending action (press reports based on Bank of Japan sources). But Finance Minister Hashimoto had denied the reports and expressed his view that a discount rate rise was unnecessary. The Financial Times commented (on 23 December) that a rare public row between the Bank of Japan and the Government over the need for an official discount rate increase flared again yesterday as Mr. Mieno, the bank’s new governor, hinted publicly that a rise was necessary. Mr. Ryutaro Hashimoto, the finance minister, promptly rejected the governor’s comments. Tokyo’s financial community is agog over the row, which has cast something of a pall over the entry of Mr. Mieno, a long-time Bank of Japan official, to the governor’s office on Monday. As a rule, new governors, like other top Japanese officials, spend the first few months of their tenure paying courtesy calls on the great, the good, and the influential, while leaving their responsibilities to others.

Figure 4.6

Japan money rates, 1989–95

From Bubble Economy to Yen Bubble (1988–93) 129

Two significant comments for the future came out of Mieno’s press briefings made at the time of the rate hike. First, referring to the timing of a change in the discount rate, Mieno stressed that the Bank of Japan, as the watchdog of prices, must raise the rate whenever necessary, by overcoming difficulties including the so-called ‘taboos’ (meaning prior agreement with the Minister of Finance). Jiji newswires quoted Mieno as saying, ‘although the government might have its own convenience, it also understands that a rate hike should be carried out when needed.’ Second, the new governor expressed the hope that the interest rate hike would contribute to the correction of the yen’s ‘weakness’ – thus hinting already at his preference for a ‘hard’ yen. A report in the Nihon Keizai Shimbun on 30 December 1989 went further. ‘According to sources, Mieno and other bank officials are concerned that the weaker yen, rising land prices, and manpower shortages, amongst other factors, will prove inflationary, unless the discount rate is increased. While the Deutsche mark has strengthened against the dollar, the yen has been left behind. For example, the yen in inter-bank trading averaged 144 to the dollar in November, 17 per cent lower than 123 a year ago (Figures 4.7 and 4.8).’ But how could anyone, unless suffering from severe time myopia, have assessed the yen as weak in late 1989? After all there had been the heady rise of the yen from the Plaza Accord (autumn 1985) until the Louvre

Figure 4.7

US$ vs. DM and yen, 1987–92

130 The Yo–Yo Yen

Figure 4.8

Yen vs. US$ and DM, 1987–92

Accord (spring 1987), during which time the yen/dollar rate had moved from around 240 to 140. Since then the yen had been on a volatile but flat trend – appreciating first to a peak of near 120 in the immediate wake of the Wall Street Crash (October 1987) and then falling back, with the DM, through late 1988 and early 1989 as the US dollar was in a solo-rise spurred by the continuing sharp tightening of US monetary policy. In the face of rising inflation, the Greenspan Federal Reserve acted promptly to reverse the excess monetary creation that had occurred around the time of the Wall Street Crash (when the top priority had been to avoid the risk of recession). From spring 1988 to spring 1989 the Federal Funds rate rose by 350bp to almost 10 per cent (Figure 4.9). The yen/dollar rate was back to the Louvre level of around 140. For the rest of the year (1989), the yen/dollar rate had drifted down only slightly against the dollar but had fallen sharply against the mark. That movement – yen down, mark up, and dollar in between – could have been seen as an early indicator of the US economic slowdown already developing (Figure 4.21) (the basis of this indicator property is described more fully below, turning essentially on sensitivity of Japanese economy to US and Asian demand). In any case the particularly sharp rise of the mark (against both the yen and the US dollar) had a direct source in the rapid disintegration of the German Democratic Republic (East Germany) as floods of refugees poured into West Germany (via Czechoslovakia). In November,

From Bubble Economy to Yen Bubble (1988–93) 131

Figure 4.9

Japan vs. US money rates, 1986–91

the Berlin Wall opened. Foreign exchange markets discounted a sharp rise in German interest rates caused by a surge in the demand for capital to rebuild the East. It is odd in that context why Yasushi Mieno and his colleagues would have been troubled by the rise of the DM and the failure of the yen to keep pace. And they must have been aware of the Greenspan Federal Reserve’s concern, as symptomised by a 200bp drop in Federal Funds rate from its peak level in the spring (Figure 4.9), about the sudden slowing of the US economy. In fairness, myopic exchange rate vision was not just in evidence amongst policy-makers in Tokyo. Back in the late summer and autumn (1989), Washington had organised G-7 intervention in the currency markets aimed at combating ‘excessive’ strength of the dollar against the yen. But Washington’s myopia with respect to the yen–dollar rate was not an affliction but a cynical pulling down of the shutters. The US Treasury was not set on determining the long-run equilibrium value of the yen–dollar rate but on aiding the Bush Administration to reach an accommodation with Congress over trade policy. A stronger yen would help placate the mercantilists in Congress. In March 1989, the Bush Administration, under tremendous pressure from Congress, had branded Japan an unfair trader suitable for retaliatory action under the Super 301 provision in the Trade Bill passed the previous year (August 1988). In June 1989 Washington and Tokyo had agreed to

132 The Yo–Yo Yen

start so-called Strategic Initiative negotiations aimed at averting action. The idea was to agree on a package of economic reform measures in Japan that would placate Congress and allow the Bush Administration to cross Japan off the 301 list before the deadline for sanctions (spring 1990). One key area where US negotiators achieved success was the demand that Japan raise its public investment spending – the aim being to reduce the overall savings surplus and hence the current account surplus, with a stronger yen being a part of that solution. In the final agreement signed in June 1990 one of Tokyo’s commitments was to 430 trillion yen of public works spending over the next ten years, an increase from 6.7 to 9 per cent of GDP. Unlike their counterparts at the US Treasury, economists at the International Monetary Fund were able to take a longer-term view on exchange rates. The spring 1990 World Economic Outlook stated that it would be inappropriate for Japan to adopt financial and fiscal policies aimed (via yen appreciation) at reducing its trade surplus. The world (according to the IMF) was running out of sources of capital to finance the economic development of Eastern Europe and developing nations. Therefore Japan’s role as a capital supplier was becoming essential. This was a rare example of the IMF distancing itself from the view that Japan’s current account surplus was a bad thing. Even so, two criticisms can be made of the IMF’s view. First, as a matter of fact, Japan in 1989 was running its smallest current account surplus for years as the bubble economy sucked in imports at a voracious rate. Second, the appropriate balance between savings and investment in Japan should hardly be decided on the basis of so-called global need. That is the language of a command economy. Rather the balance should be an equilibrium outcome influenced by market forces reflecting the array of savings rates and investment opportunities throughout the global economy. Nonetheless the IMF had put down a marker. A Japanese current account surplus was not bad in itself. Why did Governor Mieno fail to take any cue from the IMF ? A cynical view is that he was a puppet of powerful antireformers in the Japanese business and political world. The best way of deflecting US pressure for reform was to push the yen higher. Then the Bush Administration could settle for less reform and still reach agreement with Congress on not applying sanctions. (Reform was of course multifaceted, involving greater opportunities for US exporters to Japan and also opening up the Japanese business world to increased foreign participation, particularly in the financial and insurance industries. A strong yen would please US exporters, and US industry faced with Japanese competition, but it would do little to advance the aims of US enterprises faced with regulatory or other types of barriers to selling services in Japan often by opening up subsidiaries there or buying up Japanese companies.) There is no evidence, however, for Yasushi Mieno being an active participant in such an

From Bubble Economy to Yen Bubble (1988–93) 133

anti-reform strategy. Indeed, quite the opposite: he spoke in favour of economic reform (as we shall see below). At most, anti-reformers within the economic policy-making establishment would have been quite happy with his hard yen leanings. Was there any basis other than myopia (concentrating on the 20 per cent fall of the yen over the previous year rather than its more than 100 per cent rise from 1985 to end 1987) or faulty analysis (arguing that the yen should rise just because Japan had a trade surplus, rather than taking account of the balance between savings and investment in the economy and the pressure of capital outflow) for Mieno to have considered the yen to be undervalued in late 1988? There were two possible strands of argument, albeit unconvincing ones. First, suppose the rate of return to capital (or, equivalently, the amount of investment opportunity) in Japan had really increased in the late 1980s and the rate of personal savings had really fallen (as justified by new optimism about the long-run outlook for the Japanese economy). Then the amount of surplus savings and momentum of capital outflows would have diminished from the norm in the first half of the 1980s, especially if investment opportunity elsewhere, especially in the USA, had shrunk (disillusionment with Reaganomics). That would go along with a rise in the equilibrium value of the yen (although it is far from obvious that the new equilibrium would be higher than the reference range around 140, which formed part of the Louvre Accord). In his public remarks, however, Governor Mieno gave no indication that he believed in a new Japanese economic miracle. Quite the contrary: he spoke of excessive speculation and unjustified euphoria. His drive to push up interest rates to extraordinarily high levels was never justified (in public) by a view that these were indeed appropriate to the new long-run dynamism of the Japanese economy but rather that they were necessary to burst once and for all a dangerous speculative bubble. A second justification for seeing the yen as undervalued in late 1989 was that capital outflows were at an unsustainable high level, driven by the same speculative craze as other forms of so-called ‘zai-tech’ (making large profit from financial investment). The huge wealth gains created by the land and equity market bubbles had made Japanese investors unusually willing to assume foreign exchange risk in the pursuit of high returns. Governor Mieno may well have been sympathetic to this view based in common sense. But there was a flaw. Yes, if the bubble burst, there might be less speculation in foreign assets. But the fall in interest rates that would accompany the bulge in the private sector savings surplus (a crash should be a catalyst to higher personal savings and lower business investment as households and corporations retrenched) would surely mean a greater momentum of capital outflow in the long run even if the recent speculative element burnt out. Overall, a

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bursting of the speculative bubbles might bring less of a fall in the yen than would have occurred if there had been no zai-tech in foreign investments – but most probably there would still be a fall.

Tokyo equity market crash 1990 brings only brief fall of yen The Crash was not far off. In the first quarter of 1990, the Tokyo equity market slumped by 25 per cent from its peak level of end-1989 (Figure 4.10). After a brief ‘dead cat bounce’ the market was down by 40 per cent from its peak by late 1990. The real-estate market slump is more difficult to chart than the equity market slump given the lack of ‘real time’ data. Official indices of land prices lag far behind market reality. Moreover the first indication of real-estate market slump is usually a collapse of liquidity as would-be sellers are reluctant to cut prices to the new market-clearing level. Nonetheless, there is strong reason to believe that the real-estate market had already entered a downturn in the first half of 1990. Real-estate companies and construction companies were at the forefront of the equity market slump, suggesting that a turnaround in the land market had already been recognised. The prices of golf club memberships were widely regarded as the best quoted indicator of the real-estate market and these had already peaked in February 1990 (and fell by over 40 per cent in the next eighteen months). In January 1990, the Nikkei News Bulletin was

Figure 4.10

Japan vs. US equity markets, 1987–93

From Bubble Economy to Yen Bubble (1988–93) 135

publishing survey evidence that suggested that the peak of the Tokyo land market had long passed. For example, on 9 January 1990, Nikkei news reported that ‘land prices in Tokyo and Kanagawa Prefecture which shot up in 1987 have passed their peak and fell during 1989, according to a real estate information company related to Misawa Homes Co.’. By late 1990 the evidence of a land market downturn was undeniable. The Ministry of Construction reported falling resale prices of homes in Tokyo, Osaka and Nagoya. A plunge in the number of real-estate transactions taking place was putting realtors out of business at a record pace – the highest level since the recession of 1974–5. Already in early 1990 US credit-rating agencies had begun to downgrade Japanese banks, citing their overexposure to ‘the grossly inflated Japanese commercial real estate market’. As we discussed in the previous chapter, a sharp decline in asset markets brings downward pressure on the national currency. This occurs via a rise in the households savings rate (as wealth gains no longer fuel consumer exuberance) and a fall in the business investment rate (as corporations lose access to cheap capital and profit prospects dwindle). The implied rise in the private sector savings surplus means greater capital exports. A new equilibrium is eventually reached with a higher current account surplus, higher private sector savings surplus, higher capital exports, lower interest rates, and a lower exchange rate (devaluation). Of course this equilibrium situation can take a considerable time to emerge, especially if there is no nucleus of market participants that are fully aware of the likely change in the savings–investment balance and its likely implication for currency values. In fact there was a sharp initial response of the yen to the asset market crash, as it fell in the first quarter of 1990 to almost 160 against the dollar (from around 145 at end-1989 and near 120 at the start of 1989) and to almost 95 against the DM (from around 90 at end-1989 and near 70 at the start of 1989). In real effective exchange rate terms the yen was now back down to a level barely 10 per cent above that of the 1980–4 period and most of the post-Plaza appreciation had melted away (see Figure 2.1). This pattern of exchange rate decline following the bursting of asset market bubbles was indeed observed, albeit over a longer time-span, in other advanced industrialised economies in the late 1980s and early 1990s, with the interesting exception of Switzerland. Two examples that stand out are the UK and Finland. Feverish real-estate speculation occurred in both countries in the late 1980s. In the aftermath of the bubbles bursting both the British and Finnish currencies fell sharply (Figures 4.11 and 4.12). (Sterling’s decline was delayed until the UK’s exit from the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) in autumn 1992.) The sharp rise in the current account surplus and fall in the exchange rate played key roles in short-circuiting a threatening process of deflation (Figure 4.13). But that did not occur in Switzerland or Japan.

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Figure 4.11

Finnish mark real effective exchange rate, 1985–95

Figure 4.12

British pound real effective exchange rate, 1988–95

From Bubble Economy to Yen Bubble (1988–93) 137

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Figure 4.13

Japan, UK and Finland current account balances (% of GDP), 1987-95

In Switzerland, the tremendous real-estate boom at the turn of the decade (1989/91) coupled with booming exports to Germany following unification brought the economy into a near bubble-state. The bursting of the bubble did bring a sharp fall of the Swiss franc in late 1991 and early 1992 but then it rose sharply over a 3-year period until mid-1995 (Figure 4.14). Amidst turmoil in the European Monetary System during late 1992 and 1993 the Swiss franc was in demand as a safe-haven and it rebounded. Then as the likelihood of European Monetary Union increased, despite the break-up of the fixed-exchange rate mechanism (ERM) in mid-1993, the Swiss franc enjoyed inflows from, particularly, German retail investors anxious about the eventual disappearance of the DM. Furthermore, like the Bank of Japan, the Swiss National Bank was guilty of monetary overkill during the late stages of the bubble and beyond into the early stages of recession, although the inflation run-up in Switzerland had been more serious (Figures 4.15 and 4.16), justifying in part the severe course taken. Through the early 1990s the Swiss budget deficit, like the Japanese government deficit, grew rapidly (Figure 4.17) as the government sought to reflate the economy – and this provided underpinning for the currency (because the rising private sector savings surplus was absorbed mostly domestically rather than via capital exports). From the early mid-1990s,

138 The Yo–Yo Yen 105

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however, Switzerland, unlike Japan, embarked on a major fiscal consolidation, and indeed fiscal conservatism became constitutionally enshrined. The overall scale of the monetary and exchange rate ‘deviations’ was in any case less for Switzerland than Japan (the Swiss franc in real effective exchange rate terms rose by only 20 per cent from its trough in 1990 to its peak in mid-1995) and the Swiss economy did not have to contend with a second big currency appreciation late in the 1990s. The mechanisms for recycling Switzerland’s private sector savings surplus into foreign assets worked well in contrast to the grave impairment which became evident in Japan during the late 1990s. Doubtless the robustness of capital outflow from Switzerland could be attributed in part to the launch of the euro and the associated general weakness of European currencies (including the Swiss franc). In Japan, the promising yen weakness of early 1990 soon proved to be a false dawn to post-bubble adjustment of the economy. First, in early spring (1990), there was a rebound of the yen against both the US dollar and DM – a solo-rise which took the yen back to the low 150s against the dollar and 90 against the DM (see Figures 4.18, 4.19 and 4.20). Then as the DM swung up against the dollar on the news of German unification the yen found itself in-between, rising to around 145 against the dollar and falling to 95 against the DM. Finally, through the summer and autumn, the yen pushed ahead with the dollar the weakest currency in the dominant US dollar–DM–yen triangle and the yen the strongest, with the DM in-between (yen–US$ axis holding sway, in the terminology of Chapter 3). By autumn 1990 the yen was back to near 130 against the dollar and 85 to the DM. In real effective terms the yen had appreciated to around its Louvre Accord level. In the last quarter of 1990 there was a brief fall of the yen – mostly against the DM but also against the dollar – on news of the US economy falling into recession. That move was a typical currency market response to the onset of US recession. It is justified by US interest rates falling relative to European rates and by the expectation that the Japanese economy would be the hardest hit because of its large exports to the USA and Asian countries (themselves highly dependent on the US economy). But by December there was a reversal with the yen recovering to near 130 against the dollar and somewhat less against the DM. This movement was partly due to the approaching Gulf War, in which Japan, unlike Europe and the USA, was a non-combatant, but still vulnerable to an interruption of oil supplies. How can we explain the overall strength of the yen in 1990 despite the bursting of its equity and real-estate market bubbles? One important factor was the ferocious monetary squeeze imposed by the Bank of Japan under Governor Mieno. The collapse in the asset markets and evident slowdown in the economy (the Japanese leading indicators had been declining in step

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with those in the USA ever since spring 1989 – see Figure 4.21) did not deter Mieno from pursuing his mission of smothering the bubble economy. He was not yet convinced that it was dead. Moreover, current inflation was still above 3 per cent, and he was unready to follow a policy based on a forecast fall of inflation. By contrast the Greenspan Federal Reserve was following a highly contra-cyclical policy. Whereas the Federal Funds rate had fallen from 8 to 6.5 per cent over the year as a whole (1990), the Japanese overnight call rate had risen from around 6.5 to 8 per cent (see Figure 4.9). There is also a more subtle explanation for yen strength in 1990. The emergence of an enlarged private sector savings surplus following the bursting of asset market bubbles and its influence on the exchange rate is not an overnight affair. There are many lags and possible short-circuits in the process. First, it is not entirely clear that the bubble has burst – big equity market bounce-backs are possible and data in the land market is very hard to come by in a timely fashion. Second, the revision of savings and investment plans does not take place immediately (albeit that on some occasions changes have occurred with remarkable speed). Third, even without a central bank governor following an antispeculative crusade, the fall of market interest rates may lag considerably

From Bubble Economy to Yen Bubble (1988–93) 145

behind the decline in the so-called natural rate of interest (at which the economy is in overall equilibrium given the raised savings surplus). Fourth, there might be a general misalignment of exchange rate expectations. (For example, investors may believe that a dollar rate of between 120 and 140 is consistent with a Japanese economy in external and internal equilibrium, but, in reality, the true range could be 180–220. Then the yen might eventually come under downward pressure and exchange rate expectations adjust in line as non-speculative capital exports exceeded consistently the trade surplus. But it is also possible that a prolonged period of exchange rate turbulence would affect the equilibrium outcome by inflaming Japanese investors’ perceptions of foreign currency risk.) In 1990 all four points contributed to the overall resilience and, indeed, strength of the yen. Bank of Japan Governor Mieno was the best-known sceptic regarding the bursting of the land market bubble. In most settings the central bank governor holds some sway over market opinion – unless he has lost all credibility and become a point of ridicule. That was not the unfortunate situation for Yasushi Mieno in 1990 (although two years later a powerful LDP politician was calling for his head to be delivered on a plate). Indeed, developments in the Japanese bond market during that year (with yields on a sharply rising trend until the autumn – see Figure 4.22) highlight that Governor Mieno was far from alone in failing to see that a big rise in the private sector savings surplus lay ahead, which eventually

Figure 4.22

Japan 10-year JGB yield vs. overnight call rate, 1990–5

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called for a much lower exchange and interest rate level. But economic historians can criticise Governor Mieno for having a role in pushing market expectations away from the equilibrium level (by continually favouring a strong yen and emphasising the necessity of a long haul to completely overcome speculation in the land markets). If, not withstanding Governor Mieno’s views, bond markets had been more efficient in terms of assessing the direction of the economy and trends in equilibrium interest rates, the yen might have fallen (overall) in 1990 regardless of the increase in short-term rates driven by Governor Mieno. In principle, and in practice, investors or borrowers are more influenced by long-term than by short-term interest rate differentials in their decision as to whether to switch between currencies. After all, a shortterm rate differential is likely to be swamped by any significant exchange rate move. If, in our example, yen bond yields had fallen to reflect the upcoming huge private sector savings surplus, capital outflow from Japan would have been stronger at this stage and the yen weaker. Instead, bond yields shot upwards in sympathy with short-term rates – illustrating that many investors believed that rates could remain high for a very long time to come, hardly consistent with a ballooning of the private sector savings surplus in a post-bubble economy. As an illustration, 10-year yields on Japanese government bonds shot up from 5.5 per cent at the start of 1990 to 7.5 per cent by the autumn, before falling back (Figure 4.22). That rise in yields was consistent with a view that Governor Mieno had adjusted money market rates up to a high natural level appropriate to an ongoing super-strong Japanese economy, as opposed to the view that he was puncturing a bubble economy with temporarily high rates (which would fall sharply as a huge savings surplus re-emerged). Indeed to many contemporary observers in late 1990 it was the US economy rather than the Japanese that was suffering the consequences of a punctured bubble (Figure 4.23). The simmering Savings and Loans crisis had combined with a severe downturn in several regional real-estate markets to threaten a banking crisis. In late 1990 rumours were flying that some of the largest US banks and other US financial institutions were in major trouble. A credit crunch was visible to all. If economic logic pointed to countries in a post-bubble phase requiring low interest rates and a weak exchange rate to offset a rising private sector savings surplus, then the US dollar was a more obvious case study than the yen at this point. Of course a far-sighted analyst would have pointed out that the rise in the US savings surplus was likely to be much smaller (relative to economic size) than in Japan, and that the bubble bursting in Tokyo was many times greater than the headline-grabbing real-estate market declines in various US metropolitan areas. There had already been an unmatched (in the USA) precipitous fall of the US Japanese equity market. But such analysis was not the moving force in the currency markets of 1990.

From Bubble Economy to Yen Bubble (1988–93) 147

Figure 4.23

Japan, US and (West) Germany real GDP, 1990–4

In the early months of 1991 the gloom surrounding the US economy suddenly lifted as the Washington-led allies repelled the Iraqi invasion of Kuwait and indicators suggested that the recession was over. The dollar rose from around 130 to 140 against the yen – but that move was modest compared to a much larger rise against the DM. Indeed by the second quarter (of 1991) the yen had levelled out at around 135, barely changed from late 1990, whilst the DM was still much weaker (than at the end of 1990) against the dollar. There was nothing strange about the yen moving closely with the dollar against the DM at a cyclical turning point. (As already described, this pattern stems from the importance to the Japanese economy of exports to the USA and Asia. In addition foreign capital inflows into the Tokyo equity market tend to be correlated with US cyclical indicators – albeit that this time there was little sign yet of a revival of foreign interest.) What was strange was the failure of the yen to fall with the dollar – and by more – in the second half of 1991 when confidence evaporated in a US upturn and the DM bounded ahead (Figure 4.19). Instead, the yen moved virtually in line with the rising DM despite the Bundesbank continuing to tighten monetary policy to fight the inflationary pressures created by unification (political union of East and West Germany had occurred the previous autumn). Whereas short-term German interest rates rose from 9 to 10 per cent in the second half of 1991, Japanese and US overnight rates both fell by around 200bp (Figure 4.24). By year-end the yen was at around

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Figure 4.24

3-month euro-yen, dollar, and DM rates, 1990–3

125 to the dollar. From mid-year on it was evident that the Japanese economy was in a sharp slowdown and the risk of a recession rising.

Bizarre strength of the yen in second half 1991 How can we explain the bizarre strength of the yen in the second half of 1991 – a clear episode of the yen pursuing a path radically different from that implied by theoretical considerations of how the currency should behave as a bubble economy bursts? A sample of quotes from contemporary media provides some insight: 4.6.1991 (The Mainichi Daily News) Masaru Hayami, newly appointed president of the organisation of leading companies (and, from 1998, the Governor of the Bank of Japan), in his first press conference as president, comments ‘the yen is undervalued against the dollar considering the strength of the Japanese economy. That’s because Japan’s politics and its economic and foreign policies are not trusted. The lack of political philosophy on the part of Japanese politicians has fermented the distrust in the Japanese currency.’ 18.10.1991 (Nihon Keizai Shimbun) ‘Monetary policies only targeting economic growth would disturb the improvement of imbalances and

From Bubble Economy to Yen Bubble (1988–93) 149

cause the yen to depreciate’, Mieno said. Earlier in the day, Miyazawa, who was expected to become prime minister early the following month, hinted that the Bank of Japan needed to reduce interest rates again soon. Asked about Miyazawa’s remarks, Mieno said ‘I listen to the views of others, but the Bank of Japan will decide its policy as its own.’ 22.11.1991 (Nihon Keizai Shimbun) Bank of Japan Governor Mieno rules out a further discount rate cut as a way of rectifying Japan’s growing external trade surplus. Temporary (in particular the German unification boom) rather than structural factors were responsible for almost all of the $40bn p.a. widening of the trade surplus in the first half of the fiscal year (April to September 1991). 27.11.1991 (Reuters) Reports on a speech by Bank of Japan Governor Yasushi Mieno say that Japan needs to make an effort to ensure that the yen will be steady to firmer in the long-term. Japan’s economic growth is likely to slow moderately for now, but is unlikely to decline sharply. Japan should continue to open its markets to cope with its growing current account surplus, but it should not adopt policies that will too easily stimulate domestic demand, which would endanger price stability (he said). In this context ‘Japan needs to make an effort to ensure a steady to relatively firmer yen in the long term.’ Japan’s current account surplus is growing but it is largely accounted for by temporary factors. 3.12.1991 (Reuters News) According to a pooling of six forecasts on the economy, ‘the slowdown that started in 1990Q4 should carry through until the middle of 1992 before easier money has an effect. GDP growth in 1992/3 (fiscal year) should be down to 3 per cent from 3.8 per cent expected this year.’ Many of the forecasts were bullish on the yen, partially due to expectations of a higher trade surplus. 4.12.1991 (Reuters News) Japan’s resurgent current account surplus is increasing pressure on financial authorities to take action by strengthening the yen. The Finance Ministry has announced that the surplus in October more than doubled from a year earlier. Salomon Brothers (Asia) Ltd. forecasts that Japan’s current account surplus will continue to swell, reaching $80bn this fiscal year ending March 1992, more than double 1990’s total. And the surplus will top $100bn next year. 16.12.1991 (Reuters News) Japan’s economy is now slowing, but this is part of an unavoidable process of heading towards more balanced growth from a period of excessively high growth in the past, Bank of Japan Governor Mieno said today. But the economy was unlikely to suffer a major downturn. ‘The economy still retains its underlying

150 The Yo–Yo Yen

strength.’ Mieno said corporate capital investment, a primary engine of economic expansion, was expected to remain strong. 18.12.1991 (Reuters News) Talk of a ‘mini-Plaza’ pact refuses to die completely. Currency dealers sold the dollar ahead of an October meeting of financial leaders from the Group of Seven (G7) nations in Bangkok on speculation, later proved wrong, that a mini-Plaza accord would be struck. The prospect of US President George Bush meeting Japanese Prime Minister Miyazawa in Tokyo in early January has sparked speculation that the two could publicly agree that a stronger yen is desirable. ‘Bush will come to Japan and the focus will be on Japan’s economy, especially the huge trade surplus’, said Fuji Research Institute chief economist Masaru Takagi. ‘Bush and top Japanese officials will agree on a higher yen against the dollar.’ Japanese officials have been talking of a stronger yen. ‘There is talk by both US Treasury and Japanese officials of the desirability for the dollar to ease further to the 120 yen level’, former US Federal Reserve Board vice chairman Manuel Johnson said in a speech in Tokyo on Friday. Bank of Japan Governor Mieno lent the reports credibility by commenting in an interview ‘the yen rate should reflect fundamentals, Japan needs to make a greater effort to stabilise the yen in the direction of a firm tone.’ Several key points emerge from these quotes. First, the Bank of Japan Governor and many economic commentators were far too optimistic – failing to perceive the risks of a severe recession, which indeed was to become reality in the following year. This false optimism and the failure to realise that a sea-change in the balance between savings and investment in the economy was occurring were, undoubtedly, factors keeping interest rates above their natural level and promoting yen strength. Second, the model of exchange rate determination used by the Bank of Japan Governor and by many market practitioners was simplistic and wrong. They had no doubt that the sharp rise of the trade surplus, which became apparent in the second half of 1991 (Figure 4.25), should mean a stronger yen. They were blithely unaware of the argument that the rising trade surplus was merely a reflection of weakening investment and rising savings and that this should be accompanied by lower interest rates, increased capital exports and a weaker yen. Third, the clear messages from the Bank of Japan Governor that a stronger yen was to be expected and similar signals from G-7 meetings had an impact on market sentiment. Whereas capital exports would normally accelerate markedly as the savings surplus increases, the continual harping by officials on the need for yen appreciation must have acted as an impediment. Enlightened high-up economic policy-makers should have been

From Bubble Economy to Yen Bubble (1988–93) 151

– – –

Figure 4.25 Japan vs. US current account balance (excluding transfers) as a % of GDP, 1987–95

pointing the way to lower interest rates and a weaker yen – Yasushi Mieno was pointing in the opposite direction.

As Japan economy slides into recession, yen fails to decline, 1992 Governor Mieno did not change his mind in the New Year (1992) despite growing evidence that the Japanese economy was experiencing a full recession. Through most of the first half of 1992 the yen moved closely with the DM against the dollar, falling in the first few months on encouraging evidence of a US economic recovery, and then rising through the spring on speculation that the Federal Reserve would ease policy further as US unemployment data continued to disappoint expectations in an election year. Over the summer quarter the Greenspan Federal Reserve did indeed cut key short-term rates, by a cumulative 75bp bringing them to a lowpoint of 3 per cent, and the dollar continued to fall back. But now the decline was considerably sharper against the DM than the yen (Figure 4.19) – reflecting the continuing bad news (about recession) from the Japanese economy (Figure 4.26) and some further easing of policy by the Bank of Japan whilst German monetary policy remained on hold (until the early autumn). By summer’s end the yen was at around 120 to the dollar, somewhat stronger than at the start of the year. In autumn (1992), it became evident

152 The Yo–Yo Yen

– – – – – Figure 4.26

Japan industrial production vs. real GDP, 1990–2001

that Germany had fallen into recession and the Bundesbank began to ease. Meanwhile the US economy was in a strong upswing at last (albeit not a sufficient condition for President Bush to win a new term) and the dollar rose, more against the DM than the yen. Against the US dollar, the yen finished the year near its starting level of around 125 (Figure 4.20). Again, a sample of media quotes helps explain why the yen failed to decline despite the powerful emerging evidence that Japan was in a postbubble depression: 1.2.1992 (Nikkei Weekly) To foreign exchange dealers in Tokyo, the current scene looks similar to 1985 when the US was struggling with low economic growth and high trade deficits. The US pressed for the Plaza Accord where a deal was struck to devalue the dollar. Foreign exchange dealers are now whispering about the possibility of a new Plaza Accord, this time between the US and Japan only. Many dealers, though certainly not all of them, predict that such an agreement could cause the dollar to tumble to an exchange rate as low as 100 yen. ‘If an exchangerate adjustment is needed, it will be done between Japan and the US because about 60 per cent of the US trade deficit comes from Japan–US trade’ said Kenji Mizutani, managing director of Tokai Bank. Finance Minister Hata has repeatedly said he endorses the recent strong yen. Bank of Japan Governor Mieno said on Jan. 22 ‘in general, the yen

From Bubble Economy to Yen Bubble (1988–93) 153

should be stabilised at high levels if commodity prices and the trade balance are considered.’ On January 17, the Federal Reserve Bank of New York intervened in the market by selling the dollar at 127.15–20 yen. That surprised most dealers because no central bank had ever intervened at a level below 130, dealers said. 28.2.1992 (Nihon Keizai Shimbun) A top Finance Ministry official criticised as ‘rude’ and lacking in ‘common sense’ remarks by Shin Kanemaru, deputy president of the leading Liberal Democratic Party, that the PM should sack Bank of Japan Governor Mieno if he opposes an immediate further cut in the discount rate. 14.3.1992 (Nihon Keizai Shimbun) Kanemaru reiterated his appeal that the official discount rate be cut. He said that although some people say the economy will bottom out soon, an economic free fall ‘into an abyss’ cannot be ruled out. 27.3.1992 (Reuters News) While Mieno has won praise for his attack on asset inflation, a sharp slowdown in the real economy now has critics charging that his too cautious easing of credit is prolonging the slump. GDP shrank in the October-December 1991 quarter. ‘Ultimately Mieno, or the central bank as a whole, overestimated the inflationary pressures’ said one Japanese bank economist. Last month, LDP baron Shin Kanemaru suggested the discount rate be cut even if it meant firing Mieno. There was also a very different view. ‘I think he’s done a brilliant job,’ said the chief economist at Salomon Brothers Asia. ‘He was facing an economy in 1989 that was essentially a powder key ready to blow up. I think he deflated the bubble in an extremely cautious but clear and steady-handed fashion.’ 24.4.1992 (JIJI Press) Bank of Japan Governor Mieno said he expects that the Japanese economy will pick up in the middle of the year. 27.4.1992 (JIJI Press) Bank of Japan Governor Mieno and Finance Minister Hata welcomed the yen’s rise against the dollar in the wake of Sunday’s G-7 meeting. A statement issued after the meeting said ‘exchange markets have been generally stable in recent months, though they noted that the decline of the yen since the last meeting (in January) was not contributing to the adjustment process.’ 28.4.1992 (JIJI Press) Bank of Japan Governor Mieno rebuffed a call for quick domestic demand stimulation, warning that short-term economic measures would spawn inflation.

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29.4.1992 (Reuters News) None of the G-7 nations demanded when they met in Washington last weekend that Japan take any monetary steps to stimulate its economy, Bank of Japan Governor Mieno said. Mieno said this week’s appreciation of the yen against the dollar is natural given the effect of the G-7 communiqué which mentioned that the decline of the yen since the previous G-7 meeting in January was not contributing to the adjustment process. A stronger yen will help reduce Japan’s massive current account balance of payments surplus. 21.6.1992 (The Daily Yomiuri) Masaru Hayami, chairman of the Japan Association of Corporate Executives, warned that a further cut in the official discount rate would further aggravate the nation’s economy. Government and business leaders should remember the negative impact on the economy of the cut in the official discount rate to an historic low of 2.5 per cent in 1987. There are no short-term solutions for problems caused by the bursting of the bubble economy. 23.6.1992 (Reuters News) Japan must seek to stabilise the yen with a firm tone in the currency market to correct external imbalances, Bank of Japan Governor Mieno said. 26.6.1992 (JIJI Press Newswire) The yen’s uptrend in currency markets will likely continue for now as the Japanese and US governments appear to tolerate a stronger yen against the dollar, a former New York Federal Reserve official, Scott Pardee, said. 27.6.1992 (Nihon Keizai Shimbun) The Ministry of Finance will be under intense political pressure in the coming few weeks to fiscally stimulate Japan’s sagging economy. Top LDP politicians convinced PM Miyazawa that the government should hammer out the outline of a supplementary budget before he leaves (June 30) for the G-7 Summit in Munich. Party sources said it would amount to 3–5 trillion yen. 8.7.1992 (Reuters News) Mieno says Japan’s prices remain stable although services prices are still relatively high. But price stability alone will not allow the Bank of Japan to ease credit, he said. ‘We will manage monetary policy by taking into account not only prices but other factors as well.’ 16.9.1992 (Reuters News) A stable and firm yen is desirable to help correct Japan’s current account surplus, Bank of Japan Governor Mieno said. Japan’s severe economic adjustment is seen continuing for a while, but may be nearing a bottom. The Bank of Japan will closely watch the effects of past monetary and fiscal policy steps on the economy, he said.

From Bubble Economy to Yen Bubble (1988–93) 155

3.10.1992 (The Nikkei Weekly) For an economy in the middle of a recession, exports are one of the few sources of growth. In the April to June quarter, domestic demand actually shrank slightly, and it was external demand that allowed GDP to grow at an annual 1.1 per cent annual rate. ‘The yen’s current level is acceptable’, said Yuji Tanahashi, vice minister of the MITI, when the yen rate briefly broke the 120 yen to the dollar last week. Bank of Japan Governor Mieno who used to call for ‘stability on the side of a stronger yen’ now merely acknowledges that a stronger yen is ‘desirable from a long term view.’ 8.10.1992 (Nihon Keizai Shimbun) Masaru Hayami, chairman of the Japan Association of Corporate Executives (Doyukai) said the yen’s current rate of about 120 to the US dollar is bearable for Japanese industries. It is not a rate we can complain about, considering Japan’s looming trade surplus. 31.10.1992 (The Economist) Americans grumble loudly about their credit crunch. It is trivial compared with what faces Japan. Yet Bank of Japan Governor Mieno continues to claim that anaemic monetary growth will not hold back economic recovery. Federal Reserve Chairman Greenspan noted in a speech in Tokyo earlier this month that ‘Japan-based risk, largely through inter-bank transactions’ is American banks’ largest country exposure. These press clippings reveal a new theme as well as continuing several old ones. The new theme is the formation of an unholy alliance between Washington (assiduously avoiding criticism of Japanese monetary policy and instead pressing for aggressive fiscal expansion as a way of both stimulating the Japanese economy and fostering a stronger yen together with lower trade surplus) and big spenders in the Liberal Democratic Party (LDP). The old themes are, first, the attachment of Bank of Japan Governor Mieno to a strong yen and his failure to realise the seriousness of the economic downturn already afflicting Japan. Second, there is the continuing apparent ignorance of Governor Mieno, and of other key policy-makers, concerning the equilibrium exchange rate implications of a post-bubble surge in the national savings and current account surpluses. Instead they made and accepted simple and erroneous assertions that a larger current account surplus meant currency strength. Third, international economic officials who should have known better – whether in Washington (IMF) or Paris (OECD) – failed to provide any alternative framework for market analysis (for example, writing articles on why a rising savings surplus and current account surplus should indeed mean yen weakness). Instead, G-7 meetings were sources of communiqués that served only to make Japanese investors even more risk averse with respect to assuming foreign currency risk, and so impeding the adjustment of the

156 The Yo–Yo Yen

Japanese economy to post-bubble realities. Japanese investors may indeed have been inclined towards healthy scepticism towards G-7 statements on currencies or of Washington’s power to influence exchange rates. But even the most sceptical might well be influenced by the dominant view expressed in contemporary economic commentaries, whether official or private, that larger current account surpluses meant the yen could only rise. The contrarian opinion had no airing, and inaccurate histories of the Plaza Accord circulated without correction. As we saw in Chapter 2, the surge of the yen from summer 1985 to 1987 had much more to do with changed investment outlooks on both sides of the Pacific (the end of the Reagan boom and big new investment opportunities in Japan) than any exchange of words in the Plaza Hotel.

US ‘economic diplomacy’ drives up the yen, early 1993 If words from Washington were important at any times during the run-up of the yen to its bubble peak in spring 1995 it was surely most evident in the early few months of 1993 as the new Clinton Administration drew up its agenda for international economic diplomacy, particularly vis-à-vis Japan. The other main instance of the yen being driven up by talk in Washington during the climb to its bubble peak was in early 1994 – to be discussed in the next chapter. In the first four months (of 1993) the yen rose from around 125 against the dollar to below 110, whilst the DM/dollar rate was broadly flat (see Figures 4.18, 4.19 and 4.20). This was against the background of various blatant hints from the new Administration that the yen should rise and that Japan’s current account surplus was at an unacceptably high level. As already pointed out (Chapter 3), neo-mercantilist policy thrusts from Washington do not have an inevitable upward influence on the yen. Investors could fear that protectionist threats, if carried out, would seriously damage the Japanese economy and yen devaluation might be essential to any subsequent recovery. The lesson of history so far, however, from the Nixon shock (1971) to the Plaza Accord (1985), was that somehow the yen could be engineered upwards as part of a package solution to trade frictions. The methodology was not well spelt out but presumably would involve some combination of fiscal ease and inflammation of exchange risk perceptions (so as to decrease the momentum of capital exports). Inflammation would have its source in various hazy elements – speculation on a Plaza II, the Bank of Japan Governor broadcasting a simplistic and erroneous theory linking trade surpluses and inexorable currency appreciation, and perhaps ‘voluntary guidance’ to Japanese investment institutions concerning their rate of foreign asset acquisition. None of these elements were robust but their possible presence could raise the anxiety level of Japanese investors concerning possible exchange loss on foreign assets.

From Bubble Economy to Yen Bubble (1988–93) 157

The lesson was soon being re-taught in practice. The new US Treasury Secretary, Lloyd Bentsen, let it be known that he wanted a stronger yen. Bentsen had been one of the Senate sponsors (in 1985) of the most notoriously protectionist legislation in the 1980s (albeit not signed into law) – the so-called Gephardt Amendment (which would have required Japan and other countries with which Japan had large deficits to reduce those deficits by 10 per cent per annum under threat of sanction). In mid-February Bentsen announced at a press conference that he would ‘like to see a stronger yen’. As discussions developed in following weeks between Washington and Tokyo it became clear that the Clinton Administration was intent on starting a new round of negotiations on opening up Japanese markets. This time the approach was to be results orientated – specific targets for growth in US access. Laura D’Andrea Tyson, the new head of the Council of Economic Advisers, was the author of an anti-free-trade tome entitled ‘Who’s Bashing Whom?’. As a mid-April summit loomed between Prime Minister Miyazawa and President Clinton, policy-makers in Tokyo scurried to put together a giant fiscal reflation package to help take the heat out of trade frictions. The following quote illustrates the effort: 14.04.1993 (Reuters News) PM Miyazawa is packing a jumbo $117bn economic stimulus package for his first summit with the new US president – one he hopes to sell as a plan to trim Japan’s trade surplus. In the US, the Clinton administration is preparing to talk tough on trade. ‘The Prime Minister is aware of Clinton’s tough stance and is mulling all possible measures to reduce the trade imbalance’ said a Japanese government official working on preparations for the Miyazawa–Clinton meeting. Miyazawa’s aides have approved a 13 trillion yen package they hope will pump new life into an economy facing its worst crisis of the post war era. At the Summit, Japan agreed to the opening of talks, and by July proposals for detailed negotiations had been drawn up – forming the so-called ‘Framework Talks’ which continued through until spring 1995. The implicit stick was the option of reinstating the Super 301 provision of the US trade law, which would allow direct action against Japanese exports (in fact Super 301 was reintroduced in March 1994, as the framework talks hit a road-block). Furthermore President Clinton was not unwilling to pass comment on the currency markets as a negotiating tactic. On 16 April, at a news conference following his talks with PM Miyazawa, the new President dropped a clanger – ‘I think there are three or four things working today which may give us more results. Number one, the appreciation of the Japanese yen.’ The remark sent currency dealers pushing down the dollar to a global post-war low of 112 to the yen in New York trading (113 the previous day).

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What role was the Bank of Japan playing during this crisis time for the yen (crisis in the sense that the currency was rising unilaterally and threatening to prolong the recession)? In fairness, under intense pressure from politicians and business, Governor Mieno had cut the discount rate by 75bp to 2.5 per cent on 4 February – matching its previous record low between 1987 and 1989. Money market rates in Japan were now at around 3 per cent and had thereby fallen to the same level as in the USA for the first time since 1990 (see Figures 4.9 and 4.22). The various forms of pressure on Governor Mieno are illustrated by the following quote: 6.2.1993 (Reuters) The interesting point is why it took the central bank (Bank of Japan) so long to cut rates. The conventional explanation is that the central bank held off to increase pressure on the finance ministry to ease fiscal policy. Another explanation is that Governor Mieno has been pursuing a political agenda – to reform dirty-money politics in a country increasingly marred by scandal and policy-making paralysis. As companies’ earnings fall, so too do their political contributions. If that is true, it could explain the unprecedented public campaign against Mr. Mieno in the past few weeks. The Japanese press reported that a finance ministry ‘old-boy’ network was out to get rid of Mr. Mieno. Then a press article blamed Mr. Mieno’s older brother, who works for the Norinchukin agricultural co-operative, for the build-up in Norinchukin loans to housing-loan companies which today hover near insolvency. An interesting point from this report (albeit ‘unsourced’) is the notion that the Bank of Japan had been keeping monetary policy overly tight so as to increase pressure on the Ministry of Finance to break with orthodoxy and sanction fiscal pump-priming by the government. But why should Governor Mieno have been striving for fiscal reflation rather than first using all the available monetary policy levers? The best explanation is that Governor Mieno had no belief in the power of monetary policy to deliver any further meaningful stimulus and he was trying to act as a catalyst of macro-economic policy development in the most effective way he saw to lift Japan out of recession. The conspiratorial type explanation, for which there is no hard evidence, is that Governor Mieno realised that aggressive monetary expansion could mean a weaker yen, which he inherently disliked, and would work against any narrowing of the trade surplus. (It is clear from public comments that Governor Mieno implicitly accepted neomercantilist type arguments that Japan’s current account surplus would have to fall a long way to achieve a better international equilibrium.) It is likely that the new fiscal stimulus programme that the Miyazawa government delivered to President Clinton in mid-April (1993) played a role in the yen’s overall advance – an interesting instance of neomercantilist pressure in Washington pushing up the yen via the fiscal lever.

From Bubble Economy to Yen Bubble (1988–93) 159

Indeed, Leonard Schoppa (1997) writes that ‘Treasury Department officials were pressurising the Japanese to adopt bigger and better fiscal stimulus packages from Day One of the Clinton Administration.’ Ten-year yields on Japanese government bonds (JGBs) spiked up to 5 per cent from 4 per cent in spring 1993 (Figures 4.27) as concerns grew about the looming huge financing needs of the public sector (some optimism about the Japanese economy emerging into a business recovery also played a role). By contrast, ten-year T-bond yields were not moving at this time, even though the Clinton Administration had consummated a deal (in February) with the Greenspan Federal Reserve whereby a cut in the budget deficit would be rewarded with patience on monetary policy (Figure 4.27). (From spring 1993 and into the summer there was a steep fall in both US and Japanese government bond yields – in the USA this was primarily in response to cyclical data indicating the strong expansion of second half 1992 had given way to a lull in growth, whilst the Japanese fall reflected anxiety that the yen’s jump would ruin recovery prospects and create deflation.) Some commentators have claimed that the yen surge of early 1993 had more to do with US fiscal tightening than with the Clinton Administration’s talking up of the yen, pressing Japan to ease fiscal policy, and threats of trade action. But why then was the dollar flat against the DM at this time? (see Figures 4.18, 4.19 and 4.20). It is not convincing to retort that the DM was held back by recession in Germany; the recession’s arrival

Figure 4.27

10-year JGB yields vs. 10-year T-bond yields 1991–5

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– and degree of severity – had been fully digested by markets in the last quarter of 1992 and there was little new information. Leading indicators of the business cycle were picking up in Japan (Figure 4.28) – a few months ahead of a similar turn-up in Germany (Figure 4.29). But the jump of the yen can hardly be attributed to such fragile evidence. The yen in real effective exchange rate terms had now (spring 1993) reached a level some 10 per cent above its previous peak in early 1988 (see Figure 2.1). Yet the hard currency enthusiasts at the Bank of Japan and outside were hardly daunted. Masaru Hayami wrote the following comments in the Nikkei Weekly (5 April 1993): The yen’s recent surge against the dollar, following a Feb. 20 comment made by the US Treasury Secretary Bentsen, may have adverse economic effects in the short term. Historically, though, the strengthening of the yen has had a positive outcome in the long run. Whenever the yen surges, the deleterious effect on exporters and others is mentioned. But the yen’s appreciation has never destroyed Japanese industry. Rather it has helped by prompting companies to streamline operations and results in lower prices for imported materials, including fuel, which greatly benefits Japanese industry. Streamlining involves up-front costs but pays off before long. By doing so, Japanese companies have emerged in a more competitive position

–

– Figure 4.28

Japan vs. US leading indicators, 1992–8

From Bubble Economy to Yen Bubble (1988–93) 161

–

–

Figure 4.29

Japan, US and euro-area real GDP 1989–2001

each time the yen has surged relative to the dollar. A review of Japanese economic developments in the past two decades points to the fact that without the yen’s appreciation as a regulator of the Japanese economy, Japan could not have gained the distinction of being the nation among the advanced countries with the most stable consumer prices, the fastest real economic growth and the second largest GNP. It goes without saying that the rise in the yen’s value has eventually worked in favour of the Japanese nation, companies and consumers. There’s reason to expect, as in the past, a stronger yen will benefit Japan’s economy. Before joining a trading firm in 1981, I witnessed changes in the yen–dollar relationship for 34 years as a member of the Bank of Japan [he joined at the same time as Mieno]. The yen has risen against the dollar at an average pace of 5 per cent since the floating exchange rate started in 1973. Whilst the yen’s value has tripled to the dollar over the past two decades, Japan’s nominal gross national product grew 5.5 times. During the same period, real GNP increased at an average annual rate of 4.4 per cent, the fastest rate of growth among industrialised nations. In the last 5 years in particular, Japan saw its real GNP grow at almost 5 per cent a year. In comparison, the US economy expanded at an annual average rate of 2.5 per cent over the past 20 years while the European Community grew at an average 2.8 per cent a year. This shows that the stronger yen has not hindered Japanese economic growth but

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enhanced Japanese industrial competitiveness by prompting industry to restructure. The future Bank of Japan Governor and then head of an important federation of employers was telling the world, and his Japanese audience in particular, not to expect any fall-back of the yen. Indeed monetary policy-makers probably think its present high value is a good thing. Critics could argue that Hayami was totally ignoring a big new phenomenon – the hollowing out of Japanese industry in response to the yen’s surge as businesses decided to shift production to Asia. Hollowing out would be at the long-run cost of employment and income growth in Japan (but not of corporate profits potential). But the voices of the critics were not loud or influential. Even in the summer (1993) when the yen was briefly in sight of the 100 level against the dollar, Governor Mieno stated ‘the central bank will not alter its current monetary policy even though the rapid appreciation of the yen is excessive and may harm the Japanese economy’ (Nikkei News Bulletin, 18 August 1993). But by summer 1993, the Clinton Administration had backed away from its policy of talking up the yen, amidst signs that an incipient Japanese economic recovery was aborting. On 2 July, US Treasury Secretary Bentsen remarked that ‘he was not hoping for a further appreciation of the yen’ (then at 107 to the dollar) (Nikkei News Bulletin). He stressed in a joint interview with the Nihon Keizai Shimbun, Wall Street Journal, and Handelsblatt, that too great a fluctuation in the currency was destabilising for the Japanese economy. The eventual further cut in the Bank of Japan’s discount rate in late September 1993 by 75bp (to 1.75 per cent), bringing money market rates below 2.5 per cent (Figure 4.22), received warm applause from Lloyd Bentsen – indicating that monetary ease was acceptable to Washington even though it could mean a weaker yen. Indeed, in late 1993 the yen did fall back somewhat against both the DM and US dollar. How would the Japanese economy have differed in the 1990s if Bank of Japan Governor Mieno had cut the discount rate to 1.75 per cent by autumn 1991 (rather than two years later), and had spent the subsequent two years educating international opinion as to why a weak yen was essential for the Japanese economy to return to prosperity (as opposed to preaching the deadend virtues of a strong yen and smaller current account surpluses)? There is a saying that judgement nourishes the dead – and so it may be in the case of judging monetary policy-makers with respect to the casualties of severe deflation. Even without reaching a conclusion at this stage of the narrative we can surely support the preliminary verdict that money in the years 1990–3 had indeed become a monkey-wrench in the Japanese economic machine.

5 Yen Opportunity Gained and Lost (1993–2000)

By summer 1993, the Japanese economy had proceeded far down the wrong road since its asset market bubbles had burst. Overly tight monetary policies, wrong currency signals from the policy control tower (especially the Bank of Japan Governor) and a new profligacy in public expenditure had all played a role in the misdirection of the economy. True, the Bank of Japan had at last brought interest rates down to a historic lowpoint (official discount rate (ODR) at 2.5 per cent) in early 1993, and in the autumn (1993) was to reduce rates further (ODR down to 1.75 per cent), but that was far short of the aggressive ease required (ODR at 0.25 per cent coupled with massive open market operations designed to step up the pace of monetary expansion) to reverse the errors of the previous two years. And the yen was at a stiflingly high level (except as perceived by those policymakers in Tokyo or Washington who assessed equilibrium exchange rates in terms of their consistency with the single aim of extinguishing the Japanese trade surplus). Although each separate move of the yen over the preceding 3–4 years could be rationalised according to some plausible story, the totality of the moves had resulted in an acute misalignment. The yen, which had been at 160 against the dollar after the first slump in the equity market (spring 1990), was now at almost 100 (Figure 5.1) . The tormenting rise of the yen was to continue a further two years. When the turn came, it was abrupt – one of the four almost equally violent downturns in the history of the yo–yo yen (the other three being summer 1978 to 1980, spring 1988 to early 1990; and autumn 2000 to early 2002) when measured in effective terms (against a basket of trade partners’ currencies) and the most violent when measured bilaterally against the US dollar. Between summer 1995 and early 1997 the yen fell by around 30 per cent in real effective exchange rate terms (Figure 2.1), to near 130 against the dollar. That was where the effective fall stopped, and indeed threatened to reverse sharply in the wake of new meddling in the currency markets by both Tokyo and Washington. But then the Asian crisis of summer 1997 followed by Japan’s own financial system crisis brought a further big 163

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Figure 5.1

Yen vs. US dollar and DM, 1993–8

decline of the yen against the dollar (and a somewhat lesser decline against the DM) to near 150 yen/dollar in summer 1998 (at that point the yen’s real effective exchange rate was no lower than in early 1997 owing to the sharp decline of several key Asian currencies) compared to the peak of 80 in spring 1995 (Figure 5.2). At that depreciated level of the yen in summer 1998 there was cause for rare optimism about Japan’s economic prospects. At last industrial exporters – the main potential engine of growth in Japan whose level of efficiency ranks with the best elsewhere – could pull ahead and take up some of the slack from the shrinkage of old inefficient Japan. Maybe even some of the hollowing out of the mid-1990s, where big chunks of Japanese industry had been relocated abroad under the influence of the super-strong yen, would go into reverse. These hopes never materialised. In fact they were dashed finally in just one day. On 12 October 1998 the yen jumped by over 20 per cent in 24 hours. This shock from the currency markets gravely impaired the mechanisms for recycling Japan’s huge private sector savings surplus into foreign assets. A simultaneous further explosion in the budget deficit took up the slack (private sector excess savings flowing into government paper). Meanwhile at the Bank of Japan there was a reincarnation of the ‘hard currency, central bank independence at all cost’ spirit in the person of the newly appointed Governor, Masaru Hayami. By summer 2000, the yen was back

Yen Opportunity Gained and Lost (1993–2000) 165

Figure 5.2

US dollar vs. yen and DM, 1993–8

to 100. That incredible story of opportunity gained and lost is the subject of the present chapter. The story starts in summer 1993, as the Japanese economy has just been exposed to the powerful unilateral appreciation of the yen during the first eight months of the year, bringing it to new peaks against the dollar and DM (near 100 and 60 respectively). Japan has its first government in almost 40 years made up of parties other than the hitherto dominant LDP (Liberal Democratic Party). Critical negotiations are in progress with the Clinton Administration where Washington’s aim is to obtain measurable results in terms of greater foreign access (particularly US) to Japanese markets. On the ground, the Japanese press is full of accounts describing the scramble of Japanese industry to relocate outside the country in cheaper-cost centres in Asia. For example: 11.1.1994 (The Yomiuri Shimbun) ‘The yen’s exchange rate against the dollar briefly approached 100 yen last year. Japanese manufacturers, doubly hit by the bubble’s burst and the yen’s appreciation, stepped up production overseas, particularly in China. This trend will not be reversed even if the yen depreciates in value. But it poses a new problem: the hollowing out of Japan’s manufacturing industry base. Newspapers have almost every day last year carried such headlines as ‘NEC to produce personal computers in Hong Kong’, ‘Ricoh to form joint ventures with

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Chinese and Hong Kong firms to produce fax machines’, and ‘Mitsubishi Motors setting up joint venture in Vietnam.’ New waves of investment in Asia surged last year. Direct investment in China resembled a stampede. 91 per cent of companies polled by the Japanese Machinery Exporters Association said that hollowing out would occur if the transfers of industrial plants continued to progress at the current rate.’ Hollowing-out of Japanese industry was the way in which the major manufacturers in particular could preserve profits and thereby bear the super-strong yen. But the resulting squeeze on domestic employment opportunity was bound to increase domestic opposition to economic reform (in the direction of deregulation). The unanswered question for US–Japan relations was how much steam the higher yen would take out of protectionist pressure (from US industrial lobbies) in Congress and the Clinton Administration thereby allowing an economic settlement to be reached with little reform. A test was not far away. A stand-off came in early 1994. Ahead of a mid-February summit between Japan PM Hosokawa and President Clinton, Tokyo had delivered its by-now-customary sweetener in the form of a fiscal package, this time containing around $50bn of income-tax cuts and $65bn increases in public spending. Washington had been demanding the tax cuts but expressed dissatisfaction that they were being presented as ‘one-off’ (effective for one year only). At the actual summit, the mood was bad as Tokyo refused to make concessions towards the Clinton Administration’s demands for measurable targets on trade. The meeting broke up without agreement.

Brief unilateral rise of the yen, early 1994 The failed Clinton–Hosokawa summit was the catalyst to a sharp unilateral rise of the yen (against both the dollar and the DM). Immediately following news of the summit break-up, the yen rose 6 per cent to around 101 against the dollar. It settled in following days at around 103, still making a gain of around 8 per cent since the start of the year. Reports in the financial media surrounding these events make it clear that the yen’s surge was a direct consequence of the new crisis in Japan–US trade relations, heightened further by reports (proved correct in early March) that the Clinton Administration would reinstate Super 301 (a provision of the 1988 US Omnibus Trade Act which would allow Washington to impose trade sanctions within a year on Japan if agreement now reached). But what was the story in the mind of many investors (including currency dealers) which justified this response of the yen? Some hints come in the following quotes: 14.2.1994 (Reuters News) Clinton has refused to rule out a possible allout trade war with Japan. Despite denials by US officials that the White

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House has plans for a campaign to promote a stronger yen, many traders interpreted Clinton’s statements as indicating such tactics would be used. One analyst said he thinks the US will adopt a policy of ‘malevolent neglect’ with respect to the dollar yen and that he expects the dollar to push below 100 yen sooner rather than later. 1.3.1994 (Reuters News) US Trade Representative Mickey Cantor said (in testimony to a Senate Appropriations Committee) the Clinton Administration saw no risk of Japan pulling out of US money markets due to bilateral trade friction. ‘Their stake is so large’ that there is no risk of them pulling back if trade tensions worsened. He said the US Treasury Department had analysed the risk and found it to be non-existent. In broad terms the rationale for the yen rising in the wake of the failed trade talks included, first, fear that in an economic war between Japan and the USA, Japanese investors might pull funds out of the USA (perhaps out of vague fear that these could be at risk from hostile action, including tax changes; or perhaps under the influence of behind-the-scenes pressure from the Ministry of Finance which might view a yen spurt as a price worth paying to inflict damage on US markets – for example a sharp fall in Wall Street – and thereby soften the US Administration into backing down from its hard line, at which stage the yen would fall back and Japanese capital outflows resume). Second, there was a concern that the US authorities would somehow push up the yen so as to punish Japan, and in inflicting harm on its economy it would force Tokyo into submission. The suggested rationale was at best weak. Despite the rhetoric and attitudes of some US negotiators, Japan and the USA were not remotely near a situation of economic war. Indeed, on the same day the Clinton–Hosokawa summit failed in February, the two leaders announced that they had agreed they would cooperate in efforts to force the North Koreans to accept IAEA (International Atomic Energy Agency) inspections of their nuclear sites. Schoppa (1997) cites a state department official exclaiming that compared with the strategic issues at stake in North Korea the economic issues at stake in the Framework Talks were peanuts. Japanese policy-makers remained confident throughout that security leverage would not be brought to bear on economic conflicts, and their confidence was borne out by the so-called ‘Nye initiative’ in autumn 1994 (when Assistant Secretary of Defence Nye embarked on a campaign to repair what he and others in the US political-security establishment perceived to be an erosion in the bilateral security relationship). Given that confidence, why would the Japanese authorities even think of stimulating a withdrawal of Japanese capital from Wall Street? And speculation that Washington would drive the yen up to force Tokyo into submission had no basis in reality. The Federal Reserve was not going

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to oblige by cutting interest rates – indeed Chairman Greenspan was simultaneously embarking on a sharp tightening of monetary policy. Massive sterilised intervention by the US Treasury (buying yen and selling dollars) was implausible, given the historical record of US intervention only being small scale and in coordination with G-7 initiatives; there had never before been controversial intervention – to push a currency in the opposite direction to that perceived as equilibrium by the country of issue. Moreover, even sterilised intervention on a huge scale would have dubious effectiveness. And so all that remained was talk. US officials might talk the yen up. In fact there was a disciplined refusal to talk – with the exception of President Clinton who on several occasions, then and later, could not restrain himself from expressing satisfaction whenever the yen jumped (for example, in early July 1994, when the dollar had fallen to a new low of 96 to the yen, President Clinton declared that it ‘is not the US’s problem but Japan’s trade surplus which has caused the dollar’s decline’). A potential welcome, however, from the president for a market-driven appreciation did not provide much of a basis in itself for that appreciation taking place. In sum, the flurry of the yen in response to the upset in trade negotiations in early 1994 was no more than that – a superficial movement driven by fairly incoherent economic rumour-mongering. The only firm links between Washington’s trade strategy and the yen were the same as those already discussed and evident in early 1993 – the likelihood of Tokyo pursuing aggressive fiscal expansion and thereby soaking up more of the domestic private savings surplus rather than it flowing out into foreign assets, and an increased aversion towards bearing foreign exchange risk by Japanese investors (based on concern that trade frictions could mean a stronger yen even though there was no well-specified model as to how this would occur – just a feeling of unease). Perhaps all the rhetoric surrounding the failed summit had made Japanese investors somewhat uneasier than in recent months, but that mood could change for no very good reason.

Governor Mieno’s defiant exit In fact, talk by Japanese officials themselves continued to play a greater role in causing Japanese investor unease than any comments out of Washington – greater because such comments indicated action or lack of action. Critically, support for a strong yen from the Bank of Japan Governor meant that he would hardly be recommending aggressive monetary ease towards lowering it in value. At the end of 1993 there had briefly been speculation in the market-place that the Bank of Japan would ease policy. The Shinseito party, a member of the seven-party (excluding the LDP) government coalition had called for a decrease in the discount rate to 0.5 per cent from its current 1.75 per cent.

Yen Opportunity Gained and Lost (1993–2000) 169

But early 1994 did not bring any good news on monetary policy. The most effective tool towards cooling the yen currency market – an aggressive easing of monetary policy – remained locked up. Even later in the year when the yen had risen further to around 95 against the dollar, Governor Mieno continued to trumpet a model of exchange rate determination based on current account balances as the dominant factor, and thereby claim that the central bank was powerless to prevent appreciation, as the following quote demonstrates: 2.11.1994 (Reuters News) Japan’s central bank chief kept his cool in the face of the yen’s relentless rise, telling businessmen that there is no quick fix. Touring cities in western Japan, Governor Mieno called for a long-term prescription for the strong yen; cut the nation’s huge current account surplus. ‘When the dollar was moving at above 100 yen, its impact on the economy was neutral, but recent moves have made careful watching necessary.’ … ‘It is not possible to avoid the yen’s rise temporarily as it is closely based on the imbalance between savings and investment’ he said. ‘Americans spend faster than they save, which causes budget and trade deficits and keeps foreign investors away from dollar holdings. Japanese tend to save more than they spend, holding huge capital reserves at home.’ … ‘In the long run, Japan’s current account surplus must be cut back as this always becomes a factor for the yen’s rise.’ Nonetheless Osaka business leaders lambasted Mieno. A chairman of a medium-size enterprise making heavy machinery complained ‘I am very worried about the pace of the manufacturing sector’s hollowing out because once manufacturing moves overseas it won’t come back.’ Another businessman asked ‘are we going to start paying our salaries in dollars if the current high yen does not stop? Are we going to pay our taxes in dollars too?’ The comments of Yasushi Mieno, barely two months before the end of his term as Governor, reveal as great a misunderstanding as ever concerning the relationship between the large private sector savings surplus, the current account surplus, and the exchange rate. Yes, a large sector savings surplus means an equally large current account surplus. But if interest rates fall to an equilibrium level which reflects the high savings rate, and the mechanisms for channelling excess private savings into foreign assets are working well, then the currency should be lower than in the time of the bubble economy when savings were lower and investment spending at euphoric levels (and the current account surplus smaller than in the early/mid-1990s). If indeed the government could engineer a lower savings and current account surplus – whether by direct measures to stimulate consumer spending or by a powerful expansion of the budget deficit – that would mean a higher, not lower, value of the yen in equilibrium.

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Currency markets are understandably more sensitive to wrong-headed and confused economic doctrines exposed by central bankers than academically respected views about an eventual equilibrium that might never come about. And so it was with the yen through the Mieno years. It is open to doubt, however, whether Governor Mieno had anything new to say that could influence markets by late 1994. And his comment just one day before retiring that ‘it must be noted that the Japanese economy can benefit from a stronger yen in the long run’ (Nikkei News Bulletin, 16 December) was hardly a new opinion. By that stage – and indeed ever since the spring (1994) – the yen had moved out of centre-stage in the currency markets. The period between March 1994 and February 1995 was one of dominance by the DM–US dollar axis, with the dollar falling, the DM rising, and the yen in-between (albeit nearer the rising DM than the falling dollar) (Figures 5.3, 5.4 and 5.5). An unexpectedly early and strong recovery of the German economy from the recession of late 1992 and 1993 was the fundamental force behind DM strength. Though the Federal Reserve was sharply tightening monetary policy, US bond yields did not rise relative to Bund yields (Figure 5.6). Dollar fixed-rates had already discounted considerable monetary tightening well in advance and so they rose only moderately. Indeed, by late 1994, long-maturity dollar fixed rates were beginning to discount a slowdown of the US economy (the shape of the yield curve is a recognised leading indicator in business cycle analysis, with a flattening of the curve typically preceding a turning point in the cycle from fast to slow growth or even recession). DM fixed-rates had jumped on first indications of economic recovery early in 1994 and then rose in step with dollar fixedrates (Figure 5.7). (It is the differential between long-term fixed-rates which is the interest rate variable of most influence on the DM (euro)–dollar exchange rate.) US hedge funds were reported to be large buyers of European bonds and equities. US investors had also been huge buyers of Japanese equities especially in the first half of 1994 (when the total foreign inflow into Tokyo equities (which were rising briefly – see Figure 5.8), reached almost $100bn p.a.) on increasing evidence that an economic recovery was indeed taking root in Japan after the setbacks of the previous year (the jump of the yen in the first half of 1993 had delayed the cyclical turnaround) (see Figure 4.28). Thus it is possible to explain at least part – and even most – of the spurt of the yen in early 1994 as due to that influx of foreign funds rather than just dark fears about US–Japan economic conflict. And, indeed, through the spring and summer there had been a calming of the rhetoric. In May (1994) talks had restarted between Washington and Tokyo, and by September agreement was reached covering all issues except autos and auto parts, both sides claiming victory. Schoppa (1997) argues that the victory lay with Tokyo, in that the agreement ‘simply fell short of what the USA needed in

Figure 5.3

DM corner, 1993–8

Solo Yen USD–Yen axis dominates Yen–DM axis dominates Solo DM USD–DM axis dominates Solo USD

1 2 3 4 5 6

171

Figure 5.4

US dollar corner, 1993–8

Solo Yen USD–Yen axis dominates Yen–DM axis dominates Solo DM USD–DM axis dominates Solo USD

1 2 3 4 5 6

172

Figure 5.5

Yen corner, 1993–8

Solo Yen USD–Yen axis dominates Yen–DM axis dominates Solo DM USD–DM axis dominates Solo USD

1 2 3 4 5 6

173

174 The Yo–Yo Yen

– – Figure 5.6

10-year yield spreads, T-bond over JGB and Bund, 1993–5

Figure 5.7

10-year JGB, T-bond and Bund yields, 1994–7

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Figure 5.8

Japan equity market vs. 10-year JGB yields, 1993–2001

order to hold Japan accountable’. In October Washington initiated Section 301 proceedings against Japan charging that Japanese government regulation of the auto parts after-market discriminated against foreign partsmakers – a less inflammatory proceeding than ‘naming Japan’, but nonetheless with a deadline attached for retaliatory action of April 1995.

Yen rises to the sky, early 1995 It is difficult to find any trace of the final stage trade negotiations over the ensuing eight months on the currency markets (until a final deal was concluded at end-June 1995). There were so many other relevant events which could explain the end-lap rise of the yen from around 95 to the dollar in late 1994 to its peak of 80 in the following April (1995). Moreover the fact that the rise of the yen was matched by the DM over the period as a whole (late 1994 to mid-1995) – albeit that there were sub-periods when the yen was rising faster than the DM, and conversely – suggests that trade negotiations were not a key influence. Surprisingly some events, which were later to prove positive for the dollar, had no immediate impact on currency markets. These included key changes amongst senior economic policymakers in both Tokyo and Washington. First, in early December (1994), Lloyd Bentsen announced his intention to resign as US Treasury Secretary, and Robert Rubin was designated as his

176 The Yo–Yo Yen

successor. The transition from a Treasury Secretary from Texas, widely regarded as sympathetic to a cheap dollar (he had made no explicit prodevaluation remark since the early days of the Administration, but as recently as October his comment that the USA had no intention of intervening in the currency markets even though the dollar was then floundering received the blame for a subsequent drop), to a Wall Street star (former vice-chairman of Goldman Sachs), renowned for his understanding of financial markets, could be good news for the dollar. Back in June, in his position as White House economic adviser, Rubin had made a public statement that the Administration was not pursing a weak dollar policy. Yet the immediate commentaries in the Japanese press were not encouraging. The Nihon Keizai Shimbun, for example, reported (December 7), ‘the government is worried that the Treasury changeover could have some negative effects because Japan can no longer count on the support of an influential moderate cabinet member such as Bentsen’. Other comments suggested that the Clinton Administration was in disarray (following the setback for the Democrats in the Congressional elections of November 1994) and this could harden Japan’s negotiating strategy, meaning a possible new crisis in Washington–Tokyo relations as in February 1994 (which brought a blip in the yen). As against that consideration, there were widespread rumours of the US negotiating team being in disarray and of the imminent departure of chief trade representative Mickey Kantor. Second, in mid-December, the Japanese government had announced that Yasuo Matsushita, a former Sakukara Bank chairman and vice-finance minister (a top bureaucratic position in the Finance Ministry), was to succeed Mieno (with effect from 18 December). As a former Ministry of Finance official, Matsushita was expected to be less zealous about promoting Bank of Japan independence. As a banker he was likely to be more understanding of the growing problems within that industry stemming from the rising total of non-performing loans made originally during the years of the bubble economy. Indeed there was evidence of a more accommodative monetary stance under the new Bank of Japan Governor already by year-end. Back in autumn 1994 Mieno had not discouraged incipient speculation on an early rise of rates as economic recovery continued. The Nihon Keizai Shimbun, on 1 November 1994, reported his approval of the recent rise in long-term interest rates, which had brought 10-year JGB yields to around 4.75 per cent from barely 3 per cent at the start of the year (see Figure 5.8), saying that interest rates must be compatible with business conditions. Mieno’s evaluation of the fixed-rate market was of course open to question. With inflation non-existent – indeed the present situation was one of deflation (see Figure 5.9) – the real yield on government bonds was almost 5 per cent, an incredibly high level for an economy just beginning to pull out of a severe post-bubble depression with a structurally high private sector savings surplus. In so far as market-participants took note of Mieno’s

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–

–

Figure 5.9

Japan private consumption deflator, 1985–2001

opinion, he helped to push fixed-rates, not just the yen, in an opposite direction to that consistent with overall equilibrium of the economy. The new Governor took the first opportunity of an interview (27 December) to distance himself from the view of his predecessor: ‘to make this move towards economic recovery more certain, we will maintain the present policy stance … the cost of holding non-performing loans will increase if interest rates go up’. His comment was a contradiction of a view expressed a few days earlier by the chief economist at Salomon Brothers Asia Ltd: ‘the Bank of Japan is likely to maintain its recent policy of gradually allowing call rates to edge upward. The overnight call rate is likely to rise from the current level of 2.25 per cent to about 2.75 per cent in the spring, with a 50-point basis point hike of the official discount rate possible at the start of the new fiscal year’ (Nikkei Weekly, 19 December 1994). That was a very bad forecast. As we shall see, call rates were down to 1.25 per cent by spring 1995 and 0.5 per cent by summer 1995 (Figure 5.10). But to be fair to Salomon’s economist, he was not to know that another steep fall of the dollar lay ahead, that the Mexico crisis was on the point of erupting (peso devalued, 21 December), and that Japan was about to suffer its worst earthquake disaster since 1923. The immediate impact of the Mexico shock, coupled with gathering evidence of a sharp slowdown of the US economy (see Figure 4.28), on currency markets was to bring about a weaker dollar most of all against the

178 The Yo–Yo Yen 4.5 Japan discount rate Japan unsecured overnight call rate

4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 93 Figure 5.10

94

95

96

97

Japan official discount rate vs. overnight call rate, 1993–7

DM. From mid-December until end-February the dollar fell from DM/$1.58 to 1.46 and from yen/$100 to 97 (see Figures 5.3, 5.4 and 5.5). Some estimates circulating put the negative effect of the Mexico crisis on US economic growth in 1995 at as much as two percentage points. Europe and Asia should not be directly sensitive to events in Mexico. Arguably the indirect effect – via the induced slowdown in the US – should be greater on Asia than Europe, justifying a stronger DM than yen. Outside the G-3 triangle, currencies of the G-7 countries which had less than top credit-rating – the Canadian dollar and the Italian lira – were sold heavily as investors worldwide scurried into supposed safe-havens. Japan itself was hardly a safe-haven. Its banking system was increasingly under the spotlight, and indeed many of the press commentaries on the appointment of Matsushita as Bank of Japan Governor had stressed that one main job would be ‘sorting out’ the festering bad debt problem. But Japan is a huge creditor nation and though foreigners may have been seeking to lighten up on their holdings on some Japanese assets, Japanese investors themselves would have been liquidating perceived high-risk foreign assets especially with the end of the financial year 31 (March) looming. And the immediate question in the currency market following the devastating earthquake which struck Kobe on 17 January 1995, was to what extent Japanese investors might pull funds out of the USA in particular to fund reconstruction – the mechanism for the pull-out being higher

Yen Opportunity Gained and Lost (1993–2000) 179

yields in Japan (reflecting increased demand for capital) drawing some funds back from foreign assets. Immediate estimates of the amount of capital required for reconstruction ranged between 2 and 3 per cent of Japanese GDP (spread over, say two years, meaning 1–1.5 per cent of GDP each year). The question of how earthquake risk should affect the yen and yen interest rates had of course been raised by some analysts well before the Kobe earthquake. But the uncertainties associated with any estimates either as to potential damage and its influence on the eventual equilibrium path of the Japanese economy or as to the probability of earthquake itself were so great that it would be difficult to demonstrate any influence of such questioning on market valuations. (The normal type of scare article on earthquake risk noted that in the past 200 years for which there were records, a serious earthquake had struck Tokyo at fairly regular intervals of around 70 years, suggesting a high risk of a new such quake in the near future, in that the last one was in 1923. The confidence, however, attached to any such estimates based on a very small historical sample and given the notoriously poor predictive power of geologists, had to be very low.) In principle, earthquake would fuel demand for capital and reduce present savings (as consumers in the stricken areas would deplete savings to maintain consumption) and so the equilibrium rate of interest would rise. This might well justify a jump in the value of the yen – although a possible counterconsideration could be a downward revision in estimates of where the yen should be in the far distant future. In principle, the run-down of foreign assets – or smaller rate of accumulation of foreign assets – during the period of reconstruction would mean less investment income from abroad over the long-run. But higher interest rates in the interval could well justify paying a higher spot price for the yen, even though its rate might be eventually lower than if the earthquake had not occurred. That higher price (for the yen) would not come about if there were considerable aversion towards assuming exchange risk (meaning net flows of additional capital into Japan would only take place if there were significantly higher returns on yen assets, net of prospective exchange rate changes, than previously) and if the earthquake itself produced a surge in demand for imports or fall in exports due to supply constraints. Under those circumstances, the currency could come under substantial downward pressure. That had been the case in the Great Tokyo Earthquake of 1923 (see Chapter 1). This time the overall magnitude of damage (relative to the size of the economy) had been much less and Japan was much more integrated into world capital markets (meaning capital flows triggered by rate spreads would be greater, although restrained by exchange risk aversion). And although dislocation to Japan’s main port city would mean loss of exports, there was not a prospective big shortage of materials (for example, cut wood for house building) as in 1923.

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Another potential negative influence on the yen would come from any unfavourable reassessment about the state of the Japanese political or economic system. And in the aftermath of the quake there was widespread criticism of Japanese public institutions – failures of the emergency services and exposure of bureaucratic inefficiencies. But none of this could be described as fundamentally new information. It could be argued that investor consciousness had been kindled about the potentially much larger disaster which could occur if Tokyo were struck by earthquake, but what that meant for the yen was unclear. Perhaps more investors and borrowers could come round to the view that long-term interest rates in yen should include an earthquake premium (reflecting the possibility that at some time before maturity of the particular instrument considered there would be a jump in interest rates due to a surge in demand for capital caused by a disastrous quake) – but more than a few basis points seemed hardly justifiable and maybe it was already included in present rates! In fact the main market impact of the Kobe quake was on Tokyo equities, which plunged amidst increasing estimates of earthquake damage, the negative effect on corporate profits and feared upward movement of bond yields. Any sober assessment, however, concerning the influence of the quake on bond yields, would have suggested only a small effect. A decrease in the net savings surplus by, say, 1 per cent of GDP for each of two years was very small compared to the huge increase in the private sector savings surplus following the collapse of the bubble economy. And as discussed above, Japanese fixed-rates were already extraordinarily high in late 1994. In fact the next major move – and very soon – of Japanese fixed-rates was sharply down, as the falling dollar and US slowdown spread pessimism about the economic outlook and speculation grew about an easing of monetary policy. That speculation was encouraged by the sharp rise of the yen, which occurred between the start of March and mid-April, bringing the yen from 95 to 80 against the dollar. During the same period, the dollar’s fall against the DM was much less – from 1.45 to 1.35 – meaning that the previous long episode (since spring 1994) of dominance of the G-3 triangle by the DM–dollar axis had given way to a brief episode of dominance by the yen–dollar axis (see Figures 5.11 and 5.12). This jump of the yen to its all-time high had no direct link to trade negotiations between Washington and Tokyo. But Japanese investors – and foreign exchange dealers – were evidently in a state of alert for any shortrun impact of a blow-up in talks to resolve the automobile dispute ahead of the deadline (May) after which Washington would announce Super 301 penalties if no agreement reached. The flurry of the yen in early 1994 was a warning to be cautious. A clumsy remark by Federal Reserve Governor Lindsey on a visit to Tokyo in early March 1995 does seem to have been the catalyst to the yen re-entering the limelight in the G-3 currency

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Figure 5.11

Yen vs. US dollar and DM, February–April 1995

Figure 5.12

US dollar vs. yen and DM, February–April 1995

182 The Yo–Yo Yen

markets, in that a highly nervous audience could deduce that the Federal Reserve was now in a pact with the Administration to lower the dollar. Specifically, on 1 March in an interview with JIJI Press, Lawrence Lindsey said that the dollar’s weakness against the yen is ‘not at a critical level yet’. According to JIJI Press Newswire (2 March 1995) he said that the upward pressure on the yen might continue as neither Japan’s trade surplus nor the US trade deficit was likely to narrow sizeably. Lindsey also commented on the weakness of the dollar against the DM, attributing this to the market’s perception that the USA probably ‘is close to the end of a cycle of interest rate increases while Europe is probably at the beginning of that cycle’. Indeed the week before in Congressional testimony Federal Reserve Chairman Greenspan had hinted that rate hikes had come to an end. The comment that jarred with the markets was ‘yen not at a critical level yet’. The rest was irrelevant – including the governor’s trumpeting of an erroneous hypothesis that so long as a country runs a current account surplus its currency will rise (Japanese audiences were used to the same hypothesis having been aired by ex-Governor Mieno). Critical for what? For the Japanese economy? But Lindsey was hardly likely to be the best judge of that. For US monetary policy? Presumably that is what Lindsey was referring to. The most plausible interpretation of the remark was that the dollar’s fall in itself was not yet serious enough to influence Federal Reserve policy. Perhaps the disproportionate effect of Lindsey’s remarks on the yen simply reflected the fact that Japanese investors had been hoping for Federal Reserve action to bolster the dollar and were now disappointed, whereas investors elsewhere in the world had entertained no such expectations. So with the end of the financial year approaching, Japanese investors and corporations rushed for cover. There was also the more sinister interpretation which could have influenced highly nervous opinion in Tokyo – that the Federal Reserve was following a policy of benign neglect towards the dollar so as to give the Administration a helping hand in its trade strategy. But in more sober mood Tokyo investors would surely have questioned whether the Federal Reserve was about to break with its long history of largely ignoring the currency markets and eschewing deals with the White House which would jeopardise its independence. And even if Alan Greenspan were inclined to make an exception in this case, why would the policy shift have a bigger impact on the yen than on the DM versus the dollar? They might also have asked whether Lindsey’s views were really indicative of what was in Mr Greenspan’s agenda. But these were not sober times in the currency markets. The dollar was plummeting towards record lows. The opposite side of the bubble yen was dollar blues. Any investor who had believed that fundamental economic forces should produce a weak yen following the burst of the bubble

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economy and acted on that belief would have lost a huge amount by now. Could he have the boldness to add to his dollar positions now or would his bad fortune have destroyed his confidence in his own ability to understand currency markets? In the short run, institutional investors had the end of the financial year to consider – they had to hedge large open positions in dollars so as to protect their profits from the possibility of more erosion in the next few weeks. And here was Governor Lindsey warning that the yen could rise further! Add to that the fact that currency bubbles normally include an important element of panic-driven liability rearrangement by international borrowers (seeking to repay loans in the currency that is rising strongly so as to limit their losses). Specifically in Asia the yen had been used widely as a borrower currency, especially by governments. There were reports now of Asian governments, or their central banks, building up yen reserves. Not all of this was as a hedge against yen-denominated debts outstanding. There was speculation that some Asian central banks had decided to reduce the share of the dollar and increase the share of the yen in their reserves as part of a long-run investment strategy. Some commentators heralded a serious erosion of the dollar’s traditional reserve role in Asia. In general any market story about portfolio shifts by central banks has been of transient significance only – whether central banks dumping sterling in 1976, dollars in 1978–9, or again in 1995. If sterilised official intervention in the foreign exchange markets to the extent of tens or even hundreds of billions of dollars is generally viewed as ineffective, why should portfolio shifts by central bank investors have any greater impact? But spring 1995 was not a time of calm reflection in the currency market-place. And a barrage of soothing comments – and action – by US officials following Governor Lindsey’s interview had virtually no impact. Indeed, almost immediately the US Treasury participated in joint intervention in support of the dollar and on 7 March Rubin issued a statement: ‘a strong dollar is in the US national interest’. President Clinton stated almost simultaneously, ‘You know, one of the things I’ve learned is that anything I say on this subject is wrong; so the Treasury Department is taking appropriate action today, and I don’t think I should say anything else. (Reuters, 7 March 1995). On 8 March, in Congressional testimony, Chairman Greenspan said that the weakness of the dollar against other major currencies is both ‘unwelcome and troublesome and adds to potential inflation pressures’. None of these three statements could be described as forceful. Investors long stung by the falling dollar could be understandably sceptical of comments from the new Treasury Secretary and the latest clever opaque statement from Federal Reserve Chairman Greenspan which suggested an attempt to encourage expectations of a possible rate rise without in any way preparing to deliver one.

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The market mood in Japan was one of alarm. Currency bubbles, unlike equity or real-estate bubbles, can be driven by cold fear rather than euphoric optimism. At the opposite end to one currency reaching the sky can be another currency plummeting to the depths. This was true of the weak dollar versus the strong yen and DM in 1994–5, the strong dollar versus the super-weak DM in early 1985, or of the extraordinarily strong Swiss franc in autumn 1978 versus the weak dollar. A currency bubble can be driven at least in part by euphoric optimism – for example the US dollar at its peak of around 3.40 to the DM in early 1985 reflected in part huge optimism about Reaganomics and in part extreme pessimism about German economic and political prospects. But there was certainly no economic euphoria to match the bubble of the yen in early 1995. Indeed, there was only gloom about the Japanese economy as the yen reached its all-time high just below 80 against the dollar in mid-April. The following press quotes give a sampling of the pessimism at large and the mood in the yen currency markets: 9.3.1995 (Los Angeles Times) A sense of crisis swept Japan yesterday as the dollar fell to yet another post-World War Two low of 88.75 yen. NEC Corp. Chairman Sekimoto declared that not only is there a real danger to recovery in Japan but that we could be witnessing the beginnings of a crisis that could engulf the entire world economy. But Prime Minister Murayami said unilateral action by Japan would be insufficient and MITI Minister Hashimoto indicated that an interest rate cut is unlikely. 21.3.1995 (Business Times Singapore) The continuing decline of the US dollar has revived the idea of a yen bloc in Asia. But while there are signs of a switch from dollars to yen in Asia’s holdings of foreign exchange reserves, the region remains ambivalent. 27.3.1995 (Nikkei Weekly) The dramatic decline in the value of the dollar against the yen over the past few weeks is probably due not to just one factor but to a confluence of circumstances. At the same time, it is clear that this is a dollar problem and not a yen one. … An immediate cause for the dollar’s drop to below 90 yen may have been comments by Federal Reserve Governor LaWare where he said that the Fed isn’t worried about the inflationary pressure of a weaker dollar as this will be offset by higher US productivity … While companies are grumbling, certainly travelling consumers are not. 7.4.1995 (Reuters News Service) With the world’s top central banks seemingly stumped by the slide in the dollar, there is little left to stop the US currency from falling to one record low after another, Tokyo dealers say.

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Despite Wednesday’s concerted intervention by Japanese, US and German central banks to bolster the dollar, the currency still spiralled down a succession of global lows this week to touch 83.65. People in the market are now convinced that any short-term policy measures cannot halt the dollar’s decline. One chief dealer said what the dollar needs (to recover) is a reduction in the US–Japan trade imbalance through greater de-regulation of the Japanese economy and a trimming of the US budget deficit. The inveterate need for Japanese exporters to convert their overseas earnings into yen is chronically dragging down the dollar. On top of that, the Bank of Japan’s dollar-buying intervention has been overwhelmed by dollar-selling from Asian central banks and Japanese life insurance firms conducting hedging strategies to protect the value of their assets. These are not speculative sales but aimed at hedging against any further falls in the dollar. 9.4.1995 (JIJI Press Newswire) The dollar is expected to remain under selling pressure this week, due to speculative action by US based fund operators and the build-up of yen reserves by some Asian central banks. Given the Bank of Japan’s failure so far to cut its official discount rate and futile co-ordinated currency market intervention by the Japanese, US, and German central banks last Wednesday, many market players appear to believe there is no effective way to stop the yen’s surge for the moment a foreign bank official said. 10.4.1995 (Nikkei Weekly) ‘Although certain Asian central banks have been converting their funds from dollars to yen for some time now, China and Indonesia have recently joined the selling party’ a senior foreign exchange manager of a Japanese bank said. A dealer at a Swiss bank in Tokyo said, ‘when you consider the Bank of Japan’s current monetary policy and the political inaction, there is simply no single compelling reason to believe the dollar will re-bound’. Market participants became increasingly bearish about the dollar during the week after the Bank of Japan continued to distance itself from growing public calls for a cut in its official discount rate. A forex manager at a German bank commented that the Bank of Japan had missed its best chance to impact the market by lowering the rate. The last two quotes indicate that a factor in the run-up of the yen was disappointment that the Bank of Japan had failed so far to take monetary action to diffuse the growing bubble. By contrast the Bundesbank had already cut rates at the beginning of the month – and its earlier move was a factor in why the yen had raced ahead of the mark. Eventually in midMarch the Bank of Japan did bend to pressure and cut its official discount rate by 75bp to 1 per cent. Conditions were coming into place for the yen

186 The Yo–Yo Yen

to turn down. But there was still widespread scepticism, as the following quote reveals: 13.4.1995 (Reuters News Service) Rubin has repeatedly professed his desire for a strong dollar, but the United States has so far shied away from taking tough action to make that a reality. Washington instead seems content to let Tokyo stew under the pressure from the strong yen – hopeful that will prod the Japanese government into attacking its big trade surplus. Japanese corporations are likely to respond to the yen’s latest surge by moving more production facilities offshore to the rest of Asia. Analysts said that should enhance Tokyo’s economic clout in the region, albeit at the expense of jobs in Japan. Asian nations like Indonesia are suffering because much of their debt is denominated in yen. In response some have begun diversifying their foreign currency holdings by selling off dollars to buy yen, raising questions about the greenback’s ultimate ability to retain its role as the world’s key reserve currency.

The yen’s almost unilateral decline, autumn 1995 In fact the dollar was almost at its nadir and the yen almost at its peak. From 12 to 19 April there was a last plunge of the dollar against both the yen and the DM bringing it to all-time lows of around 80 yen/dollar and 1.35 DM/$ respectively. During May, June, and early July the yen/dollar rate oscillated around the mid-80s and the mark/dollar rate at around 1.40. At a G-10 meeting in Washington in late April a joint communiqué had expressed the concern that exchange rates had gone beyond the level justified by underlying economic conditions. High-level trade talks resumed between Japan and the USA in early May, but Rubin reiterated recent statements in favour of a strong dollar and that Washington would not use the currency as an instrument of trade policy. In early June a bout of coordinated central bank intervention in support of the dollar began to bring about a change in market perception of the US Administration’s stance on the dollar – even though the 28 June deadline when US punitive tariffs against 13 Japanese luxury cars was to come into effect if no trade agreement had been reached, lay just ahead. After a mid-June meeting between the Japanese Finance Minister Masayoshi Takemura and the US Treasury Minister Robert Rubin a communiqué spoke of exchange rates being out of synchrony with the fundamentals. News of an agreement at end-June on the trade dispute brought no immediate significant change in the currency markets – consistent with the hypothesis that this issue had not been a direct influence on the yen in recent months. Either markets believed Treasury Secretary Rubin that the dollar was not to be used as a trade tool, or they had expected agreement

Yen Opportunity Gained and Lost (1993–2000) 187

anyhow, or they had judged that even if Washington intended to use the dollar–yen rate as a trade tool they could not – US power to manipulate currencies was just bluff. It was in late July that a sudden downturn occurred in the yen. There had been reports of growing concern in Washington about the fragile state of Japanese banks. This backed a new perception in the market-place that the USA saw Japanese recovery as the new priority in its international economic policy and that trade concerns had receded. There were rumours that Eisuki Sakakibara, appointed in late May as head of the Ministry of Finance’s International Financial Bureau at end-June, had concluded a reverse Plaza agreement whereby the dollar would be pushed higher. Although Sakakibara had a reputation as a tough negotiator, and in his book ‘Beyond Capitalism’ had extolled Japan’s distinctive non-capitalist market economy, he was well received by his US opposite numbers. With a doctorate from the University of Michigan, negotiators in Washington saw him as a diplomat who ‘acts, thinks, and responds like them’ (Reuters, 26 May 1995). Then in early August (1995) came a package of deregulation measures in Tokyo to promote capital exports whose announcement was coupled with a bout of joint US–Japanese intervention in the dollar–yen market. The yen was now through 90 against the dollar and was also down against the DM. The Bank of Japan eased monetary policy and by early autumn the discount rate and call money market rates were down to 0.5 per cent (see Figure 5.10). By late autumn 1995 the yen had crossed through the 100 level against the dollar, whilst continuing to depreciate also against the DM. The DM–dollar rate was still floundering in the low 1.40s (albeit up from the lowpoint in the mid-1.30s) (see Figures 5.1 and 5.2). How can we explain this striking turnround of the yen? The deregulation measures in themselves were hardly substantial (scrapping limits on insurers’ participation in syndicated loans and on their foreign currency loans to overseas borrowers). Probably much more important were the cuts in money rates, with the call rate falling initially by 25bp to 1 per cent in the summer and then by a further 50bp in early September in the midst of a worsening banking crisis as described below. Long-maturity fixed rates had also fallen sharply since the start of the year – with 10-year JGB yields at 3 per cent by late summer (compared to 4.5 per cent at the start of the year, see Figure 5.8). The long-term rates, however, were still high in real terms (with inflation at zero or negative), and US dollar long-term rates had fallen as much, and indeed were to fall even further in late 1995 whilst Japanese rates remained on a plateau (see Figure 5.7). There were also other factors pushing the yen down which could have played at least as important a part as the shift in monetary policy. One was psychological – notoriously difficult to measure but nonetheless potentially important. When the yen was at its bubble-peak of 80 against the dollar there were many investors who could see that this was unsustainable in the

188 The Yo–Yo Yen

long run, except in way-out scenarios to which they could attach only a small probability. Even the academic high-priest of the neo-mercantilists in Washington, Fred Bergsten (head of the Institute of International Economics and formerly senior international economic adviser in the Carter Administration), who had typically wide media coverage in Japan, said enough was enough in late April – ‘any further decline in the dollar should not take place against the yen’ (Reuters, 26 April 1995). How could the Japanese economy, with its fragile economic recovery which had started the previous year, and with increasingly evident strains in its banking system, bear a further powerful deflationary shock emanating from the currency markets? Something had to give. In the wild currency markets of spring 1995, who had the courage to buck the trend? Not many – other than small bank clients buying up stocks of dollar banknotes. Once the turn came, however, and there were orchestrated moves in Tokyo and Washington, these investors who had been sceptical of the yen’s strength were emboldened by each other’s behaviour (as evidenced by the falling yen) to move out of the yen into foreign assets (mainly dollars). More technically, the level of risk premium which these investors required to justify the accumulation of foreign assets most probably fell, given that there was no longer the danger (however imprecise or implausible) of Washington talking up the yen or of senior officials in Tokyo having the same effect. In practical terms the big security houses caught a popular mood in large-scale advertising to promote their foreign currency bond funds. The following quote illustrates the point: 4.10.1995 (Nihon Keizai Shimbun) Italy’s Treasury Ministry will issue 2 billion of dollars worth or Eurobonds maturing in 2001, targeting Japanese investors. The move comes in response to growing interest in foreign bonds among Japanese individual investors. Foreign bonds became more attractive after Japanese interest rates fell to record lows. A second factor driving down the yen was the growing crisis of confidence in Japan’s banks. Already at the end of July a credit union Cosmo Shinyo Kumiai suffered a dramatic run on its deposits and was ordered to stop operations. Then there was the insolvency of Hyogo Bank (a regional bank) and Kizu Credit Union in early September. Alongside was the question of the ailing Jusen (specialised housing loan firms), which were heavily indebted to the banks and to politically well-connected agricultural bodies. Then in late September came news of the huge losses connected with fraudulent trading at Daiwa Bank’s New York branch. Ominously the so-called Japan premium emerged in the international deposit market (last seen in the aftermath of the 1979 oil shock). Even leading Japanese banks had to pay as much as three-eighths of a percentage point over LIBOR (London Inter-Bank Offered Rate) for funds borrowed in the interbank market. With

Yen Opportunity Gained and Lost (1993–2000) 189

no natural deposit base of their own in dollars, Japanese banks were traditionally huge borrowers in the interbank market to finance their international lending and also their trade credit business (an exceptionally large share of Japanese exports and imports were denominated and financed in dollars). The growing liquidity problem of Japanese banks in international markets raised the likelihood of the Bank of Japan having to use large amounts of its international reserves to provide emergency funding (refinancing the withdrawal of dollar credits by foreign banks). The Japanese authorities could have a straight prudential reason for huge dollar purchases in the foreign exchange markets – to bolster their reserves to provide a backstop for the banking system. On top, some Japanese banks might draw on their capital reserves in yen (selling equity holdings for example) to fund the withdrawal of foreign bank credits in dollars. These points were well understood in the markets, as the following quote reveals: 16.9.1995 (Business Times, Singapore) Japan’s Ministry of Finance has indicated it stands ready to provide US dollar liquidity to banks if needed … The source of such funds would be from Japan’s official reserves which have been greatly supplemented in recent weeks by aggressive Bank of Japan intervention in foreign exchange markets. … Market intelligence suggests that the Ministry of Finance has already been increasing dollar deposits with Japanese banks of late in order to ensure their liquidity.

Strong dollar, 1996 Near the end of 1995 the Japanese government had introduced legislation which provided for a partially publicly funded resolution of the Jusen crisis and this was eventually approved by the Diet in spring 1996. The simmering problems of the Japanese banking system remained a background negative factor for the yen, though not strong enough until autumn 1997 to bring a further unilateral depreciation (against both the US dollar and DM). In fact from late autumn 1995 until end-winter 1995/6 there was a unilateral rise of the dollar against both the DM and the yen, taking the DM/dollar and yen/dollar rates to around 1.50 and 105 respectively (see Figures 5.3, 5.4 and 5.5), driven most probably by important evidence of the US economy having entered a powerful new upswing after the neargrowth-recession conditions of the first half of 1995. The German economy, by contrast, had been slowing down since mid-summer. Ten-year US T-bond yields having fallen to 5.75 per cent in late 1995 were up to 7 per cent by spring 1996 (Figure 5.13) and the US equity market was surging ahead. The USA had become the magnet of international funds and the dollar rose in line to acknowledge that new fact. The dollar continued to move up through spring 1996 albeit at less even rates

190 The Yo–Yo Yen

Figure 5.13

10-year JGB vs. T-bond yields, 1996–9

against the other two major currencies (a spurt against one being followed by a spurt against the other), reaching almost 110 against the yen and 1.55 against the DM by early summer. Thus the yen continued to fall against the dollar despite encouraging evidence that the Japanese economy had at last entered a strong recovery phase. In fact, in 1996 Japan tied with the USA for the place of fastest growing G-7 nation (Figures 5.14 and 5.15). But there were considerable doubts about the sustainability of the recovery – in particular how much spending was being simply brought forward ahead of a rise of the sales tax from 3 to 5 per cent scheduled for 1 April 1997. Moreover long-maturity Japanese government bond yields had continued to fall – touching almost 2.5 per cent for 10-year maturities by the summer, indicative of a growing view that rates would remain low for a very long time – and this was a new stimulus to capital outflow from Japan, as evidenced by the following quote: 31.10.1996 (Market News Service) Encouraged by the dollar’s rise against the yen and disconcerted by minuscule returns on local bonds, Japanese institutional investors have overcome their aversion to overseas bond risks, say managers who warn that continuation of this trend depends on continued dollar–yen strength. International markets for at least a year have been expecting to see a ‘wall of money’ coming from Japan as life insurers and other financial institutions shook off their reticence to

Yen Opportunity Gained and Lost (1993–2000) 191

– – –

Figure 5.14

Japan, US and Germany real GDP growth, 1993–7

Figure 5.15

Real GDP: Japan, US and euro-area, 1995–2000

192 The Yo–Yo Yen

take on foreign currency risk and reversed the repatriation into yen seen in the early 1990s. Now the Japanese institutions have concluded they can’t afford to stay home. … The dollar’s firmer footing at higher levels with the endorsement of US Treasury Secretary Rubin and Japanese officials has almost guaranteed domestic institutions that they can invest overseas and be fairly comfortable. … Many Japanese investors regret not having made the move into foreign assets sooner. Through summer and early autumn 1996 the yen had continued to weaken against the dollar, and also now against the DM, albeit to a lesser extent. In terms of our currency geography this was a period of the G-3 currency triangle being dominated by the yen–dollar axis (see Figures 5.3, 5.4 and 5.5). The most likely, though non-provable, reason for the yen outpacing the DM in its fall against the dollar at that time was the rising momentum of capital outflow from Japan, as described above. By the time of the US mid-term elections of November 1996, the yen was at around 115 to the dollar. Over the turn of the year the DM–dollar axis took over as dominant in the G-3 currency markets, with the dollar continuing to rise but now by more against the DM than the yen. This coincided with gathering speculation that the Federal Reserve was about to tighten monetary policy – the first tightening since rates were brought down in 1995. Then from February to April 1997 the yen led the fall against the dollar, reaching a low of 127. There was a new factor to explain the yen’s decline. In late 1996 the government of Ryutaro Hashimoto (Prime Minister since January of that year) had indicated that fiscal policy was to be tightened substantially in the next fiscal year (starting in March 1997). This had been the catalyst to a further decline in government bond yields (and helped to dampen expectations of a subsequent rise despite continuing economic recovery), and as US bond yields continued to rise on the back of the booming US economy (and speculation on Federal Reserve tightening) the yield spread in favour of 10-year T-bonds over JGBs reached a record 450bp (see Figures 5.13 and 5.16). The tighter fiscal policy in Japan had been foreshadowed back in September 1996 when the Hashimoto government rejected calls for a supplementary budget, maintaining that the economy was strong enough to move forward without new fiscal injection. Then in early December (1996) the government confirmed its plan to end the 2-year provisional income tax-cuts (drafted in spring 1994). And already the 2 per cent increase in sales tax was looming (effective April 1997). The government endorsed a medium-term programme of reducing the budget deficit to 3 per cent of GDP by 2005 and called for a major cutback in public works spending. The overall plan was agreed on 20 December (1996) and in fiscal year 1997–8 the general government deficit was to fall by 1.3 per cent of GDP. In principle when major fiscal consolidation occurs, such as in Japan under PM Hashimoto, there is likely to be downward pressure on the national currency (in this case the yen). If reduced government deficits are

Yen Opportunity Gained and Lost (1993–2000) 193 5.0

4.5

4.0

3.5

3.0

2.5

10yr yield spread (T-bond over JGB)

2.0 Jan 96 Jul 96 Jan 97 Jul 97 Jan 98 Jul 98 Jan 99 Jul 99 Jan 00 Jul 00 Figure 5.16

10-year bond spread (T-bond over JGB), 1996–2000

not matched by a spontaneous fall in the private sector savings surplus (an unlikely scenario which corresponds to so-called perfect Ricardian equivalence), then in the new equilibrium the overall savings surplus (public and private combined) rises, the natural interest rate falls, and the exchange rate falls. If the process is not to short-circuit and involve a painful period of economic disequilibrium, the central bank must not stand in the way of market interest rates falling to the new equilibrium level. Benign fiscal deflations, following this theoretical model, occurred in a number of OECD nations during the 1990s, including the USA, Italy, UK, and Canada. Indeed, as we saw in Chapter 2, Japan went through a benign fiscal deflation in the early 1980s. But Hashimoto’s efforts were doomed, albeit that markets made a promising start (bond yields down and currency down). There were two vital preconditions of success for Japanese fiscal consolidation in 1997. First, the Bank of Japan would have to take the new budgetary policy seriously into account in the conduct of monetary policy. With money rates already at near zero, that meant giving a clear commitment to hold rates there for a long time, until satisfied that private demand was rising vigorously enough to offset fiscal deflation. Second, Japanese and US officials would have to avoid studiously doing or saying anything which might inflame risk aversion amongst Japanese investors with respect to buying foreign assets. If their new-found confidence in investing abroad was to evaporate, Japan could be confronted with a deflationary jump in the yen occurring at the same time as fiscal deflation.

194 The Yo–Yo Yen

In sum, success would depend on the Hashimoto government pursuing a clearly mapped out strategy embracing monetary and exchange rate policy. On top, the strategy would have to be explained clearly and persuasively both inside and outside Japan. In fact none of this happened. Washington, Bank of Japan officials, and the Hashimoto government itself, all played key roles in sabotaging the policy of fiscal consolidation.

Yen shock of spring 1997 and its after-effect Following a tamer-than-widely-expected 25bp rise of Federal Funds rate on 27 March, US Treasury Secretary Rubin started to qualify his strong dollar policy. He was quoted as saying (Reuters, 27 March) ‘a strong dollar is in US interests and the dollar has been strong for quite some time now’. The astute observer could not but notice the beginning of a shift. Was Secretary Rubin concerned, as some commentators argued, that a further decline of the yen would add to the woes of the Japanese banking system (the yen value of their balance sheets would rise, given the substantial share of dollar assets and liabilities, increasing thereby their need for capital to meet BIS (Bank for International Settlements) ratios?). Certainly there had been growing anxiety about Japanese banks’ health in recent months (and this may well have been a contributory factor in the weakness of the yen). It was not clear, though, that Secretary Rubin would embrace that concern. After all, the best scenario for Japanese banks was the return of economic prosperity, and if yen depreciation was an essential route to that end, then immediate accounting-type concerns should be overlooked. Implicitly Rubin had accepted that argument in favouring a depreciation of the yen in summer 1995. But the yen had now fallen far already. Reports from Washington were ominous, even though in 1997 Japan’s current account surplus was the lowest since the peak of the Bubble Economy. There seemed little prospect that the mercantilists in Washington would accept the argument that Japanese fiscal consolidation should be accompanied by a higher current account surplus in the medium term. But how much influence did the mercantilists have with Secretary Rubin? At end-March, just before a visit of Treasury Secretary Rubin to Tokyo, there was a disturbing remark from his deputy Lawrence Summers. On 28 March, the deputy said “we have been expressing concern for some time about the dangerous possibility that the Japanese current account surplus could expand substantially” (Business Times, Singapore, 28 March 1997). On 1 April came further bad news on the banks. Nippon Credit Bank (17th largest bank) announced the abandonment of its international operations and contraction of its domestic ones. And Hokkaido Takushoku, the smallest of the 10 top commercial banks announced its merger with Hokkaido Bank, its cross-town rival in Sapporo. Both moves were seen as

Yen Opportunity Gained and Lost (1993–2000) 195

only sweeping huge bad loan problems under the carpet. On 21 April, Fred Bergsten weighed in: ‘if the yen were to fall further sharply, it could really have a further devastating effect on the financial system’. The neomercantilists had a new argument to justify US action to drive the yen higher. But below the new clothing, the old arguments could be found, as Bergsten continued: ‘the weak yen means trouble on the international front because it will lead to a bigger Japanese current account surplus. If the dollar stays above 120 yen, the surplus will jump to record levels in a year or two. … the long-run equilibrium level is 100 yen to the dollar” (Reuters News Service, 21 April 1997). Bergsten argued that intervention would be more effective if it were backed up by easier Japanese fiscal policy, which we have already pinpointed as being the main tool of mercantilist efforts to push the yen up. Then came a barrage of commentaries from the G-7 finance ministers meeting at the end of April. In its summary of 29 April, Market News Service made the following points. The G-7 finance minister and central bank heads had called for avoiding excessively volatile exchange rates and exchange rate movements that could widen trade imbalances, without making specific mention of the yen–dollar rate (which was nonetheless implied). US Treasury Secretary Rubin did not back away in separate comments from his recent statements of concern about the Japanese yen’s fall against the dollar. Rubin said he would be watching what measures Japan took to stimulate domestic demand and curb growth in its trade surplus, and suggested that more steps would be demanded of that nation if it failed to achieve its pledged objective of a strong domestic demand-led growth and the avoidance of a significant increase in its current account surplus. Japanese Finance Minister Mitsuzuka reiterated the need to avoid exchange rates that would increase external imbalances and said there was a full concurrence of views between the US and Japanese authorities on the concerns over recent developments of the yen rate. Finally, Bank of Japan Governor Matsushita hinted at a tightening of monetary policy when he commented that there was concern about prices, mentioning that preliminary data suggested that the increase in sales tax had not been accompanied by any weakening of demand. Nonetheless, Matsushita reiterated his determination to maintain the current low interest rate policy, saying the priority of the Bank of Japan would remain making domestic economic recovery solid. What a bombshell! It was now absolutely clear that the Hashimoto government had failed to realise that a continued cheap yen and enlarged trade surplus was crucial to its fiscal consolidation efforts, let alone try to convince its G-7 partners of that point. And without any case being made by Japan, the mercantilists in Washington were back in the driving seat. Indeed there was a mood of hostility in Washington towards Japanese fiscal deflation – as if Tokyo were revoking on an undertaking to keep its current

196 The Yo–Yo Yen

account surplus within politically acceptable bounds by running large budget deficits. Still, cynics in the market-place could dismiss all the G-7 related talk as hot air. What could Washington actually do to drive the yen up? There was no sign that the Hashimoto government would reverse course on fiscal deflation. The Bank of Japan Governor’s opaque remark about inflation was well hedged and did not imply monetary tightening was anywhere on the horizon. And surely Japanese investors would not be scared about going into foreign assets just because the mercantilists had barked? But was there any bite? If, in fact, international investors became scared by the mercantilist talk in Washington, the dollar would fall not just against the yen but also the DM (albeit by less). A general fall of the dollar, however, could increase US inflation risks and thereby endanger the apparently emerging US economic miracle – surely not a danger to which Secretary Rubin would be blind? Indeed in the first week following the G-7 meeting there was little market movement. Then came a clanger from Tokyo, not Washington. In the most virulent open-mouth currency intervention yet, Eisuke Sakakibara, widely credited for having engineered together with Secretary Rubin the yen’s devaluation of late summer 1995, said (JIJI Press Newswire Report, 8 May) that the dollar could fall to 103 yen given past examples of yen–dollar rate moves. The method of getting the yen up was still obscure, but the source of the remark was enough to make Japanese investors who had recently shed some of their risk aversion with respect to foreign assets think twice. How important the remark was in itself is not provable because by coincidence several other developments were occurring capable of putting upward pressure on the yen against the dollar. In a speech on 8 May, Federal Reserve Chairman Greenspan hinted that no further tightening of monetary policy was necessary (refuting thereby a widespread view that the 25bp hike of Fed funds rate in March was the start of a series of moves). Then on 11 May, a report in a Tokyo daily quoted an unnamed Bank of Japan official as saying the low-interest-rate policy would soon end (Figure 5.17) (Investor’s Business Daily, 12 May 1997), which sent 10-year JGB yields 10bp higher in the day. Rumours of monetary tightening had caused a gradual climb in JGB yields ever since they touched bottom on 7 April. Thus whereas US T-bond yields had been falling (on speculation about a let-up in Fed tightening), JGB yields had been rising – a convergence which should help the yen recover (see Figure 5.18). The yen, which had been at 124 on 7 May, was at 119 on 11 May. A US Administration official added fuel to the fire by saying that the US Treasury would be comfortable with a dollar/yen rate between 110 and 115 (Reuters News Service, 12 May 1997). Japanese officials helped by reiterating that latest anecdotal evidence suggested fiscal deflation was not dampening overall demand (implying

Yen Opportunity Gained and Lost (1993–2000) 197 0.59

5.81 3mth Euro-$ Japan 3mth CDs (RHS)

5.79

0.58

5.77

0.57

5.75

0.56

5.73

0.55

5.71

0.54

5.69

0.53

5.67 1-Apr-97 Figure 5.17

0.52 15-Apr-97

29-Apr-97

13-May-97

27-May-97

3-month Japan CD rate vs. 3-month euro-dollar, April–May 1997

3.0

7.1 10yr JGB yield 10yr T-bond yield (RHS)

2.8

7.0

2.6

6.9

2.4

6.8

2.2

6.7

2.0 1-Apr-97 Figure 5.18

15-Apr-97

29-Apr-97

13-May-97

10-year JGB vs. T-bond yields, April–May 1997

6.6 27-May-97

198 The Yo–Yo Yen

thereby that interest rates could rise). Following a G-10 central bankers meeting on 12 May, Bundesbank President Tietmeyer commented, ‘we had a new assessment of the Japanese economy (from the Bank of Japan representative at the meeting); fears that fiscal drag could have a big negative impact seemed to be less now than before’ (Reuters News Service, 12 May 1997). Market News carried a report the same day: ‘A Japanese official said the discount rate has been held down much longer than anyone had a right to expect … the Japanese economy has been underestimated. Recent data shows we can go through this period of fiscal consolidation without damaging expansion. People begin to realise that we shouldn’t be so pessimistic about our economy.’ All cannot be blamed on officials. The Japanese bond and money markets were alight with broker forecasts of uninterrupted economic strength and rising interest rates (see Figures 5.17 and 5.18). At the beginning of April the yield on the benchmark bond had been as low as 2.07 per cent. Now it was at 2.6 per cent. The Senior Economist at Yamaichi Research Institute of Securities and Economics said (Reuters, 12 May 1997), ‘We have started to consider the possibility of an official rate hike in July. The effects of the rise in the consumption tax are fading away and the central bank’s Tankan quarterly business survey, released in July, may come out with a positive forecast.’ By 15 May, the yen was at 114 (Figures 15.19 and 5.20). A senior LDP official was quoted as hinting at higher rates (South China Morning Post, 16 May 1997): ‘As we undertake reforms, there will be complaints from those hurt by low rates and interest rates of a certain level will be demanded.’ Goldman Sachs said it was changing its forecasts for the dollar on the basis that Japanese rates would rise by the fourth quarter. An influential Washington newsletter cited Secretary Rubin as seeking a cheaper dollar of around 115 yen. There was also increasing readjustment of dollar holdings of Japanese investors, ‘who have been behind much of the yen’s past weakness’. Then on 21 May the yen touched 112 on a shock media report (JIJI Press Newswire, 21 May 1997) that Senior Deputy Bank of Japan Governor Toshihiko Fukui indicated the central bank’s readiness to raise the discount rate. ‘The report dealt a telling blow to the bond market first and pushed Japan’s long-term interest rates higher, which in turn ignited a welter of dollar selling in the foreign exchange markets’. In an interview with Le Monde on 23 May, Eisuke Sakakibara said that a rise of 50bp in the Bank of Japan’s discount rate should be expected in the coming year, although he qualified the remark by saying that he did not think the Bank of Japan would act before it was sure of a solid economic upturn. Thus the yen had risen by around 12 per cent in less than two weeks against the US dollar and by virtually the same amount against the DM. Flatterers of Treasury Secretary Rubin could say he had successfully pulled

Yen Opportunity Gained and Lost (1993–2000) 199 1.80

128 Yen/USD DM/USD (RHS) 124

1.75

120

1.70

116

1.65

112 1-Apr-97 Figure 5.19

15-Apr-97

29-Apr-97

13-May-97

1.60 27-May-97

US$ vs. Yen and DM, April–May 1997

128

75

126

74

124

73

122

72

120

71

118

70

116

69

114 112 1-Apr-97 Figure 5.20

Yen/USD Yen/DM (RHS)

68 67

15-Apr-97

29-Apr-97

13-May-97

Yen vs. US$ and DM, April–May 1997

27-May-97

200 The Yo–Yo Yen

off a unilateral rise of the yen without the unpleasant side-effect of undermining the so-called strong dollar policy. But many points remain unclear even well after the dust has settled on this exceptional happening in the currency markets. Was Japan’s Ministry of Finance orchestrating the interest rate comments that played such a powerful part in pushing the yen higher on its own? Or was it just coincidental that Bank of Japan officials were changing their minds about the direction of rates at the same time as a yen offensive was in process? And how real was the conversion of view at the Bank of Japan? Had Governor Matsushita really become convinced of the need for higher rates – or did he simply acquiesce in pressure to comply with the yen policy and permitted his deputy to broadcast a strong view which was not his own? Why was opinion in the Japanese government bond markets so gullible – did participants really believe that economic fundamentals had changed so much in a few weeks to justify such a spike in long-maturity yields? Should they not have remained very concerned that fiscal consolidation could dampen seriously overall demand? And did no senior Japanese official argue even in private that Tokyo should say no to Washington’s demand for a revaluation of the yen? After all there was a strong and internationally respectable case for saying that fiscal consolidation should take place now and should be accompanied by easy money and a cheap yen. What did ‘Mr. Yen’ (Eisuke Sakakibara) or any of his colleagues fear from saying no? Was this a rare example of the yo–yo yen string indeed being pulled by Washington, albeit with the compliance of Tokyo? Possibly. But the pull was not strong and could not be sustained for long in the face of economic fundamentals that were pulling the yen in the opposite direction. Indeed, there is a cynical interpretation that can be given to the events described. The Clinton Administration was irritated by its lack of real progress in opening up Japanese markets despite the long-drawn-out Framework Talks, and now Tokyo seemed to be getting away with a yen devaluation. It had remained quiet, however, until after the mid-term Congressional elections (November 1996), so as not to suggest in public that its strategy for dealing with Japan had failed. After the elections, Clinton officials began to take a stronger line again, probably implying the threat of new trade action (starting with the normal round of sectoral talks). Tokyo officials had no stomach for a new round of negotiations which might bring a new harmful upward spiral of the yen (there was not much logic behind this connection, but nonetheless the history of the yen bubble coinciding with the Framework Talks had made them fearful that there was some connection via market psychology). Maybe it would be best to offer Washington a pre-emptive rise of the yen. But how could this be pulled off? The Bank of Japan held the key – a hint of monetary tightening could

Yen Opportunity Gained and Lost (1993–2000) 201

do the trick. Governor Matsushita, an ex-Ministry of Finance official, might be compliant. The collection of statements by government officials suggesting rates could rise and then corroborated by Matsushita’s deputy, smacked of a ‘conspiracy’. Cynics could say that it was all short-term tactics and Governor Matsushita had no real intent of sanctioning a tightening of monetary policy any time soon. The bond markets and currency markets, however, fell for the trick and Washington was satisfied. By the summer the yen could be down again (if indeed no monetary tightening could be justified), but Tokyo could say to Washington that everything possible had been done. In any case by that time the Clinton Administration could have moved on to other topics in its international economic agenda and Japan have shifted out of the limelight. The cynical interpretation has considerable plausibility and if true would suggest that Eisuke Sakakibara exercised considerable diplomatic skills in dealings with both Washington with other key officials in Tokyo. He was a skilful communicator to markets. Nonetheless, the sudden large jump in the yen that was engineered had damaging consequences, and both the Clinton Administration and the Hashimoto government bear responsibility. The yen jump triggered an immediate reversal of important volumes of hedge fund lending to the ASEAN countries. Hedge funds had been engaged in the carry trade of borrowing yen and lending into the high interest currencies of the Asian ‘cubs’ which were pegged to the dollar, gaining both from a wide interest rate differential and from the fall of the yen. On the turn of the yen they rushed for the exits, setting the stage for growing financial strains in these Asian economies which were in the midst of fantastic real-estate and equity market bubbles. (In fact, the reversal of carry trades probably played a key role in the violence of the yen’s upturn.) A more forward looking international economics team in Washington might have been addressing the question of inevitable post-bubble adjustment in these countries and how to cushion the bursting of the bubbles (perhaps by pre-emptive devaluations or floats) rather than setting off a trigger to their bursting. As regards the Hashimoto government, and Eisuke Sakakibara in particular, they paid too little attention to the harmful impact of a yen spike, however short, on the vital mechanisms for recycling Japan’s savings surplus to the world outside. The damage done to those mechanisms surely exceeded the small risk – allowing for bluff – of the Clinton Administration reopening trade talks. And in any case, even if Washington did follow that route, Tokyo could have learnt from the experience of 1993–5 that resolute action would be necessary to prevent the yen being used as a trade tool. For example, the Japanese government could have stated explicitly that fiscal consolidation, itself deflationary, should be offset by a stimulus from yen depreciation. There was indeed evidence to support that view from a

202 The Yo–Yo Yen

number of fiscal consolidations in the OECD area during the previous 20 years. The Japanese government could have given substance to its view by setting an agressive target for the expansion of its foreign exchange reserves over the medium term, and issuing public instructions to the Bank of Japan to buy foreign currencies continuously for that purpose. Instead, a yen spike was engineered that rocked the recently found confidence of Japanese investors to buy foreign assets. And the enlarged risk premium that they would require in future so as to justify further accumulation of foreign investments meant that the Japanese economy was in danger of falling into a deflationary trap. For example, what would occur if the economy lurched into a new recession and the private sector savings surplus ballooned? With interest rates already near zero, the equilibrium outcome would be for a prompt and sustained fall in the exchange rate accompanying a big increase in capital exports (and the current account surplus). Whether market forces would bring about that outcome depended on the willingness of Japanese investors to buy foreign assets and of foreign borrowers to increase liabilities in yen. The extent of that willingness would soon be put to the test. The possibility of a deflationary trap became a real danger within months, not years.

From Asian crisis to yen lowpoint of summer 1998 The combination of the Asian crises of summer/autumn 1997, the lagged deflationary impact of the yen’s jump in the spring (1997), and a new crop of bank and security house failures in Japan (including Hokkaido Takushoku Bank and Yamaichi Securities), paved the way to a sharp downturn of the Japanese economy from late 1997 (led by falling exports to Asia and plummeting business investment). During early summer 1997 the main event in currency markets had been the news that Italy would almost certainly be a founding member of European Monetary Union (to be launched on 1 January 1999) which triggered a sharp fall of the DM against the dollar (from around 1.70 to 1.80 DM/$), with the yen finding itself inbetween (rising against the DM, falling against the dollar). Then as the Asian crisis began to unfold (starting with the devaluation of the Thai baht on 2 July 1997) the yen was at first steady at around 120 to the dollar (through late summer and early autumn) whilst the DM rebounded (to around DM/$1.70). The initial consensus view in currency markets was that Europe would be least impacted by the Asian shock. That view already began to shift in late 1997 as estimates of the exposure of European banks and the European economies to Asia ratcheted upwards and as the recessionary trends and financial woes in Japan became increasingly evident. The yen again entered the limelight of the G-3 currency markets falling almost without break from to a level of 145 against the dollar in summer

Yen Opportunity Gained and Lost (1993–2000) 203

1998 whilst the DM/$ rate was flat at around 1.80 (having risen there from 1.70 in a brief late-year correction in 1997)(see Figures 5.3, 5.4 and 5.5). What drove that sharp and persistent decline of the yen? As Japan’s recession deepened it is quite likely that some investors gradually came round to the view (encouraged in that process by evidence from the market that other investors were thinking similarly) that economic equilibrium could be reached only at a much lower level of the currency than what had been seen in recent years. Anyhow, given the sharp fall in the currencies of several Asian trade partners, the yen had to fall itself just to maintain a constant overall effective exchange rate. With the Japanese financial system tottering, surely at last the mercantilists in Washington would be silenced as the aim of Japanese economic recovery took precedence over other considerations. A cheaper yen was surely essential to that recovery. But it is impossible to demonstrate how deep or wide was that shift in view. Japanese investors themselves were not at the forefront or even in the mainstream of this opinion change. They were either still too shell-shocked by the events of spring 1997 (when the abrupt rise of the yen had inflicted sudden large losses on their foreign investments) or in financially too weak a position to take bold new positions in foreign assets. There were important capital outflows stemming from Japanese borrowers in distress repaying foreign creditors (unwilling to extend their loans). In particular, Japanese banks were repaying credits from foreign banks out of their own capital. (In addition, some banks received life-support dollar deposits from the Bank of Japan for the purpose of repayment, but this set of transactions did not imply a net capital outflow.) But these repayment-related flows were forced rather than driven by calculation of expected exchange rate gain. It was in the so-called carry trade – non-Japanese borrowers willing to take on yen liabilities to fund non-yen assets – which was now surging, that expectations of a weaker yen were rampant. Borrowers’ willingness to act in this way would have been influenced in many cases by some notion of the equilibrium value of the yen having fallen far below what was seen in the recent past. In other cases, bandwagon effects might have been important together with the immediate speculative appeal of substantial income gains from borrowing a falling currency at virtually zero interest cost. The fact that Japan’s again growing current account surplus (the counterpart to the rise in the savings surplus which accompanied recession) might be flowing out in the form of highly speculative foreign borrowing of yen, rather than long-run foreign investment by Japanese savers, was a point of vulnerability. In the market-place – and amongst international monetary officials including those at the Bank for International Settlements – there was some unease about the huge volume of carry trade in the yen and the possibility that this could unwind suddenly. The unease was all the greater because of the huge imprecision of any estimates. The hedge funds were one group of

204 The Yo–Yo Yen

big players and potentially the most fickle. They were hardly ‘in there’ for the long haul (meaning a decision that the yen should represent a significant share of their liabilities for a long time ahead). Other carry traders – for example, corporate borrowers throughout the world – might be less volatile in their behaviour, but who could know? A sudden change in direction for the yen coupled perhaps with international liquidity problems could bring a mass scramble out of positions, threatening grave instability in the currency markets. And there were three events in particular through spring and summer 1998 that pointed to a possible yen reversal ahead even though they did not cause any immediate flurry. First, in March 1998, Bank of Japan Governor Matsushita had resigned, taking responsibility for a bribery scandal involving a senior official charged with leaking sensitive information to banks in return for lavish entertainment. Prime Minister Hashimoto appointed in his place Masaru Hayami, ‘known as a proponent of a strong yen’ (Reuters New Service, 20 March 1998) and ‘renowned for his bluntness’ (The Japan Times, 30 March 1998). The 72-year-old governor took office barely a week before the new Bank of Japan Law came into effect aimed at increasing the central bank’s independence from the government and its accountability to the Diet. It was ominous when Governor Hayami used the first opportunity (Nikkei Weekly, 23 March 1998) to attack the policy of ultra-low interest rates (‘Japan’s prolonged ultra-easy monetary policy has had negative effects on the private sector’) and to wish for a stronger yen (‘A strong yen does not go against the national interest’). And there were warnings, both in the Japanese media and international media: 17.3.1998 (Nihon Keizai Shimbun) One area of concern is that Hayami has been quoted in the past as making repeated statements arguing that a strong yen is positive for Japan. He is the author of a 1995 book analysing the foreign exchange market, titled ‘The Day the Yen Wins Respect’ (not translated into English, the book argued for a bigger international reserve role for the yen). A senior economist at Dai-Ichi Life Research Institute said he hoped Hayami would not get carried away by any attachment to a strong yen. 6.4.1998 (Wall Street Journal) Masaru Hayami, the new governor of the Bank of Japan, is a devout Christian who believes central bankers should act as the ‘conscience of Japan’s economy’, and his conscience bothers him because Japan’s flat growth and weak yen are posing a threat to Asia and the rest of the world. In his first interview since becoming governor he said that the weak yen is eroding the buying power of Japan’s businesses and consumers. The resulting fall in demand could prolong recovery for the region’s troubled economies. ‘A stable and strong yen is well within our national interests.’

Yen Opportunity Gained and Lost (1993–2000) 205

Second, in mid-June 1998, there had been a bout of joint US–Japanese intervention in an albeit unsuccessful attempt to push the yen higher. The intervention had been timed to precede a visit by President Clinton to Beijing – and was regarded as a pre-Summit present to China which had been complaining about the harm to its economy from a cheap yen and how it might be forced into a devaluation of its own currency which could set off a further round of currency depreciation in Asia. Many economic commentators were sceptical of the Chinese concerns, seeing these as reflecting a political relations strategy – after all, there was little direct competition between Chinese and Japanese goods in export markets and Japanese direct investment in China was likely to continue falling in any case from its peak levels of the early and mid-1990s given its disappointing profits record to date. Nonetheless, Washington was again expressing irritation with the cheap yen. Third, at end-July Prime Minister Hashimoto had resigned following a bad outcome for his party in the Upper House elections, and he had been succeeded by Keizo Obuchi, who had won the LDP leadership election on a promise of bold fiscal reflation. Indeed Obuchi had appointed the aged Kiichi Miyazawa, an old-fashioned Keynesian (and ex-prime minister), as his finance minister. Whilst campaigning (for leadership election) Obuchi had pledged to implement a permanent income tax cut of 6 trillion yen and to pass a 10 trillion yen supplementary economic stimulus package. The new prime minister promptly had announced his intention to introduce legislation to suspend the law providing for gradually falling fiscal deficits over the medium term (introduced by the Hashimoto government). Fiscal reflation meant – everything else the same – a stronger yen.

Shock (autumn 1998), mini-bubble (summer 1999 to summer 2000), and their aftermath (to winter 2000/01) Despite these warning signs the violence of the yen reversal, when it came, could hardly have been predicted. The outbreak of the international liquidity crisis of autumn 1998 following Russia’s debt default at first went along with a modest weakening of the dollar against both the yen and the DM. According to the dominant market view, the US economy was most at risk from the knock-on effect on emerging market economies. The US equity market plunged. There was speculation on an early easing of US monetary policy. Indeed on 29 September came a first 25bp cut in the Fed funds rate. By the beginning of October the US dollar was down to 135 against the yen and 1.65 against the DM from 145 and 1.80 back in late August (Figure 5.5). One factor helping to restrain the rise of the yen was an easing of monetary policy by the Bank of Japan in early September (call rates fell from 0.50 per cent to 0.25 per cent) and an associated plunge in 10-year Japanese gov-

206 The Yo–Yo Yen

ernment bond yields, which fell below 1 per cent. The collapse of Long Term Capital Management (LTCM), the ‘Rolls Royce of the hedge fund industry’, in late September, had no immediate substantial impact on the yen. In the first few days of October the outlook for the US economy continued to darken amidst reports of a growing credit squeeze. Then – almost out of the blue (nothing should ever be a total surprise to alert market-participants continuously revising their probabilistic view of the future) – the dollar plunged by almost 20 per cent (from high to low point) against the yen in a 24-hour period from Wednesday 7 October to Thursday 8 October, bringing the yen/dollar rate to an intraday low of 111. During the same period the dollar fell by barely 3 per cent against the DM (see Figure 5.21). The immediate cause of the yen’s surge was reputed to be hedge funds, faced with liquidity pressures, bailing out of their carry-trade positions. Why did this happen on 7–8 October rather than 6 October or 9 October? The ultimate reason may have more to do with the micro-positions of the hedge funds involved. But relevant macro-economic news which could have caused them to throw in the towel included news that the Obuchi government had introduced legislation into the Diet which would provide important support for the Japanese banking system, and a speech from Federal Reserve Chairman Greenspan indicating alarm over deteriorating economic prospects and foreshadowing a substantial easing of US monetary policy. If there was ever a case of so-called disorderly foreign exchange

Figure 5.21

US dollar vs. Yen and DM, October 1998

Yen Opportunity Gained and Lost (1993–2000) 207

markets which would have justified stabilising action from central banks this must surely have been it. And the complete failure of any such action to materialise left Japanese investors even more risk averse with respect to foreign assets than before and the carry-traders who had been playing a major role in exporting Japan’s current account surplus during the recent past traumatised. The prospects for a smooth recycling of Japan’s massive private sector savings surplus were bleaker than ever before. How was there such a dramatic case of currency market failure? The following quotes provide some insights: 8.10.1998 (Reuters News Service) US Treasury Secretary Rubin declined to comment on the recent plunge of the US dollar against the Japanese yen. ‘This is not the time I can do it. I’m late.’ 8.10.1998 (FWN Financial News) President Clinton said today the Japanese yen had become ‘too weak’ versus the US dollar and there are some benefits to a stronger yen versus the dollar. ‘It led, for example, to breathtaking increases in imports of Japanese steel, which hurt a lot of our people, our industry and our workers, who were clearly competitive internationally.’ Anyone who thought the Bank of Japan would help stabilise the situation were soon to be disappointed: 10.10.1998 (Nihon Keizai Shimbun) The yen’s sudden surge against the dollar, coupled with the decline in Japanese stocks, is fuelling sentiment within the Bank of Japan that an additional easing of monetary policy is needed. 15.10.1998 (Nihon Keizai Shimbun) Hayami said that at Tuesday’s policymaking board meeting, the large majority decided it wasn’t appropriate to take further monetary action now, as effects from last month’s easing would require some more time to emerge on economic activities. 11.12.1998 (Nihon Keizai Shimbun) Markets pushed the dollar down to 115 yen today. The selling was accelerated by comments from Bank of Japan Governor Hayami, who said current exchange rate levels aren’t abnormal. Ultimately, of course, the shock rise of the yen in early October 1998 would have gone into reverse if it had been driven only by the liquidity problems of hedge funds. But there was a lot more which had changed. First, Japanese investors in foreign currencies and foreign borrowers of yen had raised their assessments of its potential volatility, and so they

208 The Yo–Yo Yen

would require more return in the form of future depreciation to justify crossing the currency frontier (meaning that the yen would have to be more obviously expensive in the present). Second, the new Governor of the Bank of Japan had declared his enthusiasm for a strong yen – quashing doubts that his views may have changed. Third, outflows of capital via the banking sector had been stemmed as a consequence of the big new support package, which included not just provisions for public fund injection but widespread government guarantees for small and medium sized borrowers. Fourth, in early November the Obuchi government had presented to the Diet the most ambitious programme yet of fiscal reflation. Indeed this fourth fact, together with a belated realisation that the Bank of Japan was adamantly against supporting the bond market (which may well not have been effective, even if tried), had caused long-maturity JGB yields to double almost at a stroke to around 2 per cent in mid-December 1998 (Figures 5.22 and 5.23), which was a further drag on the outflow of capital from Japan. Conspiracy theorists saw the handiwork of Governor Hayami and Eisuke Sakakibara behind the abrupt rise of government bond yields (to which one catalyst may have been the announcement that the Trust Fund Bureau was to scale back purchases of government bonds). The idea was that higher yields would be necessary if the yen were to stand a chance of competing as

Figure 5.22

Japan yield curve, 1995–2001

Yen Opportunity Gained and Lost (1993–2000) 209

Figure 5.23

10-year JGB yield vs. 3-month CDs, June 1998–March 1999

a reserve currency in the new monetary era about to dawn in Europe (the launch of the euro). The euro started existence at the opposite end of the pole to the US dollar. For the first half of 1999 the euro was falling, the US dollar rising, and the Japanese yen in-between. Thus the yen fell from around 115 against the dollar to near 120 by late spring, whilst rising from 130 to 125 against the euro (Figures 5.24, 5.25 and 5.26). Dollar strength corresponded to dissipating pessimism about the US economy, whilst euro weakness corresponded to disappointing economic performance and growing misgivings in the market-place about the European Central Bank. There followed one of the most remarkable upswings of the yo–yo yen. From mid-year (1999) to late autumn the yen soared to almost 100 against the US dollar and 100 against the euro. The upturn was driven by a sudden blossoming of optimism about the Japanese economy. The bubble in the US new economy proved a powerful lever in helping to pull Japan out of its recession. Exports bounded ahead to the US new economy and to Asian countries themselves feeding the US bubble with soaring exports of new economy merchandise. Business investment turned up strongly rather than continuing its widely predicted long fall. And foreign investors piled in to the bubble new economy stocks in the Tokyo equity market, many of which were essentially high-geared plays on NASDAQ, and into old economy stocks too. Many European institutional investors were simulta-

Figure 5.24

Euro currency corner, 1999–2001

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Figure 5.25

USD currency corner, 1999–2001

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Figure 5.26

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Yen currency corner, 1999–2001

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Yen Opportunity Gained and Lost (1993–2000) 213

neously piling into the Japanese government bond market, frightened that they might underperform their peers if the yen remained under-weighted (compared to the standard bond indices) as in recent years. In fact, the yen currency markets had become largely one-way markets. In addition to the huge commercial demand for yen corresponding to the current account surplus, there was huge investor demand. Japanese investors who might once upon a time have taken advantage of a stronger yen to buy foreign assets were still suffering from shock, and preferred the safety for example of postal savings accounts offering near the long-term bond yield (equivalent to around 3 per cent in real terms when account was taken of the falling price level) and a put option (they could demand redemption after a short period if yields rose). Japanese, unlike European, investors, were sceptical of bubble-type equity markets, whether on Wall Street or in Tokyo. Indeed Japanese corporate and bank investors were prudently taking advantage of the huge foreign demand for Tokyo equities and their high prices to offload their interlocking shareholdings and so building up liquidity. If the Ministry of Finance had not been selling huge quantities of yen for dollars (via the Bank of Japan) it is possible that the yen would have had to rise considerably further before Japanese investors in foreign assets and some carry-traders were catapulted back into action. Indeed it was an open secret that the Ministry of Finance was highly concerned about the rebound of the yen, not least because it viewed a continuing external stimulus as essential to the Japanese economy returning to prosperity in the face of large potential deflationary influences (including eventual fiscal consolidation and accelerated clean-up of the banking system). But translating its concern into powerful action would require the cooperation of the Bank of Japan. Sterilised foreign exchange intervention was widely viewed in the markets as ineffective. The key to successful intervention was for the Bank of Japan to finance the official purchases of dollars by money creation. But Masaru Hayami would not oblige, even though the Ministry of Finance had an unusual ally – the new US Treasury Secretary, Larry Summers – in the debate. Why was Governor Hayami so uncooperative? The evidence of public remarks suggests several explanations. First, Hayami saw as one of his missions the building up of central bank independence, granted only recently as a legal possibility. If the Bank of Japan agreed to monetise the purchase of foreign exchange as dictated by the Ministry of Finance its independence could suffer. Second, there were theorists within the Bank of Japan who provided a respectable handle on which to hang the independence argument. Sterilised intervention involved the simultaneous actions of the Ministry of Finance buying foreign currency and issuing T-bills and the Bank of Japan expanding the monetary base by the identical amount via buying those same T-bills. But with interest rates already at zero (the call money rate was

214 The Yo–Yo Yen

cut in February 1999), expanding the monetary base would have little or no macro-economic impact. Banks would simply end up holding more excess reserves. The Ministry of Finance could run foreign exchange policy without any help from the Bank of Japan. Third, Hayami was not convinced that a stronger yen was such a bad thing for the Japanese economy. There were strong potential counter-arguments to Governor Hayami’s points but these did not emerge clearly in public and foreign exchange markets were dominated by the view – in fact correct – that the Bank of Japan would not budge. Independence could have been preserved by the Bank of Japan setting a target for monetary base expansion and specifying that a given percentage (of the increase in base) would take the form of foreign currency purchases. The argument that monetary base expansion would be ineffective with rates at zero has never been resolved in any practical historical instance. Several US economists wrote confidently in newspaper articles about some black box mechanism which transforms excess reserves into aggregate demand. They might be wrong. But was there any harm from at least experimenting? In any case monetary financing of foreign reserve acquisition might well impress currency markets more than Ministry of Finance funding, in that the latter is subject to limits which can be expanded only by legislative consent, whilst the former is a matter only of agreement between the central bank and the government (what proportion of monetary base expansion should be matched by foreign currencies?). Finally, the argument that a strong yen was good for the Japanese economy was directly opposed to the view which was very belatedly beginning to gain ground both in Washington and in various supranational organisations (for example the OECD in Paris) that Japan’s huge private sector savings surplus should indeed be matched by current account surpluses and capital exports, meaning a cheap currency, rather than wasteful public works projects. Governor Hayami did not budge, but the world about him did. The crash of NASDAQ in 2000 followed by the descent of the Japanese economy into recession brought the yo–yo yen under a new downward pull. From autumn 2000 when the US economic downturn from the long boom became apparent until spring 2001 when the extent of the Japanese downturn became evident, the yen fell by around 15–20 per cent against the euro and US dollar (Figure 5.26). That was only a modest reversal of the overall climb between autumn 1998 and late 1999. But there were some encouraging pointers to important rethinking about the problems of the yo–yo yen, both in the market-places and in the corridors of monetary power. What to do about the yo–yo yen is the subject of the next chapter.

6 What To Do About the Yo–Yo Yen?

Previous chapters have given an account of the people and forces which have pulled the strings of the yo–yo yen. The relative importance of people as against forces is of course a perennial issue in historical analysis – whether in the arena of international relations (would the First World War have taken place if Archduke Ferdinand had not made his provocative visit to Sarajevo?) or of monetary affairs (would the Great Inflation of the 1970s have occurred if Arthur Burns had not secured his appointment as Federal Reserve Chairman by ‘indicating’ to President Nixon that he would end the tight money policy then in force and concentrate on reviving the economy in time for the upcoming elections?). In the case of Japan’s Lost Decade of the 1990s, one ‘people question’ is whether the economy would have been more prosperous if someone less attached than Yasushi Mieno or Masaru Hayami to a strong yen for its own sake, less zealous about wrenching independence from government, and more understanding of the surplus savings ‘problem’, had been appointed as head of its central bank. Earlier in this book (see Chapter 4) the view was put forward that it would surely be wrong to blame all or even most on personalities. In the area of monetary and exchange rate policy-making there are conventional wisdoms which come to dominate thinking. It would be rare for an unconventional and even contrarian spirit to find himself or herself appointed as chief bureaucrat responsible for monetary policy. Rather, if a given set of policy-makers contrive to get a monkey-wrench into the monetary machine, there should be a search for how the framework of policy-making could be improved to prevent the same type or a newly imaginable type of accident occurring again. That – rather than the laying of blame against individuals – is the true challenge of the experience to date of the yo–yo yen, particularly during its most violent episodes in the 1990s. The specific questions in search of an answer can be summarised as follows. Can we say from the history of the yo–yo yen that an improved set of policy-rules and institutions, implying new constraints on policy-makers who can pull on its string and new macro-checks designed to reduce the 215

216 The Yo–Yo Yen

violence of its motion, would have led to a better outcome for the Japanese economy? Do we have reason to believe that these improvements should help restore Japanese prosperity in the future? Finally, are there flaws in national or international monetary orders revealed by the history of the yo–yo yen which should be addressed for the sake not just of Japan but for the prosperity of the whole world? There is of course a possible sceptical response to these questions. What is so bad, after all, about the yo–yo? The yen has been the most volatile corner of the dominant currency triangle (linking first the US dollar, yen, and DM, and subsequently the US dollar, yen and euro) only in the 1990s. In the 1980s it was the US dollar. And surely it was to be expected, given the instabilities in the Japanese financial system and the violence of the cyclical fluctuations in the Japanese economy through the bubble years and into the subsequent post-bubble period, that the yen would be particularly volatile. The sceptic could continue further. It is true that the effective exchange rate of the yen (which is weighted by the currencies of Japan’s trading partners) has been substantially more volatile than that of the dollar or euro. But that is a consequence of economic geography. The US and the euroarea have each as important trade partners several countries whose currencies are related closely to their own (for example, many of the Asian and Latin American currencies are dollar-linked, and the Canadian dollar or Mexican peso move more closely with the US dollar than the euro; whilst the Swiss franc, Swedish and Danish kroners, several central European monies, and to some extent the British pound have links to the euro). By contrast, the Japanese yen is on its own. Though violent fluctuations of the yen have usually pulled certain other Asian currencies (in particular, the Singapore dollar, Taiwan dollar, and South Korean won) alongside eventually, the lags in adjustment have been long, and the extent of the eventual co-motion highly variable. And two key neighbouring currencies – those of China and Hong Kong – remain pegged to the US dollar. Such scepticism, however, hardly forms a convincing case against action on the yo–yo yen. Geography does matter. A given percentage fluctuation of the dollar against the yen means more to the Japanese economy than the same move of the dollar against the euro means for the euro-area economy – precisely because the yen is on its own (rather than with a cluster of satellites around it). Volatility of their own currency against the other two currencies in the dominant triangle is a more important concern for Japanese than for US or euro-area economic policy-makers. And there is little prospect of currency geography changing – in particular of Asian currencies and the yen moving more closely together. Not only are there political obstacles to the furtherance of co-motion, but the degree of economic interdependence is far short of that which existed within today’s euro-area in the decade before monetary union.

What To Do About the Yo–Yo Yen? 217

If a new framework were successful in curbing violent swings of the yen, that would be in itself good news for the Japanese economy (‘in itself’ means so long as the method of taming the yen does not impose more costs than the benefits of risk reduction). But volatility is not the only issue in considering what to do about the yo–yo yen. Other issues include the total misalignment of the yen which occurred during the 1990s – its failure to reach and remain at the competitive level which would have fitted an economy with a sudden bulge in its private sector savings surplus. In turn, the misalignment of the yen and its episodes of extreme overvaluation fuelled a deflationary process which monetary policy-makers had already set off and then lacked the confidence to attack boldly. One factor in the failure of the yen to fall to a competitive level was the inflammation of risk aversion on the part of Japanese investors (with respect to foreign assets) caused by violent throws of the yo–yo. That inflammation had a detrimental effect on equilibrating capital flows between Japan and the rest of the world. Huge fluctuations in the yen and extreme risk aversion in effect insulated Japan from the international capital market. Rates of return could remain much lower in Japan than elsewhere without an exodus of capital occurring. The persistence of a low domestic cost of capital allowed a range of inefficient economic activity to persist and, as we shall see below, added to the burden of demographic adjustment. The expensive average level of the yen – and in particular the episodes when it reached dizzy heights – was a catalyst to a hollowing out of manufacturing industry. Yet manufacturing is where Japan’s comparative advantage lies. If manufacturing industry had been able to take advantage of a competitively priced yen, then it might have absorbed labour being shed from the inefficient services sectors of the economy subject to liberalisation. Instead, the bleak condition of manufacturing was a deterrent to bold reform elsewhere.

Why not turn the clock back to a fixed yen–dollar rate? One approach to the problem of the yen is to stop the yo–yo – in effect to turn the clock back to an era of fixed exchange rates. That idea formed the centre-piece of proposals put forward a few years ago by McKinnon and Ohno (1997). These authors set out proposals for a monetary accord between Japan and the USA, including ‘new rules of the game for the steady state’. The first rule is a target zone for the yen-dollar exchange rate with a margin of fluctuation of 5 per cent either side of a central rate based on purchasing power parity derived from wholesale price levels. (Some years after confidence in the accord is established, narrow the band of exchange variation.) Second, neither the Bank of Japan nor Federal Reserve is to fully sterilise intervention in the foreign exchange markets, and the

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US Treasury should build up large reserves in Japanese yen. Third, both central banks are to pursue policies of credit expansion aimed at anchoring the price level of tradable goods (as measured by the WPI in Japan or the PPI in the USA). Fourth, in the case of a speculative attack that would require very sharp increases in short-term interest rates to defend the exchange rate, the bands of permitted exchange rate fluctuation are to be suspended temporarily but the traditional yen–dollar exchange rate parity is to be restored as soon as possible. And crucial to the success of the pact would be the conclusion of a new US–Japan Compact for Commerce and Trade in which Japan would commit itself to a comprehensive programme of economic liberalisation in return for which the USA would unequivocally abandon any commercial use of exchange rate policy. The idea, however, of a US–Japan monetary accord along these lines has deep flaws. Why would Washington sacrifice any independence in monetary policy and embark on potentially large-scale foreign exchange market intervention which is widely disliked in Congress, the Federal Reserve, and the Treasury? The supposed carrot is Tokyo finally saying yes to a catalogue of demands for liberalising the Japanese economy (and incidentally providing big new opportunities for US business there). But why would Washington have full trust in yes meaning yes – the ability of Tokyo to deliver on its promises? If there were indeed a breach, would currency markets not immediately question whether the days of the monetary accord itself might be limited? Would it not be better just to wait until the climate inside Japan changed in favour of economic reform – and desist from deals offering the carrot of an exchange rate pact? And if the climate did not change, the standard of living in Japan would be the main casualty. US business has many international opportunities for expansion outside Japan! The flaws were not all on the side of US perceptions. Tokyo, by tying itself into a monetary accord as described, would increase its vulnerability to a new shock from Washington. Suppose, for example, in the context of a US recession, Washington demanded that Tokyo embark on further fiscal reflation and accelerate economic reform, with the veiled threat that failure to comply would mean the end of the monetary accord. Massive outflows of ‘hot money’ from dollars into yen could lead to an immediate suspension of the exchange rate bands and in some circumstances create monetary instability in Japan (not a near-term problem, given the persistent deflation; anything that increases monetary expansion would be good news). If serious about preserving the pact, Tokyo might have to become subservient to Washington in the setting of fiscal and structural economic policy. Monetary policy, in any case, would be subservient, as the Bank of Japan’s ability to pursue an independent course would be constrained by the exchange rate limits. In so far as there was indeed confidence in the pact lasting, Japanese interest rates would be tied closely to US rates (although the margins of permitted exchange rate fluctuation would make

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scope for differentials to open up between interest rates on the two currencies). An abrupt rise of Japanese rates to near US levels could inflict large adjustment costs on the Japanese economy (bankruptcy of many marginal firms who have been surviving on the life-support machine of zero interest rates; big losses in the financial sector as government bonds would collapse in price) – and so there would have to be a long period of time between agreement to a monetary pact and its implementation. There are questions concerned with the parity to be agreed. A central observation through earlier chapters has been that the yen did not fall to reflect the huge private sector savings surplus that emerged following the end of the bubble economy. A big expansion of the fiscal deficit played a role in the misalignment. In any medium-term profile for the Japanese economy, the fiscal deficit has to fall. The wholesale price level in Japan in, say, 2000 reflected the highly valued and misaligned yen. A reflection of serious disequilibrium should not be the basis of calculating the new parity. Rather, the assumption should be that parity would be well below the average level of the 1990s, implying that Japanese wholesale prices would rise substantially. Moreover, given the deflationary trap into which the Japanese economy had fallen by the end of the 1990s, and the questionmark as to whether conventional monetary policy could create an exit from that trap, there was a basis for arguing that a big yen devaluation was required simply as a last-resort unconventional monetary instrument capable of diffusing deflationary expectations. But how could Washington and Tokyo agree on the use of such a tool, and would not Washington argue anyhow that there should be provision for the yen to rise once the deflation crisis was over, rather than Japan stealing long-run unjustifiable competitive advantage? Would Washington and Tokyo not have to consult with other Asian countries whose economies would be highly sensitive to any big realignment of the yen? The need for such multilateral consultation would in itself be inhibiting to the whole plan. In sum, the McKinnon–Ohno proposals are not promising as seen from the early 2000s as a method of tackling the yo–yo yen. That does not mean an emergency fix should be ruled out in all circumstances. At various stages in the history of the yo–yo yen recounted in earlier chapters an emergency fix might have been an attractive option. For example when the yen was spiralling up on its own in spring 1993, the Japanese government could have announced that the absolute ceiling for the yen against the dollar would be 120 and ordered the Bank of Japan to sell unlimited amounts of yen at that level. Once market-participants believed in the existence of the ceiling, and if indeed Japanese interest rates were below US rates, then the yen would sink to well below the ceiling (meaning a yen/dollar rate in the 130s, say). The same prescription could have been applied in summer or autumn 1999, when large-scale sterilised intervention on its own was largely ineffective.

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Another situation in which an emergency ceiling could have been introduced is that of 2001, when a view had gained widespread acceptance in Tokyo and Washington that yen devaluation was the only tool left which could end deflation now that interest rates were already at zero and there was no further scope for fiscal reflation – indeed a start on fiscal consolidation was already on the agenda. In this climate, Tokyo might have announced that the yen was to be devalued and that a ceiling of 140 would apply to the yen against the dollar ‘over the medium term, until deflation is ended’. Once the ceiling was believed, the yen might have settled, say, in the 150s (in that investors would want compensation in the form of, probably, yen appreciation to compensate for lower interest income than on dollars). The nearest historical example to the tactic described was the Swiss government’s introduction of an emergency ceiling for the franc against the DM of 0.80 (francs/DM) in autumn 1978 to burst a bubble of its currency which threatened to transform it into a ‘collector’s item’. The success of the emergency ceiling does depend on the notion of unlimited amount of the national currency potentially for sale, and that requires the cooperation of the central bank in the form of undertaking not to sterilise funds created for the purpose of intervention. That cooperation has not in general been forthcoming from the Bank of Japan. The emergency ceiling is by definition short-lived. The government does not announce for how long it will be kept (though hinting for some considerable time) nor does it promise to warn markets of its demise. There are not complex international discussions leading up to its imposition. It is a tool to be used only rarely – otherwise the government involved risks being accused of currency manipulation.

A new framework for the floating yen If the float of the yen is not to be stopped, what answer is there to the problems of its behaviour revealed to date? The proposal here is for a completely free float within the context of a new framework for Japanese macro-economic policy. Specifically: 1. There is to be no government intervention in the currency markets (meaning official operations outside those required for government transactions) except as required to fulfil targets for foreign exchange reserve accumulation and monetary base detailed below or in an emergency situation of liquidity crisis (these concepts are detailed below). 2. Government and central bank officials are not to express opinions on the level of the exchange rate or in which direction they hope it will move. (This prohibition would not stand in the way of research

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3.

4.

5.

6.

branches of the government or central bank publishing papers on currency markets or seeking to educate the public regarding the economics of exchange rate determination – see below.) In effect, there is to be no ‘open mouth’ currency policy. Japanese officials are not to be active participants in G-7 discussions about currencies given their country’s commitment to a free float. That does not mean Japan would refuse to explain or consider international criticism of its policies as regards capital exports, foreign exchange reserve accumulation, and (when in force) use of foreign currencies acquisition towards expanding the domestic monetary base. The Japanese government (including the Ministry of Finance) would run educational programmes (including publications, talks, and seminars) both for its own officials and for outsiders on ‘currency economics’, seeking to increase in particular, understanding of the concepts of private sector savings surplus and how equilibrium is reached between savings and investment (including net export of capital). Students of the programme are to be warned of various common fallacies, including simplistic links between the current account balance and the level of the exchange rate. The government is to publish a medium-term target (over the next few years) for the level of foreign exchange reserves and also its expected rate of acquisition of reserves over the coming quarter. Net transactions to achieve the target are to be publicised on the day they occur. Justifications for the chosen medium-term target are to be publicised in full. (For example, need for an increased contingency reserve against foreign creditors reducing positions with Japanese banks; or building up foreign assets in anticipation of bulging pension liabilities and in view of high risk aversion towards foreign assets amongst the investing public; or exceptionally as part of a package of measures to end deflation when a situation of deflation alert has been declared by the government, as below.) If the authorities responsible for monitoring the currency markets determine that a situation of severe illiquidity has developed (otherwise described as disorderly market), then an emergency release or addition should be made to the foreign exchange reserves, with no change in the medium-term target. (In the example of October 1998, the authorities would have determined that massive attempted closing of positions by hedge funds had created a disorderly market, and would have sanctioned, say, an emergency increase in foreign exchange reserves of up to $30bn over the next week. These decisions may not have been taken until late in the day, but some exchange market participations, knowing that such contingency arrangements existed, would have been willing to go short in the yen in anticipation of them coming into effect, and so the jump in the yen would have been much less.)

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7. Constitutional limits on budgetary policy would be introduced (and if not possible, the next best thing would be legislation setting out a clear profile of falling budget deficits and automatic corrective action if these are overrun) with the long-run aim of budget balance enshrined. These limits would be unbreachable even under pressure from outside. (Just as Japan cannot be asked to participate in most types of international military operation because of pacifist provisions in its constitution, so Washington would not be able to demand that Japan take reflationary fiscal action.) 8. There is to be no tolerance of deflation. The normal situation is to be core inflation of between zero and 3 per cent. In a situation of actual or threatened deflation, various emergency provisions which can override usual divisions of responsibility between the central banks and government take effect. (These are detailed below.) 9. The Bank of Japan Law is to be modified. It is to be clear under the new law that the central bank and its Governor have no responsibility for currency policy either directly or indirectly (via pronouncements of officials). The Governor’s appointment is to be made subject to more effective scrutiny by the Diet. His term of office should be limited to 3 years, with reappointment subject to approval in the Diet, where the relevant committee would be asked to publish a report rating his performance to date. The BoJ must set out clearly at the start of each year medium-term targets for money supply and monetary base growth consistent with the inflation target. The Governor must explain these targets to the relevant Diet Committee and be subject to questioning concerning their derivation, implementation, and failure (where applicable) to meet. Serious and repeated failure to meet the targets can be grounds for the Diet to vote for the dismissal of the Governor before the end of his term. If a situation of deflation alert comes into existence (to be determined by the government on the basis of published yardsticks, including recent behaviour of various price indices and possibly leading indicators), then provisions of central bank independence are suspended as detailed in (10) below. 10. In a situation of deflation alert, the government can itself determine the target for monetary base expansion to be followed by the BoJ and stipulate further that it be achieved by purchasing foreign currencies up to a stipulated amount. The foreign currencies bought would be included as part of the foreign exchange reserves and count towards meeting the target for these (which may be increased to take account of the deflationary situation). In a situation of severe deflation which has not responded to full use of conventional tools, including accelerated growth of foreign exchange reserves and foreign currency use towards meeting the monetary base growth target, the government can take all

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powers necessary to implement an emergency regime of negative interest rates (to be described below). 11. The government is to be responsible for promoting a capital export policy. The idea behind this is that huge past volatility of the yen and inflamed risk aversion are seriously impeding the flow of capital out of Japan into much higher yielding assets abroad and a serious misallocation of capital is thereby coming about. Moreover, an increase in the momentum of capital outflow would help raise the equilibrium level of real interest rates in Japan and so reduce the risk of the economy falling into a painful deflationary trap out of which even zero interest rates might not provide an escape. Explicit tax breaks should be given on foreign portfolio investment (and all tax disincentives to capital outflow scrapped). All public sector managers of pension funds would be ordered to raise the share of foreign assets in their portfolios according to an ambitious formula. The capital export policy would be subject to continuing review – so that if risk aversion were determined to have fallen, some of the incentives could be gradually withdrawn.

Emergency provision for negative interest rate regime The idea of removing the zero barrier to interest rates in a situation of severe deflation has a long history – in fact Keynes in his ‘General Theory’ attributes an original proposal to an Argentinian economist writing in Switzerland at the beginning of the twentieth century. The normal barrier to rates falling below zero is of course the existence of banknotes. If the central bank were to cut key money rates into significantly negative territory then holders of bank deposits would withdraw large volumes of funds, preferring to hold them at no interest in safe-boxes or under the mattress rather than at negative interest rates. On top of the deflation problem would be superimposed a banking crisis. All proposals to pierce the barrier involve some method of imposing a cost on the holding of banknotes. Each method is more or less clumsy (for example, banknotes with magnetic strips on the back which register the payment of stamp tax at say monthly intervals) and can be dismissed readily by sceptics as impractical. Why make changes to the most basic element in circulating money when the deflation problem may well be temporary? In any case, there are other ways of combating deflation, even when rates are already at zero and can be cut no further – for example massive expansion of the monetary base, devaluation, or simply spraying banknotes from helicopters. Why not try these first? In fact, there is not much empirical evidence as to whether monetary policy on its own is capable of wrenching an economy out of a severe deflation (which in itself must be due to serious previous errors in monetary policy). In general, large explicit devaluations of the national currency

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have been the way out of past deflations – including the Japanese deflation of the 1920s (yen devalued end-1930), the US deflation of the early 1930s (dollar devalued 1933–4), or the European deflations of the 1930s (gold bloc currencies devalued 1936). There is no actual example from the twentieth century of massive monetary base expansion in peacetime taking place with rates already at zero without an explicit devaluation alongside. Hence the laboratory of history does not provide evidence for or against the hypothesis that monetary policy on its own is capable of ending deflation. A first-time success is of course possible. Several commentators have suggested that Japan could indeed be this first case. But their optimism on monetary policy is based on belief in so-called ‘black box mechanisms’ familiar to monetary economists. (Milton Friedman was a proponent of the view that the specifics of how changes in the money supply affect the economy are unknown in some respects but what matters are the predictable relationships derived from past history.) It seems that the optimists on the power of monetary policy to end deflation, despite rates already at zero and without any explicit policy of devaluation alongside, have in mind various asset-price effects and perhaps some hypothetical ‘revulsion’ amongst the public against amassing notes rather than spending them. Specifically, vast open market operations might be successful in pushing up bond and equity prices, and this in itself would help stimulate demand in the economy. Cynics retort that if bond markets even suspect that the new aggression in monetary policy might be successful, prices would fall there, as long-term rates began to discount the end of deflation. And there are too many legal and other complications in the way of the central bank making large purchases in the equity market, which in any case would be of dubious impact. It is difficult to imagine why purchases which at most would be a tiny percentage of the total stock of equities should have a big price impact. But suppose they did, would there be much of a wealth effect on spending? Even if some optimists were to admit doubt about asset price effects they might be more hopeful about ‘revulsion’ effects. Specifically, as the central bank pumped up the monetary base with vast open market operations, the banks would find themselves with huge excess reserves. As money market rates were at zero and most likely their capital positions weak they would not respond by stepping up their lending to commercial or household borrowers (in fact, if the equilibrium rate of interest is indeed negative, but actual rates cannot get there because of the zero barrier, there might be no new borrowers out there in any case). Instead, they might cut their deposit rates to effectively somewhat negative levels by imposing new charges – and so they could derive some profit from the slim margin between deposit rates and the zero rate on reserves. Some depositors would pull their funds out and hold them in banknotes under these circumstances, and this withdrawal would mean that excess reserves

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in the banking system drained out. Households finding themselves with rising piles of banknotes could decide that it would be better to spend some of them on consumer durables. Such revulsion is indeed possible – that households were quite happy to accumulate bank deposits at zero rates but once rates fall slightly below zero and their money holdings shift in some degree into banknote hoards they are driven to spend. But there is no firm basis for hope. Indeed, the danger of a systemic banking crisis might well increase. A long period of zero money market rates would seriously undermine bank profitability as one of the main sources of earnings – the margin between rates paid to retail depositors and wholesale money rates – yielded only a trickle. It is the possibility of failure for monetary expansion as described, and the potential inability to devalue the national currency by a large amount (perhaps because other major economies are also in recession) that justifies a monetary framework having provision for crisis measures in a severe deflation which would permit interest rates to fall to substantial sub-zero levels. The potential package of measures would be there for all to see and that in itself might help dampen the extent of deflationary expectations, even though there may be doubts as to whether the government of the day would decide to implement them and receive the necessary legislative approval. Implementation would not mean any let-up of efforts to achieve the aggressive targets for monetary base expansion and foreign exchange reserve accumulation as already described. The package could be presented as a ‘currency reform plan’ (the ideas here were published in articles by the author of this book in the Nihon Keizai Shimbun, 23 December 1998 and in the Nikkei Weekly, 11 January 1999). The government would announce that at a given date, say five years hence, all then-existing yen banknotes would have to be converted into new yen notes, where the rate of conversion would be less than 1 for 1 – say 100 old yen equals 90 new yen. From the coming of the plan into operation until the conversion at the end, the normal one-to-one link between banknotes and bank deposits would be suspended, and there would be a free market in banknotes against bank deposits (indeed in the pre-Federal Reserve history of the USA there were various episodes of precisely this type of arrangement – banknotes trading at variable discounts against bank deposits). Thus banknotes would depreciate at a rate of around 2 per cent p.a. versus bank deposits over the illustrative 5-year period. Rather than a free market, the authorities could fix a gradually depreciating exchange rate between banknotes and deposits (with its agent, the Bank of Japan, willing to transact at these rates), where the fixing occurred each month. For example, suppose the 5-year period started on 1 January 2003. In the first month an exchange rate would be set of 100.17 banknotes = 100 deposit. Thus investors paying in yen banknotes to their bank would get slightly less than the full nominal equivalent amount as a

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deposit. Conversely, depositors pulling out banknotes from their bank accounts would get slightly more than the full nominal amount. Banks would charge a small fee on banknote transactions, making it impossible for customers to arbitrage by paying banknotes in at the end of a month and take them out at the beginning of the next month. At the level of retail transactions in goods and services, sellers would charge a premium (rising gradually as conversion day approached) if payment was to be made in banknotes (rather than by cheque or credit card). During the lifetime of the currency reform plan money market rates could fall as low as –2 per cent p.a. without any move being triggered of funds out of banks into banknote hoards. In practice the central bank might guide money rates to a somewhat higher level (say, –11⁄2 per cent) so that banks could earn a profit margin on small deposit business (the interest rate on small deposits would be at, say, –2 per cent). The Bank of Japan would pay negative interest on deposits placed with it (almost all bank reserves), with the rate of negative interest being set as equal to the rate of depreciation fixed for banknotes versus bank deposits. And under the emergency powers which the Minister of Finance would have in a serious deflationary crisis (described in the previous section), he or she could order that the official discount rate be lowered towards –2 per cent p.a. (not right up against that limit given that discount rate is normally somewhat above market rates). The case for the currency reform plan is that substantially sub-zero interest rates would foster a strong economic recovery from which all would ultimately gain. The stimulus would come from several various possible sources. First, there would be the incentive for households to bring forward consumption (although in principle the income effect might dominate – meaning that they would save more to make up for negative income if they are trying to build up a given size nest-egg for their retirement). Second, a lower cost of capital should favour corporate investment. Third, there would be relief for highly levered borrowers in the form of an effective write-down of their debts (through the application of negative interest). Fourth, bank profitability should improve, reducing the risk of financial system meltdown under deflationary pressure. Fifth, the yen would fall sharply against foreign currencies at the start of the plan (more accurately, as soon as the plan became a likely scenario), given the widened rate spread between the yen and other monies (and, indeed, the dollar might replace the yen in some areas of the Japanese black or grey economy, given the prospect of an eventual conversion which might not be on an anonymous basis). There would be a widespread expectation of yen appreciation through the lifetime of the plan, as the period of negative rates left to go became shorter and shorter. Of course if deflation came to an end and a strong economic recovery got under way, say, half-way through the 5-year period, then money market

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rates (and the official discount rate) could again rise above zero (but the main provisions would remain in effect as regards notes depreciating against bank deposits and reserves at the Bank of Japan paying negative interest). And no doubt if a government ever had to sell this plan to their electorate, it would stress that fact. Another piece of packaging which could help obtain popular backing would be re-denomination. Specifically, the conversion of old yen into new yen banknotes in 5 years’ time would be joined with the introduction of a new heavyweight yen. Thus a conversion rate of 100 old equals 1 new yen would apply to all assets and liabilities (including bonds, bank loans and deposits) except for banknotes, for which 110 old yen would equal 1 new yen. Special help could be given to retired persons highly dependent on interest income from savings. In any case their plight would be mitigated by the possibility of investing in foreign currency deposits or in long-term bonds (long-term fixed rates would reflect the likely return of economic prosperity and end of deflation, hastened by the currency reform). Such are the apparent complexities of currency reform that it is evidently the weapon of last resort against deflation. First there should be the historical experiment of bold monetary base expansion in the hope that a blackbox mechanism does indeed exist. Only if that mechanism is found out (by trial) not to exist, and a big explicit devaluation of the yen (perhaps accomplished via monetary base expansion taking the form of huge central bank purchases of foreign currencies) proves impossible or ineffective, should the currency reform be implemented.

The new yen order – an improvement? Would the blueprint for a freely floating yen, together with its emergency provisions, have meant Japan would not have gone through a lost decade, and does it hold out a better prospect of economic prosperity in the present decade? Any new constitutional arrangement draws on experience which may not be fully relevant to future conditions. The Federal Reserve System was constructed with the aim of overcoming the shortfalls of the previous monetary regime without a central bank (in particular the periodic banking crises and emergency suspensions of banknote convertibility). The design included no system of monetary rules for the new age of US monetary hegemony which was about to dawn and was organisationally flawed (rivalry between the New York Federal Reserve and the Board in Washington). The Bretton Woods International Monetary System was designed in the light of the currency chaos of the 1920s and 30s and the diagnosis that large international capital flows were usually a source of disequilibrium rather than a benign feature of a well-integrated global economy. The whole concentration of the Bretton Woods System on the notion of balance of payments equilibrium (meaning current account and

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net direct investment flows summing to zero, but excluding financial or speculative flows) became an anachronism, and there was a design flaw in that the issuer (the USA) of the numeraire currency (the dollar) could unleash inflation. The blueprints of the European Central Bank drew in part on the perceived inadequacies of the soft money central banks in Europe during the 1970s and 80s in comparison with the Bundesbank. Central bank independence combined with strict inflation and monetary targets were central tenets of the new order. But early experience of the new monetary union revealed some unforeseen flaws. Even so, every new framework is not doomed to failure. Indeed all three examples above have been widely interpreted as improvements on what went immediately before, even if imperfect and, in the case of Bretton Woods, of revealed short life. Although the designers did not and could not possess perfect foresight, they did provide for some flexibility and the possibility of institutional evolution. And the new arrangements did indeed usher in a period of prosperity during which the old problems were at least dormant. Is that likely to be the case with the blueprint here built largely out of the experience of the yo–yo yen in the 1990s? A first point is to demonstrate that the blueprint would have been more conducive to economic prosperity in the recent past than the policy-making order that actually existed. Demonstration involves an exercise in counterfactual history. Second, given the situation in which the Japanese economy finds itself early in the first decade of the twenty-first century, would adopting the new framework improve the long-term outlook? Third, what are the potential flaws in the framework and can improvements be made flexibly without seriously lessening the constitutional constraints on policymakers? As regards its operation in a counterfactual re-run of the past decade, the outcome would have been favourable (compared to reality) in several ways. Governor Mieno would not have been able to preach in favour of a strong yen. He could not have ignored the decline in money supply growth. And he might well not have won reappointment at the end of his first three years (1992). The explosion of budget deficits from the early to mid-1990s on just could not have taken place. Japanese investors in foreign assets could have ignored talk of Washington threatening to devalue the dollar against the yen if Tokyo did not deliver what was asked on trade. Capital outflow from Japan would have been much stronger. Japanese governments, no longer able to placate Washington with bigger and bigger budget packages and yen appreciation, might actually have had to make much larger moves towards undertaking economic reforms. The notorious Sakakibara–Rubin deal to push up the yen in spring 1997 in defiance of the logic of budget tightening could not have taken place. Masaru Hayami, if he had been approved as Governor by the Diet in 1998, would soon have

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encountered firm constraints on his power. The independence of his institution would have been suspended as a state of deflation alert was declared by the government. All that is with the benefit of hindsight. But would implementation now of the new framework seriously help Japan enter a long period of economic prosperity? There are some potentially powerful weapons in the framework usable towards ending deflation and steering Japan back to an equilibrium economic path (along which capital exports would boom, the yen find a cheap level, and a growing export sector accommodate big structural reform in the service sector) from which it strayed in the early 1990s and by a growing distance (as a trend). It is not likely, though, that policy could be run on a virtual basis (the possibility of a weapon being used having a big impact on the economy via expectations, without the relevant weapon being used). Not just market participants but also business decision-makers and households would need much convincing that anything had really changed after a decade of multiple policy failure. Moreover, the influence of the new framework on relations between Tokyo and Washington would be an area of potential uncertainty. Would the Japanese government succeed in persuading the USA of the advantages for both countries? Or would there be a period of new friction? On balance, Tokyo would have a good case to make – that the new framework should be successful and is fully consistent with economic liberalism both in Japan and globally. But the personality and skill of the diplomats matter. An effective way of demonstrating good faith (against the charge that the new framework was a disguise for old-type beggar-your-neighbour policies of devaluation) would be to adopt simultaneously a programme of economic liberalisation – offering important new business opportunities in Japan to foreign companies. It is from within Japan itself rather than from outside that possible flaws would most probably emerge. The Bank of Japan itself is likely to be less than enthusiastic about a new order which takes away some of its previous independence. This would be a first time that a major central bank had won treasured independence from government and then lost it, at least to some degree. Would the Bank pursue a strategy of rearguard actions and less than full cooperation with the anti-deflation policy, and so risk a further curtailment of independence which would damage the balance of power within the economic policy-making establishment? Or could the central bank under the new regime gain in status and preserve the important degrees of freedom (from government control) which remain? The Bank of Japan could gain popularity via cooperating with government in policy-making that proves to be successful. A grey area in which understanding rather than friction would be desirable between the central bank and government is where to aim for within the broad target for inflation. That would not be an immediate problem,

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given the starting point of deflation. But once deflation is overcome, should monetary policy aim for inflation near the bottom or top of the target range? Ideally, that should be a decision taken by the central bank, with due caution to the dangers of running an economy too close to the zero inflation limit (in that bold anti-cyclical policy might become infeasible given the zero barrier to money rates) but also aware of the risks of steering too near the top (in that a blip could force sudden tightening in monetary policy or else serious loss of credibility). In fact the optimum rate of inflation at which to aim within the target range may vary over time. Clumsiness – or worse, incoherence – in explaining to the markets where in the target range the central bank is steering inflation (within the target range) could emerge as a possible flaw in the hypothetical arrangements.

The demographic challenge – a reason for action on the yen? Would action on the yo–yo yen as described so far in this chapter help the process of adjustment in the Japanese economy to demographic change? Japan stands out – together with Italy and Germany – as having a bulging share of its population which is aged over 65. That situation dates back already to the mid-1990s and continues into the second decade of the present century. After that the rate of bulge decreases in these three countries, whilst it accelerates in some other major economies. Moreover the three countries mentioned face big declines ahead in their total population and particularly in their labour forces. Germany, however, is expected to experience (allow) a big increase in the rate of immigration. And both Italian and German demographic change is occurring in the context of an integrated economic and monetary area which includes several countries with quite dissimilar demographics. By contrast, the assumption is that Japan will not become an immigration society in the foreseeable future and that there will be no economic or monetary union formed in Asia. Before discussing how the yo–yo yen might have worsened the economic problems associated with ‘unfavourable’ demographics, and how the blueprint put forward could represent an improvement, it is important to put the ageing discussion in perspective. An ageing economy – meaning a rising proportion of old people in the total population – is not a bad thing. Ageing is the result of some combination of falling fertility and rising life expectancy. It is true that ageing may be a drag on the growth of GDP per capita – if indeed the share of the working population in the total is falling. But during their working life the expectation of those now retired was that their income would fall in old age. At the level of the economy as a whole resources may well have to shift towards provision of health care and personal care (of the aged) but there is no reason to assume that private market mechanisms or public choice (via the government sector) should fail to achieve this.

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More problematic, at the level of the macro-economy, can be the substantial fluctuations (over a long period of time) in the balance between savings and investment which the ageing process generates. As we have seen in earlier chapters, shifts in the desired level of savings relative to investment can be the source of economic disequilibrium if flows of international capital are inelastic (with respect to interest rate differentials), the natural real rate of interest is negative but inflation is very low or negative (meaning that nominal rates would have to fall to a sub-zero level to produce negative real rates), and the size of the current account surplus is a direct influence on exchange rate expectations (as when there is conflict between the USA and Japan on trade). Towards understanding the relation between demographics and the savings–investment balance, let us consider first what would happen in an economy where all provision for old age occurred in the private sector, with no public provision of pensions. A characteristic of the demographics in this hypothetical economy chosen for examination is a bulge in the proportion of the population in the last two decades before retirement, the result in part of a long-gone period of baby-boom. The bulge would bring a rise in the savings rate, as the pre-retirement generation of workers sought to provide themselves with capital which they could live off (income and capital drawdown) once their labour income fell or came to an end. In the context of a closed economy the rise in the savings rate would go along with a rise in the investment rate, a raised capital–output ratio, and most probably a fall in the average rate of return to capital. The increase in the capital output ratio (meaning, in crude terms, more capital equipment per worker) should boost the level of marginal labour productivity in the economy, translating into higher-thanotherwise real wages. In turn, those higher wages facilitate the building-up of a given size nest-egg for retirement. Then, as the baby-boom cohort begins to move into retirement, the savings rate gradually falls, as the fastgrowing population of retired workers draws on their previous savings. This process may go along with some decline in the capital–output ratio, meaning smaller increases or an actual fall in real wage rates (as marginal labour productivity is adversely affected) and a rise in the rate of return to capital. If the labour force, however, is declining in size at the same time as the retirement population is bulging, the capital–output ratio might be unaffected or even rise (meaning no downward and perhaps upward pressure on real wages). In both cases the rundown of the capital stock in the economy (compared to what it otherwise would have been) allows overall consumption (including that of both present workers and the retired population) to rise relative to overall economic output (real GDP). Switching the context to an open economy, the key issue is whether demographic change is occurring at different rates in different countries (or more importantly currency areas) and being accompanied by distinct pat-

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terns of evolution in the savings–investment balance. If, for example, the bulge in the pre-retirement population is occurring in the given country A ahead of other major economies, then it may well go into savings surplus whilst the others go into savings deficit (investment in excess of savings). Capital exports from A recycle its savings surplus to the other economies. Compared to the closed economy case discussed above, the rise in the capital–output ratio will be less and there will be a smaller corresponding increase in real wage-rates. Instead, provision for retirement is made to some extent by a build-up of foreign assets. (The extent to which foreign assets substitute for a rise in the capital–output ratio depends on the degree of risk aversion towards foreign assets. If risk aversion is very low, there is a high degree of substitution, and conversely.) It could be argued from a national perspective that it is better if provision for retirement occurs through a build-up of domestic capital stock than foreign investments, because in the former case there is the bonus of real wage gain which facilitates saving and this might more than offset the advantage of extra rate of return on foreign assets. This argument is not restricted to the issue of ageing. It has reared its head in discussions of whether there should be tax incentives to domestic rather than foreign investment. The standard response is that capital should be allowed to seek the highest return available, within or outside the national frontiers. Attempts to promote domestic at the expense of foreign investment have had little proven success and can simply fuel inefficient increase in the domestic capital stock. Moreover such attempts smack of beggaryour-neighbour policies – if all countries gave incentives for capital to remain at home no one country’s efforts would achieve much and overall there would be a less efficient allocation of capital internationally (there would be less outward and inward investment for each country). A more sophisticated concern about the ageing economy A building up foreign investments (in aggregate) is what happens once it proceeds into the next demographic stage. There it is the population of retired persons which is bulging and the growth in the pre-retirement age group slows down or even becomes negative. The fall in the aggregate savings propensity of economy A would go along with a contraction in its current account surplus and slowdown of capital exports. Eventually the current account and savings balance might even go into deficit and net capital exports give way to net imports (whether this happens depends of course on what is occurring simultaneously to the demographic profile in other countries). In principle, this evolution should go along with a gradual real appreciation of economy A’s currency. That appreciation tendency would curtail to some degree the cumulative returns from foreign assets and prolong the period of low returns on domestic assets (expectations of currency appreciation are normally reflected in domestic rates being low by

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international comparison) despite the diminishing savings surplus. But all of this is knowable in advance – during the period of large savings surplus – and does not imply that the build-up in foreign assets was inefficient. Another concern relates to possible irrationalities in foreign investment. Suppose economy A’s ageing population built up portfolios of high-risk foreign bonds with low levels of diversification and these subsequently mostly go bad. A response is that irrationality could apply as much to domestic as to foreign investment. A more general point is that in practice no economy leaves provision for old age entirely to individuals but takes over some social guarantee function, normally via the public provision of pensions up to a certain limit – much higher in some countries than others. Public pension provision usually occurs in some degree on a pay-as-you-go basis (PAYG). In the case of an economy with a cohort of baby-boomers moving towards retirement, the existence of a PAYG system means somewhat lower national savings than otherwise (nonetheless possibly high by international comparison) during the period when the pre-retirement population bulges. When later the retired population bulges, the turnaround in savings (the fall in the national savings rate) could be as great as in the fully self-care system if indeed the public sector simply issues extra debt to cope with its unfunded pension payments. But given that there has not been as much build-up of domestic or foreign capital stock the bulge in pension payments is accompanied by a lower average capital–output ratio, meaning wage-rates are lower. Thus unfunded pensions impose some burden on the working population – causing intergenerational inequity – even in the case of no rise in the social security tax burden (as would happen if taxes were raised to keep the PAYG system in the black). Let us shift attention from hypothetical economy A to Japan through the 1990s and into the first decades of the twenty-first century. What deductions can we make (from the hypothetical to the actual)? First, the wild fluctuations of the yo–yo yen and the high degree of risk aversion with respect to foreign assets which that engendered most likely held back the extent of foreign asset accumulation and raised domestic asset accumulation. That was inefficient. Second, the rapid growth of public investment during the 1990s, itself stemming from efforts to contain the current account surplus and underpin a higher valued yen as sought by Washington, meant that the pre-retirement savings bulge at the level of the macro-economy was funnelled in considerable part into low or negative yielding projects. Hence when the retired population bulges there will be less cushion in the form of an elevated level of efficient capital stock which can be drawn down. Japan in the first decade of the twenty-first century is already approaching the early stages of the demographic phase where the retired population is growing rapidly whilst the pre-retirement population of 40- and 50-yearolds is growing at a slower pace. Hence the demographic influence on the

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savings rate could already be turning negative. But that is far from certain. It might be that today’s middle-aged population, seeing the weak state of the public finances, has little confidence in the present level of public pension provision being maintained and they might be concerned at much higher health charges over their retired lifetime. The retired population may be the source of less dissaving than widely assumed. Yes, there will be the age-related deterioration in the public finances (due to PAYG system being unfunded) – itself a downward influence on national savings. But at the level of private savings retired persons in aggregate might do little more than consume income (including the gains in purchasing power of monetary assets attributable to deflation) on accumulated capital rather than depleting that capital. Influences pointing in that direction are, reputedly, strong bequest motivation, a high degree of uncertainty as to possible outgoings in old age and considerable aversion to finding oneself dependent on public welfare or financial support from children. And even if the overall savings rate does fall, there is the distinct possibility of a fall in the investment rate related to a shrinking of the labour force. Thus the savings surplus might well actually rise. In sum, the demographic influence on Japan’s savings surplus might remain positive for some considerable period ahead. In that case, the benefits of promoting a lowering of risk aversion with respect to foreign assets and reduction in wasteful public investment such as would occur under the implementation of the proposed framework for monetary and exchange rate policy, would be as described already. And even if the demographic influence is already – or about to – impart a contractionary influence on the domestic savings surplus, that will probably be more than offset by an inevitable tightening in fiscal policy (meaning less public dissaving) which would occur under almost any scenario (even without the new framework being introduced). Japan’s overall savings rate (public and private sectors combined) is likely to be growing, and fostering a flow into foreign assets should be economically efficient. But what would happen well into the next demographic phase, albeit a long time off, if indeed by then Japan’s overall savings rate were to be falling faster than the investment rate, meaning downward pressure on the savings surplus and current account surplus, and upward pressure on the yen? New policy issues at that stage might include, first, educating the markets about the meaning of the ‘deterioration’ in the current account of the balance of payments (not indicative of Japan losing competitiveness, but of consumption – including that by the retired population – rising relative to output) so as to avoid a counter-to-equilibrium tendency fall of the yen. Second, there would be sense in a reassessment of measures to make the yen appealing as an international investment currency. If various restrictions or lack of competitiveness in the Tokyo market-place meant that there would be a disproportionate liquidation of foreign assets by

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Japanese investors compared to foreign buying of Japanese assets so as produce a given net capital inflow, that would be sub-optimal. In making any long-run projection, however, about demographic influences, extreme caution is advisable. Projections of population growth and age structure become less and less reliable the further out we look. The amount of immigration, fertility rates, life expectancy, age of retirement, extent of post-retirement age working, degree of participation in the labour force – are prominent examples of the variables which enter the analysis. Demographic trends are at their least uncertain over the short and medium-term future. But over that time span other changes in the economy are likely to prove more important than demographic trends in determining outcomes – real and financial (including the exchange rate).

The yo–yo yen and global economic prosperity Generations of economics students – and indeed students in many related topics – have been taught that a great depression such as occurred in the USA and several other large industrialised economies in the inter-war period (1919–39) could never happen again. International economic cooperation and treaties ruled out the type of devastating nationalistic policies which were followed then, both as regards trade and finance. The Keynesian revolution has occurred, and though it had been much deprecated since, a broad majority of economists still believed that a bold fiscal expansion was capable of countering recession. And central bankers had surely learnt some important lessons that would avoid the blundering policies which were pursued by the Federal Reserve both in the late stages of the 1920s boom and into the subsequent slump. All that was conventional wisdom. The experience of Japan, and of the yo–yo yen in particular, has challenged that wisdom, even though it must be said that the Lost Decade bares nothing of the severity of the depressions in the inter-war period. International economic cooperation concerning the problems of the Japanese economy has been deeply flawed. Highly expansionary Keynesian-type fiscal policies brought an alarming deterioration in Japan’s public finances and helped to channel a huge private sector savings surplus into pork-barrel negative yielding projects rather than high yielding foreign assets. They could not end deflation. And central bankers in the world’s second largest economy seemed to have no more skill in navigating through a period of general euphoria followed by post-bubble blues than US monetary policy-makers in the late 1920s and early 1930s. Contemporary monetary critics judged that incompetence played a role. But the issue remains unresolved – once an economy sinks into a deflationary process, can conventional monetary policy tools, however boldly applied, bring a turnaround unaided by either exchange rate policy or currency reform?

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Let us look at each of these issues in turn. What international economic cooperation has there been concerning the Great Deflation which took hold in the world’s number-two economy during the 1990s and the violent swings in its currency? In practice, the main form of cooperation has been a policy dialogue, at times highly confrontational, between Washington and Tokyo. Cooperation is here a false name. A nation-state, even the world’s largest, in pursuing its international economic policy, cannot be expected to be purely altruistic. Washington’s guiding interest in the Japanese economy has been self-interest. If that meant pulling the Japanese economy out of a deflationary spiral it would coincide with Japan’s interests. But there have been other key items in Washington’s Japan agenda – such as reducing the bilateral trade surplus and holding down the overall current account surplus – which have smacked of neo-mercantilism. Washington was quite prepared to press Tokyo into the biggest experiment of Keynesian economics whilst remaining mum about the potential for monetary reflation simply because fiscal reflation promised a higher yen and smaller Japanese trade surplus. A key US interest in Japanese economic affairs was the potential exposure of the US financial system to a Japanese banking crisis. Hence Washington tended to put large emphasis on ‘curing the banking problem’ as a priority of Japanese economic policy. US officials did not warm to the view that the banking problem was a result, rather than a principal cause, of deflation and disappointing overall economic performance, and that a solution should be left to the play of market forces operating under a new framework for monetary and currency policy. No senior economic policy adviser in Washington of the 1990s could hope to gain from advancing the view that Japan should be allowed to run huge current account surpluses reflecting its private sector savings surplus and that the yen should be much weaker. Outside the area of high-level negotiations, there has been constructive interchange of views between economic officials on both sides of the Pacific. The Federal Reserve has hosted academic seminars on key topics of interest to Japan (and also of potential future interest to the USA) including how to conduct monetary policy when the zero bound to nominal interest rates becomes an effective constraint. Individual Federal Reserve banks have published insightful papers about the failings of Japanese monetary policy and faults in the Japanese banking system. Such academic interchange, however, does not in itself mean that policy-makers swerve from their favoured path. What has been missing is an international voice of any authority, to which both Washington and Tokyo would take heed (without necessarily obeying!), issuing at times strong views, about optimum economic policies from a world perspective. In principle the IMF or OECD could have taken the lead. But at no point in 1990–1 did they sound the alarm about Japanese monetary policy being overtight, and subsequently their strong preference was for fiscal reflation.

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Other than one isolated instance in 1990 when there was concern about global capital shortage in the wake of German unification, the IMF never advanced the view that a large Japanese current account surplus was a benign development – the natural counterpart to a huge private sector savings surplus. Instead, the IMF seemed at times like a mouthpiece of the US Treasury, preaching the need for fiscal reflation to contain the size of the current account surplus. Though one function of the IMF is to survey currency markets, that institution never articulated the view that the yen had become seriously overvalued in the aftermath of the Japanese asset market bubble bursting and that the world economy needed a yen nearer 200 than 100 to the dollar. In the worst case of disorderly markets between major currencies – the 20-per-cent-plus appreciation of the yen in one day (October 1998) – the IMF head indeed uttered some concern, but there was no serious follow-up. The sceptic would argue that there cannot be an international voice as described. The IMF and OECD are not think-tanks. They are highly political organisations run by people who are appointed not for independence of view but for other qualities (including the right nationality). Anyhow, even academic think-tanks can be blind to the obvious and swayed by what is currently popular. It would be wrong to blame any supranational organisation for the failures of the Japanese economy. Rather we should just accept that economic policies are designed and run by national governments. The wise prince, where he exists, might take advantage of consultations with the best international economists at think-tanks in Washington or elsewhere. And he may be lucky – one of the many candidate advisers might actually have thought of the best policy from both a national and an international perspective. But how often does that lucky event occur, where the wise prince searches and finds the best advice? The sceptic might indeed be correct. But then it is time to unlearn one of the textbook lessons about how the world economy is better off than in the inter-war period. The periodic discussions at G-7 summits on exchange rate levels, sometimes finding expression in subsequent communiqués and flurries of official intervention in currency markets, should end once and for all. What about the next lesson – the power of fiscal policy to lift an economy out of recession? The powerful doses of fiscal reflation in Japan through the 1990s can be linked to the cyclical revivals of 1996–7 and 1999–2000. And so the argument that fiscal policy is indeed a safety-valve against a 1930s-type slump cannot be rejected in the light of Japanese experience. Nonetheless, the Lost Decade does add a new perspective on the potential long-run costs of pump-priming measures. Rather than Japan’s huge private sector savings surplus flowing out into high-yielding foreign assets, it was channelled to a large extent into negative yielding public investment projects. Surely Japan would now be more prosperous if monetary policy had been successful in lifting the economy out of reces-

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sion on its own? The counterfactual historian could indeed argue that if monetary tightening had come to an end already in late 1989, and the subsequent easing had been much bolder, then Japan would have entered a new era of prosperity by the mid-1990s. Further, he could claim that the Japanese experience of the early 1990s teaches an old lesson – monetary policy is too important to be left to central bankers exercising discretionary judgement. Rather there should be a system of rules and the central bankers’ jobs should depend on abiding by those rules. Should we be less confident in the light of recent Japanese history about the power of monetary policy to end a deflationary spiral (which is likely to stem from serious prior mistakes in monetary policy)? Some monetary economists claim that the Federal Reserve could have single-handedly ended the deflation of the early 1930s by pursuing aggressive open-market operations and thereby preventing a decline in the money supply. Indeed, Milton Friedman in his renowned monetary history attributes some success to a brief episode of monetary expansionism in spring 1932 which was terminated prematurely. Pessimists retort that conventional monetary policy might be ineffective in these deflationary situations where the equilibrium real rate of interest is most probably already highly negative, the banking system crippled (insufficient capital to support an increase in lending), and individuals have no inclination to spend the growing mountains of cash which replaced other less liquid or higher risk assets in their portfolios. In that situation a large currency devaluation might be successful in ending deflation. If that were not feasible, or was unsuccessful, the ultimate weapon would be currency reform permitting interest rates to fall well below zero. There is no guarantee of success for even that final step. The end of deflation might have to wait for an autonomous rise in the equilibrium (natural) rate of interest well into positive territory such as would be produced by an improvement in the rate of return to investment, a fall in households’ propensity to save, or a decline in aversion to exchange risk (meaning an increased momentum of capital exports). Japanese experience so far does not answer this final question. By autumn 2001, bold expansion of the monetary base had not yet occurred. If it does occur – before some other event intervenes, such as a big fall in the yen or a big improvement in the investment outlook – then we will have a first-time test of the power of monetary policy on its own to end deflation. If the test is performed under ideal conditions (meaning other influences not coming to bear during the potentially long lag between the monetary impulse and its effect on the economy) then the result – positive or negative – would be of considerable consequence for policy-making. A negative result (meaning little effect from aggressive monetary base expansion) would mean that some combination of devaluation and negative interest rates – both requiring the suspension of the normal monetary regime – has to be part of the contingency plan to counter deflation which

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should be on the shelf of any competent central bank. A positive result would be reassuring, and incidentally reduce estimates of the potential costs of deflationary errors in monetary policy. We must remember, however, that the history of paper monies (as against monies convertible into gold or silver) floating freely against each other in global markets is short. One observation of a phenomenon is not the basis for a firm prediction about the future. And so it is for the phenomenon of the yo–yo yen itself. After the violent fluctuations and gross misalignments of the Lost Decade the yen may indeed settle into a period of calm around a level appropriate to an economy with a huge private sector savings surplus. In the meantime, the experience has been humbling to all involved – enthusiasts of floating exchange rates who believed that prices (in the currency markets) would continuously reflect a sober and long-term view of economic fundamentals, currency analysts who thought that they could predict future trends, central bankers who preached that independence from politicians would usher in a new prosperous era of price stability and who viewed the hardness of their money as a virility symbol, hedge fund managers who thought they understood the dynamics of currency markets, and senior economic officials who had faith in progress of the policy-making process. Long ago King Solomon wrote that after pride comes the fall. Optimistic interpreters of the history of the yo–yo yen must believe that after the fall comes new wisdom – both amongst policy-makers, those to whom they are responsible, and amongst those who make decisions in the market-place.

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242 Bibliography Monthly Labor Review, US Department of Labor, ‘International Comparisons of Labor Productivity and Per Capita Income’ (Bart van Ark and Robert H. McGuckin), July 1999. Morishima, Michio, Why Has Japan Succeeded?, Cambridge University Press, 1982. Nakamura, Takafusa, The Postwar Japanese Economy: Its Development And Structure, University of Tokyo Press, Tokyo, 1981. OECD, Maintaining Prosperity in an Ageing Economic Society, OECD Publications, 1998. OECD, Pensions, Savings and Capital Flows (Helmut Reisen), OECD Publications, 2000. OECD Economics Department, ‘The Macro-Economic Implications of Ageing in a Global Context’ (David Turner, Claude Giorno, Alain de Serres, Ann Vourch and Peter Richardson), Working Paper No. 193, March 1998. OECD Economics Department, ‘The Tax System in Japan: A Need for Comprehensive Reform’ (Thomas Dalsgoord and Masaaki Kawagoe), Working Paper No. 231, Feb. 2000. OECD Economics Department, ‘New Issues in Public Debt Management: Government Surpluses In Several OECD Countries, the Common Currency in Europe, and Rapidly Rising Debt in Japan’ (Paul Mylonas, Sebastian Schich, Thorstinn Thorgeirsson and Gert Wehinger), Working Paper No. 239, April 2000. Ohkura, Takehiko and Hiroshi Shimbo, ‘Tokugawa Monetary Policy in the Eighteenth and Nineteenth Centuries’, in Smitka (1998) (see below), pp. 241–60. Okina, Kunio, ‘Monetary Policy under Zero Inflation’, IMES Discussion Paper Series, July 1999, Institute for Monetary and Economic Studies, Bank of Japan. Patrick, Hugh and Henry Rogovsky (eds), Asia’s New Giant, The Brookings Institution, Washington, 1976. Pavird, Anna, The Tulip, Bloomsbury Publishing, London, 1999. Posen, Adam S., Restoring Japan’s Economic Growth, Institute for International Economics, Washington, 1998. Reifschneider, David and John C. Williams, ‘Three Lessons for Monetary Policy in a Low Inflation Era’, Federal Reserve Board Research Paper, September 1999. Schiller, Robert J., Irrational Exuberance, Broadway Books, New York, 2001. Schoppa, Leonard J., Bargaining with Japan: What American Pressure Can and Cannot Do, Columbia University Press, 1997. Sheffrin, Steven M., Rational Expectations, Cambridge University Press, 1983. Siegel, Jeremy J., Stocks for the Long Run, Irwin Publishing, 1994. Smitka, Michael (ed.), The Japanese Economy in the Tokugawa Era, 1600–1868, Garland Publishing, New York, 1998. Takayama, Noriyuki, The Morning After in Japan: Its Declining Population, Too Generous Pensions, and a Weakened Economy, Maruzen Co. Ltd, Tokyo, 1998. Temin, Peter, Did Monetary Forces Cause the Great Depression?, W.W. Norton and Co., New York, 1976. Ueda, Kazuo, ‘Causes of Japanese Banking Instability in the 1990s’, Research Paper, July 1999. United Nations, ‘Demographic Ageing and the Reform of the Pensions System in the ECE Region’, Economic Survey of Europe, 1999, no. 3, pp. 45–115. United Nations, World Population Prospects: The 1998 Revisions, volumes 1 and 2, United Nations Publications, 1999. Wells, Wyatt C. ‘Economist in an Uncertain World: Arthur Burns and the Federal Reserve 1970–78’, Columbia University Press, New York, 1994. White, Eugene N., ‘The Stock Market Boom and Crash of 1929 Revisited’, Journal of Economic Perspectives, vol. 4, no. 2, Spring 1990, pp. 67–83.

Bibliography 243 Wood, Christopher, The Bubble Economy, Atlantic Monthly Press, New York, 1992. Woodward, Bob, Maestro: Greenspan’s Fed and the American Boom, Simon and Schuster, New York, 2000. Yamamura, Kozo (ed.), The Economic Emergence of Modern Japan, Cambridge University Press, 1982. Yeager, Leland B., International Monetary Relations; Theory and History, Harper and Row, New York, 1966.

Index estate market, 1990, 121; misguided views on yen in 1990s, 75, 118–19; its inflaming of exchange risk perceptions in 1990s, 74; cuts discount rate to 1.75% in Summer 1993, 163; its role in undermining Hashimoto fiscal consolidation and sparking yen rise, Spring 1997, 196–8; bribery scandal, 1998, 204; new Bank of Japan Law comes into effect, March 1998, 204; refuses to undertake unsterilised intervention in foreign exchange markets, 1999, 213; some sacrifice of independence a necessary component of economic policy reform in Japan? 229; see also Bank of Japan Governors, monetary policy, zero rate policy Bank of Japan Governors, see Hayami, Inouye, Matsushita, Mieno, Sasaki, Sumita Banking crisis in Japan, in 1920s after bursting of wartime bubble economy, 21; crisis of Spring 1927, 25; parallels between currency implications of in 1920s and 1990s, 25; US credit agencies begin to downgrade Japanese banks, early 1990, 135; Greenspan concerned about Japanese banks, 1992, 155; Governor Matsushita’s task of sorting out the banks, 1994, 178; as factor in the bursting of yen bubble, summer 1995, 189; why negative for the yen, 1995, 189; weak capital position of Japanese banks

Ageing population, effect on savings rate, 64; see also demographic challenge in Japan, Switzerland Ansei-Man’en, monetary reforms of 1859/60, 5–10; fixing of exchange rate 7; see also hyperinflation Asian bubble economies, 116; yen bubble as catalyst to, 116; see also Asian currency crisis Asian central banks, their repaying of yen loans and adding to yen reserves during yen bubble, 1995, 183–5 Asian currency crisis, role of bursting of yen bubble in, 116; summer and autumn 1997, 202–4; see also under yen Axis movement, examples of, 105; see also currency triangles Bank of Japan: founded 1882, 14; stems appreciation of yen during World War I, 18; response to bursting of bubble in 1920, 21; conduct of monetary policy in 1960s, 36–8; fatal (for Bretton Woods System) tightening of monetary policy in September 1969, 36; gross errors in monetary policy following yen revaluation, 1971–2, 41–3; tightens monetary policy in autumn 1973, 45; adopts a quasi-monetarist policy in late 1970s, 53; re-lending of foreign exchange reserves to Japanese banks in 1978, 54; bizarre tightening of policy following Plaza Accord 60; view of inflation risks in early 1989, 123; its study of real 244

Index 245

used as argument by Rubin and US mercantilists for halting yen depreciation in Spring 1997, 194; bank failures in Autumn 1997, 202; Obuchi government provides emergency help to banks, Autumn 1998, 206; has Washington’s Japanese policy been over-focused on banking situation? 236; see also Jusen crisis Bentsen, Lloyd initiates protectionist legislation, 1984, 59; appointed Treasury secretary 1993, 157; expresses wish for a stronger yen in early 1993, 157; a mercantilist, 157; resignation, 175 Bergsten, Fred as academic highpriest of neo-mercantilists in Washington, 188; calls for easier Japanese fiscal policy, Spring 1997, 195–6 Big surplus strong currency myth, 71–6; see also Mieno Blinder doctrine, 123; see also bubble markets Bretton Woods system already disintegrating in Spring 1971, 38; could Japan have salvaged a fixed yen–dollar rate in August 1971?, 40; reinterpretation of its demise, 39–41; role of Bank of Japan in its demise, 37 British pound as frequent dollar satellite, 108; see also currency geography Bubble economy in Japan, postbubble depression of 1882–5, 14; wartime bubble economy breaks in 1920, 21; comparison of currency policy following First World War bubble economy and 1987–90 bubble economy, Tanaka bubble 1972–4, 44; end of Tanaka bubble, 64, 71; early stages of Great Bubble

1987–90, 61; was the Plaza Accord a catalyst to the 1987–90 bubble economy?, 61; behaviour of savings rate during, 65; how exchange rates normally adjust to end of bubble, 71–4, 135; why did yen not follow normal downward path following bursting of 1987–90 bubble?, 135–6; rapid growth of productivity during, 122–3; see also Asian bubble economies, bubble markets, Japanese real estate market bubble, Milton Friedman Bubble markets, do they really ever exists?, 119–22; currency implications of their bursting, 135; do they burst of their own accord?, 122; should monetary policy take them into account?, 122; see also Asian bubble economies, Japanese real estate market bubble, NASDAQ bubble, Tokyo equity market bubble, yen bubble, US dollar bubble Bundesbank, tough anti-inflation policy in 1973, 45; President Tietmeyer reveals that Bank of Japan considers tighter policy in Spring 1997, 198 Burns, Arthur overturns US monetary policy in 1970, 36–7; role in Nixon’s reelection campaign, 43; opposition to closing gold window in 1971 41; view of dollar devaluation in 1973, 44; attack on inflation in 1974, 46; prediction of recovery, 1975, 49; eases policy ahead of 1976 elections and thereby breaks unofficial yen-dollar peg, 49; concern at weak dollar in 1977, 51; fails in reappointment bid, 1978, 51 Bush Administration (1988–92), presses Japan to raise public

246 Index

Bush Administration cont. spending, 132; trade conflict with Japan, 131; see also Mercantilism in Washington Business cycles in post-war Japan Jimmu boom, 1956–7, 33; Iwato boom 1959–61, 33; cyclical peak of 1952, 65; recession of 1961–2, 34; recession of 1965, 35; boom of 1966–70, 35, 65; recession of 1970–1, 43; recovery from recession of 1974–5, 47; recession of 1992–3, 151; recovery in 1994, 170; encouraging evidence of recovery, 1996, 190; recession of 1997–8, 202; see also bubble economy in Japan, Japanese economy Camp David meeting on dollar, August 1971, 39; see also Bretton Woods System, Tanaka bubble, US dollar devaluation Cantor, Mickey, 167; sees no risk of trade war causing Japanese investor to pull out of US, 167 Capital export policy in Japan, during First World War, 16; Ministry of Finance pursues in early 1980s, 57; Eisuke Sakakibara seeks to stimulate capital exports towards bursting yen bubble, Summer 1995, 187; recommended as a permanent part of a new policy framework for Japan, 223 Carry trade in yen, 201; brief turnaround in, Spring 1997 as one trigger to Asian crisis, 201; rapid growth of, 1996–8, 202–3; Bank for International Settlements gives guesstimate of total size in 1998, 203; implodes following Russia’s debt default, Summer 1998, 206; see also hedge funds Carter Administration, concern at rapidly rising Japanese exports, 51–2; presses Japan to ease

fiscal but not monetary policy, 53–4; dollar defense package, November 1978, 55 Cassel, Gustav, estimates yenovervaluation, 1922, 20 China, attitude of towards yen devaluation, 205 Chinese currency, appreciation during World War One, 18; sharp decline of in early 1920s, 22; use of as speculation vehicle in yen, 1926, 25 Clinton Administration, prepares policy towards Japan, early 1993, 156; mercantilist cabinet, 157; from Day One presses Japan to adopt easier fiscal policy, 159; backs away from policy of talking up the yen, Summer 1993, 162; was talking up the yen an empty policy? 167; presses for stronger yen, Spring 1997, 201; was the threat of new trade talks with Japan in Spring 1977 bluff?, 201; see also Framework Talks, Mercantilism in Washington Clinton, Bill, welcomes appreciation of the yen in Spring 1993, 157; in July 1994 blames dollar’s decline on Japan’s trade surplus, 168; refuses to make comment during yen bubble, March 1995, 183; his visit to Beijing in Summer 1998 as catalyst to brief yen recovery, 205; welcomes the 20% jump of the yen in one day, October 1998, 207; see also Clinton Administration Clinton–Hosokawa summit, Spring 1994, 166; discusses North Korea nuclear threat, 167; its failure as source of brief yen surge, 167, 170; see also Nye initiative, Framework Talks Clinton–Miyazawa Summit, April 1993, 157

Index 247

Consumption tax in Japan, introduced 1989, 123; its effect on inflation 1989, 123; increase in 1997, 192–4 Counterfactual historical analysis, could the Shogunate have avoided devaluation and hyperinflation despite US pressure?, 8–9; what if Japan had allowed the yen to float freely in World War One?, 19; suppose the yen had been allowed to float down freely or been devalued after the 1920 Crash?, 21; What if the yen had been on the gold standard at time of Tokyo earthquake?, 24; Would the yen have risen as much if no mercantilist ‘buzz’ from Washington?, 63; would Japan’s savings surplus have been even larger under fixed exchange rate?, 67; what if Arthur Burns had maintained tight money throughout 1970? and could Japan have saved the fixed yen–dollar rate in 1971?, 35, 40–1; how Japanese economy would have performed under gold standard in 1990s, 71–2; would Japanese real estate market bubble of 1987–90 have burst without Bank of Japan action?, 124–5; What if Governor Mieno had cut the discount rate to 1.75% already in Autumn 1991? 162; What if Japan had said no to US pressure for a stronger yen in Spring 1997?, 201; Would there have been a Lost Decade in Japan if two out of three Bank of Japan Governors during that period were not hard yen enthusiasts?, 215; How would Japanese economy have performed in 1990s under a proposed ‘new economic constitution’?, 229

Crash, see equity market crash Currency bubbles, reflections on, 184; dollar bubble of 1985, 184; Swiss franc bubble of 1978, 220; see also yen bubble, Swiss franc Currency geography, 76–107; currencies in the limelight, 105; different types of currency motion defined, 77–79; fitting in the British pound, 107–8; frequency of different types of currency motion, 103; how to distinguish different types of currency motion, 80–107; polar power defined, 77; satellites defined, 77; six main independently floating currencies, 107; triangular nature, 77; why yen should not be described as rotating around dollar–euro axis, 107; see also dollar zone, dollar–yen axis, dollar–euro axis, euro zone, solo yen movement, solo euro movement, solo US dollar movement, yen–euro axis Currency markets, sensitivity to confused economic doctrine exposed by central bankers, 170; their slowness to recognise shift in savings surplus and its implication for exchange rates, 135, 144; see also Finland’s real estate market bubble of late 1980s, Japanese real estate market bubble, market bubble of late 1990s, Swiss real estate, UK real estate market bubble of late 1980s, yen Currency poles, see currency geography Currency satellite, defined, 77; British pound as frequent satellite of US dollar, 108; Swiss franc as frequent satellite of Euro, 11; see also currency geography

248 Index

Currency triangles, axis movement within defined, 77; solo movement within defined, 77; examples of different types of currency motion within, 104–7; why is the US dollar–euro–yen triangle dominant?, 107–115; pseudo triangles, 108–9; see also currency geography Deflation in Japan, in 1882–5, 13; in the 1920s, 22–4; emergence of in 1990s, 116; responsibility for 1990s deflation, 162; see also Deflation trap Deflation trap, increasing risk of in 1997, 202; theoretical considerations, 74, 116 Demographic challenge in Japan, 231–5; see also ageing populations Deutsche mark, floats in Spring 1971, 38–9, more independent than the yen of the dollar in the early 1970s, 38 Dodge, Joseph, 27 Doge Line; see Dodge Plan Dodge Plan, 5; balanced budget doctrine, 28; Fixing of yen parity in 1949, 5, 28–9; economic constitution begins to weaken in mid-60s, 35 Dollar–euro axis dominance, defined, 79; illustrative identification, 102; see also currency geography Dollar–mark axis, its dominance of currency markets in much of 1994, 170 Dollar–yen axis dominance, defined 78; illustrative identification, 80; see also currency geography Earthquake risk in Japan, 57, 179; its influence on market prices, 180; see also Kobe earthquake, Tokyo earthquake

Economic miracle in Japan, 30, 33; the early 1930s a forerunner of, land speculation during, 120–1; end of the miracle, 48; premature diagnose of end in mid-1960s, 64; was the miracle already over in 1970?, 52; failure of IMF to recognise its end, 52; Tanaka bubble and bust delays recognisation of end, 64; see also Japanese economy Equity market crash in Tokyo, 1920, 21; in Tokyo 1990, 116, 134–5; in New York, 1929, 26, 118, 123; in New York, 1987, 61, 122, 130; see also Tokyo equity market bubble Europessimism, 56 Euro zone, defined, 109 Exchange Investigation Committee, 1918, 18 Exchange restrictions in Japan, introduced 1932, 27; should restrictions have been lifted in late 1960s? 35–6, 40; as handicap in mid 1970s, 49; gradual dismantling of in late 1970s, 54; lifting of most remaining, 1980, 57; further deregulation, 1995, 187; see also capital exports Exchange risk aversion, its role in yen’s behavior, 73; aggravated by folklore of Nixon and Plaza shocks, 156; diminishes during Tokyo equity market bubble 1988–90, 133; as factor in yen bubble, 1995, 188; increased substantially by yen spike of Spring 1997, 202; inflamed generally by Bank of Japan, 74, 119; fuelled by 20% jump of yen in one day, October 1998, 207–8; see also Plaza Accord Feudal banknotes, replacement of 13 Finland’s real estate bubble of late 1980s, currency implications

Index 249

compared with Japanese case, 135 First World War, Japan’s boom during 15–16, 21; Japanese currency policy during, 15–19; see also Neutral currencies Fiscal policy in Japan, should it have been tightened in late 1960s? 35; the Tanaka-led fiscal expansion, 1972–3, 42–3; tightened in mid-1970s, 46; eased under US/IMF pressure in late 1970s, 52, 54; bold consolidation in early 1980s, 57; why Washington continuously pressed for easing of, 70–1, 75–7 its role in driving yen higher in 1990s, 76; Bush Administration presses fiscal easing on Japan, 1989–90, 132; IMF’s view of in 1990, 132; intense political pressure in Japan for easing of, 1992, 154; fiscal stimulus offered as present to new Clinton Administration, April 1993, 158; from Day One Clinton Administration press for easing of, 159; tightened by Hashimoto government in 1996–7, 192–3; biggest fiscal expansion ever, introduced by Obuchi Government in Autumn 1998, 208; see also Dodge Plan, Hashimoto fiscal consolidation 1996–7, International Monetary Fund, Strategic Initiative negotiations with Japan Fixing of yen parity in 1948; see yen, Dodge Plan Fixing the yen–dollar rate, an option now to turn the clock back? 217–20 Floating yen, first era of, 1912–32, 19–27; a new framework for? 220–3; see also free float Foreign Ministry of Japan, favors closer Asian involvement, 71

Framework Talks, initiated Spring 1993, 157; toughness of US stance limited by broader considerations, 167; breakdown in March 1994, 166; resumed in May 1994, 170; substantial agreement on all issues except autos, September 1994, 170; Washington initiates Section 301 proceedings against Japan, October 1994, 175; May 1995 deadline for Section 301 sanctions approaches, 180, 186; was the deadline an influence on the yen? 186; final agreement reached, June 1995, 186; see also Clinton–Hosokawa summit, Clinton–Miyazama summit, Mercantilism in Washington France, as co-defender with Japan in Autumn 1971 of international monetary status quo 41–2 Free float, as option for yen during First World War, 19; a new framework for?, 220; see also floating yen Friedman, Milton, his quoting of J.S. Mill, 117; his explanation of Lost Decade 117; his view of US monetary policy in US bubble economy of late 1920s Fukui, Toshihiko, his role in sparking yen surge and sabotaging Hashimoto fiscal consolidation, Spring 1997, 198 G-7 currency statements, following Plaza Accord, 1985, 61; fan risk aversion of Japanese investors in 1992, 155; push for higher yen, 1992, 154; undermine Hashimoto fiscal consolidation by calling for stronger yen in Spring 1997, 195 G-7 intervention, to push up the yen in Summer and Autumn

250 Index

G-7 currency statements cont. 1989, 131; pushes yen in perverse direction as bubble economy bursts 1991–2, 150, 153; during yen bubble, Spring 1995, 183; towards bursting the bubble, Summer 1995, 186; to bolster the yen in June 1998, 205; see also G-7 currency statements, sterilised intervention in currency markets Genoa Conference, 1922, 20 Gephardt Amendment, 1985, 59 German recession, in 1993, 159; its influence on the yen in early 1993, 159; recovery from a source of dollar weakness in 1994, 170 German unification boom, 147; its influence on the yen, 130, 147 Gold standard, Japan’s first attempt to adopt, 1871, adoption of, 1897, Japan’s first break with in 1917, 15; early return to rejected in 1919, 19; and Genoa conference 1922, 20; return to considered in 1923 and 1926, 23, 25; return to, January 1930, 26; abandonment of, December 1931, 26; how Japanese economy would have performed under in 1990s, 71–2 Golden period, for exporting Japan’s savings surplus, 58, 62; see also Reagan Administration Golf club memberships, prices of as real estate market indicator in Japan, 134 Greenspan, Alan, his tightening of monetary policy, Spring 1988 to Spring 1989, 130; ease monetary policy from Spring 1989, 131; his concern about Japanese banks in 1992, 155; eases policy in Summer 1992 despite economic recovery, 151; tightening of policy in 1994, 167; hints that

tightening now over, February 1995, 182; follows benign neglect towards dollar in early 1995, 182; makes comment on weak dollar, March 1995, 183; becomes cheer leader for bubble economy in US during late 1990s, 123 Gulf War, 147 Hashimoto fiscal consolidation 1996–7, 192–4; its role in bringing down yen fixed-rates and the yen in 1996 and early 1997, 192–3; comparison with fiscal consolidations elsewhere in the OECD area and their influence on markets 192–3; essential conditions for success 193–4; sabotaged by combination of US mercantilist pressures, domestic political opposition, lack of understanding amongst key Japanese policy-makers concerning needed monetary and currency policy accompaniments, and failure of Japanese economic diplomacy 193–7 Hashimoto, Ryutaro, opposition to Mieno’s rate hike, December 1989, 128; becomes Prime Minister, January 1996, 192; his tightening of fiscal policy 1996–7, 192–3; resigns as prime minister in July 1998, 205; see also Hashimoto fiscal consolidation, 1996–7 Hayami, Masaru, claims that yen is undervalued in early 1991, 148; warns against easing monetary policy in 1992, 154; sees yen’s appreciation in 1992 as liveable with, 155l; his April 1993 article in Nikkei Weekly on why a super-strong yen is benign for Japanese economy, 160–2; his support for hard currency and central bank

Index 251

independent at all costs, 164, 213; appointed as Governor of Bank of Japan, March 1998, 204; negative market comments on his appointment, 204; attacks ultra-low interest rates at first opportunity, 204; refuses to ease monetary policy following yen shock of October 1998, 207; conspiracy theorists speculate about Hayami–Sakakibara plot to push up JGB yields in late 1998, 208; favours greater reserve role for yen, 204, 208; refuses to undertake unsterilised intervention towards fighting yen appreciation in 1999, 213; final verdict on responsibility for Lost Decade, 215 Hayata, Ikeda, 30; as long-time prime minister during economic miracle, 30 Hedge funds, as big buyers of European equities and bonds in 1994, 170; role in yen carrytrade, 201; pull out of carry trade in Autumn 1998, 206 Hollowing out, of Japanese industry by strong yen, 71, 116, 162, 164–6, 169, 184, 186, 217; favourable attitude towards of Foreign Ministry and MITI, 71 Hong Kong trade dollar, 10 Hyperinflation, in 1860s following monetary reform, 6; in aftermath of World War Two, 27 Inflation in Japan, in early years following Meiji restoration, 13; in the early and mid-1890s, 15; during the First World War, 16; during World War Two, 27; in the 1960s, 37–8; should Japan have tolerated higher inflation in late 1960s?, 35;

during and after the Tanaka bubble 1972–4, 44; falls below US inflation from 1978 onwards, 52–3; disappears in late mid-1980s, 123; re-appears at end of 1980s, 123; see also Commission on inflation, 1893 Inouye, Junnosoke, as Governor of Bank of Japan and Finance Minister during First World War and afterwards, 15; his role in return to Gold Standard 1930, 26; assassinated 27 International Monetary Fund (IMF), Japan becomes Article 8 member 1963, 30; calls for Japan and Germany to ease fiscal policy, Spring 1978, 52; failure to recognise end of Japanese economic miracle, 53; recognises benefits for world economy of Japan’s current account surplus in 1990, 132; fails to warn of yen disequilibrium in 1992, 155; a review of its failures as Japan descended into deflation, 237; as occasional mouthpiece of US Treasury, 237 Iranian revolution, 1978, its implications for the yen, 55 Irrational exuberance, in Japan in late 1980s, 120–6 Japanese economy, stage of development in 1914, 19; growth of, 1860–1940, 20; rapid expansion 1931–6, 26; smaller than Brazil in 1953, 33; overtakes Germany in 1966, 33; miracle years and business cycles 1953–63, 33; consumer durables industries boom in late 1960s, 35; as Asia’s new giant, 33; duality in, 29; end of the miracle, 48; see also business cycles in postwar Japan, Lost Decade, Operation Scale Down

252 Index

Japanese export booms, during First World War, 15–16; in late 1960s, 35; in late mid-1970s, 47; in early 1980s, 56 Japanese foreign exchange market intervention, during World War One and aftermath 18–25; in Spring and Summer 1971, 40; to prevent slide of yen in Summer 1973, 46; in late 1970s, 55; in 1999, 213 Japanese government bond (JGB) market, its failure to recognise rise in the savings surplus and its meaning after the bubble economy burst, 145; yields spike in Spring 1993 on pressure from Washington to ease Japanese fiscal policy, 159; at extraordinarily high real level in late 1994, 176; sharp fall of yields in 1995, 187; continuing fall of yields during 1996 as factor in weakening yen, 190; yields rise in Spring 1997 on Bank of Japan inspired rumors of imminent monetary tightening, 196–8; misreads the economy in 1997, 198; yields plunge to new low in Autumn 1998, 205 Japanese real estate market bubble, 1987–90, 116; comparison with earlier real estate bubbles in Japan, 121; comparison with real estate bubbles elsewhere, 121–2, 135–6; emergence of, 121–2; a minibreak 1988, 121; how would it have burst without Bank of Japan action, 122; was the peak in early 1990? 134–5; real estate and construction companies in forefront of equity market crash, 1990, 134; why did its bursting not bring a currency devaluation as elsewhere?, 135–6, 140; see also golf club memberships

Kanemaru, Shin his attack on monetary policies of Mieno, 145, 153 Kobe earthquake, January 1995, 178; its influence on the yen, 178–9 Korean War, 29 Liberal Democratic Party, leadership election, 1972, 42; anti-reformers and bigspenders in, 71; brief fall from power in early mid-1990s, 165; does badly in July 1998 Upper House elections, 205; see also Shin Kanemaru, Kakuei Tanaka Lindsey, Lawrence, clumsy remark is catalyst to yen surge, March 1995, 180, 182–3 Liquidity crisis, global, 1998, 117; see also Russian debt default Lost Decade, of Japanese economy 116; telling the story of 116–17; monetary diagnosis of, 117; compared to Great Contraction in US, 118; contemporary comparisons, 119; sheds new light on Keynesian policies, 237 Louvre Accord of 1987, 30, 61,129 Matsukata, Masayoshi, appointed Finance Minister 13; as Prime Minister, 15; see also Deflation, Gold Standard, monetary orthodoxy in Japan Matsushita, Yasuo, appointed as Governor of Bank of Japan, December 1994, 176; distance himself from Mieno at first opportunity, 177; job of sorting out the banking system, 178; not directly responsible for undermining Hashimoto fiscal consolidation, 195; forced to resign, March 1998, 204 Meiji restoration, 10; living standards in the first 40 years following, 20

Index 253

Mercantilism in Washington, in 1970–71, 39–41; under Carter Administration, 1976–8, 52–3; growth of during 1st Reagan Administration, 58–9; influence on Japanese fiscal policy, 70, 159; influence on yen, 63, 75, 156, 166–7; Bush Administration brands Japan as unfair trader, March 1989, 131; toughness of trade negotiations limited by wider considerations in US–Japan relations?, 167; how Washington mercantilists undermined Hashimoto fiscal consolidation in 1997, 194–5; a final review, 236; see also Bentsen, Bergsten, Bush Administration, Carter Administration, Clinton Administration, Clinton– Miyazawa summit, Framework Talks, Gephardt Amendment, Hashimoto fiscal consolidation, Summers, MOSS talks, Strategic Initiative negotiations with Japan, Unholy alliance between LDP big spenders and Washington mercantilists, Yen–dollar talks, Washington Mexican silver dollars, 7, 10 Mexico crisis, 1995, 177; its impact on currency markets, 178 Mieno, Yasushi, becomes Governor of Bank of Japan, 1989, 126; career at the Bank of Japan, 126; disdain of monetary rules, 127; an enthusiast of a strong yen, 127; his socio-political mission, 127; as Bank of Japan man, 126; enjoys shopping trips, 126; contrasted with Arthur Burns, 127; makes false diagnosis of yen weakness in 1989, 129–34; his abrupt tightening of policy in December 1989, 128–9; his dislike of speculation, 133; his mission to burst the bubble economy, 144; failure to

recognise rise in savings surplus as bubble economy burst and its exchange rate implications, 145; his influence on currency market opinion, 145; uses erroneous model of exchange rate determination, 150, 155–6; in second half of 1991 underestimates the seriousness of post-bubble economic downturn, 149; favors a stronger yen even as economy enters post-bubble recession, 150–4; his policies attacked by LDP boss Shin Kanemaru in early 1992, 153; over-optimistic on economy in early 1992, 153; still concerned about inflation in 1992, 153–4; delays easing monetary policy so as to force easing of fiscal policy in early 1993, 158; preliminary judgement on responsibility for Japanese deflation, 162; his defiant exit – still blames strong yen on current account surplus, 168–75; faces strong criticism from business leaders, 1994, 169; succeeded by Yasuo Matsushita, 176; approves of rise in long-term interest rates in 1994, 176; final view on his responsibility for Lost Decade, 215 Mill, J.S., quote from by Milton Friedman, 117 Miller, William, appointed as Federal Reserve Chairman 1978, 51 Ministry of Trade and Industry (MITI), favours closer Asian involvement, 71 Miyazawa, Kiichi testimony to Diet in July 1987 concerning contents of Plaza Accord, 59; Obuchi appoints as Finance Minister, Summer 1998, 205 Monetary orthodoxy in Japan, its intermittent appearance, 15

254 Index

Monetary policy, what account should it take of bubble markets?, 123; The risk of money rates falling too slowly once bubble economy bursts, 144–5; see also Bank of Japan, Bank of Japan Governors, Blinder doctrine, bubble markets, money market expectations, Taylor rule Money market expectations in Japan, of monetary tightening in early 1995, 177 MOSS Talks 1985, 59 NASDAQ bubble, 120 Negative interest rate regime, how this could be implemented as part of an anti-deflation strategy in Japan, 223–7 Neutral currencies, their behavior during First World War, 17 Nixon re-election campaign 1972, 43; influence on dollar, 39–41; coincides with Tanaka election campaign, 43; see also Burns Nixon shock of August 1971, 38–40; a recurrent factor in Japanese risk aversion to foreign currency assets in the subsequent three decades, 51, 75, 156; low risk of a repeat in early 1980s, 56; see also Bretton Woods, US dollar devaluations Nye initiative, autumn 1994, 167; a factor limiting toughness of Clinton Administration in trade negotiations with Japan? 167 Obuchi, Keizo, becomes prime minister, summer 1998, 205; his plans for massive fiscal reflation a catalyst to yen appreciation, 205, 208 OECD, Japan becomes member of, 1964, 30 Oil shock, in 1973, 44, 46; in 1978–9, 55

Operation Scale Down, 48 Osaka, use of silver coin in before Meiji currency reforms, 6,10; business leaders in lambast Mieno, 169 Plan for re-building the Archipelago, 42; abandoned, 146 Plaza Accord, 5, 129; takes unjustified blame for Japanese losses on foreign investments, 59; run-up to, 58–9; an empty agreement?, 60; changes in Japanese monetary policy immediately following, 60; contents of agreement revealed in Diet in 1987, 59; speculation on a mini-Plaza, December 1991 and early 1992, 150, 152; fans risk aversion of Japanese investors towards foreign currency assets even many years later, 156; rumors of reverse Plaza, summer 1995, 187; see also Miyazawa Post-bubble depression, see Bubble Economy Purchasing power parity, calculation of in 1922, 20; in 1948, 28 Reagan Administration, golden period in early years for recycling Japan’s savings surplus, 58; rising protectionist pressure in Congress during, 58–9; see also MOSS talks, Plaza Accord, Yen-dollar talks Reaganomics, 56; fading optimism in as cause of dollar’s fall, 62; see also US business cycles Real estate market, land speculation during Tanaka bubble 1972–4, 44; see also Japanese real estate market bubble, 1987–90 Rubin, Robert, appointed as US Treasury Secretary, December

Index 255

1994, 175; Japanese press react negatively to appointment as Treasury Secretary, 176; announces strong dollar in US interest, March 1995, 183; statements during the yen bubble, 186; presses for stronger yen in Spring 1997, 194–5; sides with mercantilists in 1997, 194; declines to comment on 20% jump in one day of the yen, October 1998, 207 Russia debt default, 1998 reaction of currency markets to, 205–6; see also liquidity crisis, 1998 Sakakibara, Eisuke, appointed as ‘Mr. Yen’, May 1995, 187; role in bursting yen bubble 1995, 187; joins with Rubin in pushing yen higher, Spring 1997, 195–6; forecasts monetary tightening in 1997, 198 Sasaki, Tadashi, as Bank of Japan Governor during Tanaka bubble, 126 Savings-investment balance, its relationship to the balance of payments, 48, 63, 135; takes time for markets and policymakers to recognise shifts in, 144, 150; how influenced by demographics, 231–2; see also big surplus strong currency myth Savings rate in Japan, its behavior during 1970s, 65; why stays high after recession of mid1970s, 66–7; see also savings surplus in Japan Savings surplus in Japan, lack of in late 1960s, 35; emerges in mid 1970s 48, 64–5; why savings surplus in late 1970s could not flow easily into foreign assets, 55; golden period of recycling into capital exports (in early 1980s), 59; why stays large, 66;

path of private sector surplus through 1980s and 1990s, 67; historical and contemporary comparisons with other countries having large savings surplus, 68; implications of surplus for the yen, 71–5; fall of the savings surplus during the bubble economy years 1987–90, 132; rise in surplus after bubble economy bursts, 135; failure of the Bank of Japan and of the markets (currency and bonds) to recognise the jump in savings surplus following the end of bubble economy, 145; a reduction in the surplus following earthquake, 180; mechanisms for recycling surplus to rest of the world become seriously impaired in late 1990s, 213; view that Japanese saving surplus should be exported gets belated recognition at OECD and infiltrates Washington, 2000–1, 214; see also big surplus strong currency myth, earthquake risk, Japanese government bond (JGB) market, savings rate in Japan, Switzerland, trade surplus problem, Yasushi Mieno Scandinavian real estate market bubble, comparison with Japan’s, 121; currency devaluation follows its bursting, 135; see also real estate market bubble in Japan Silk exports, in 1850s, 6; how price affected by 1859–60 monetary reforms, 8; influence on yen during 1920s, 20; slump of during Great Depression in US, 26 Silver standard, Japan’s long march from silver to gold, 10–15; Yen exchange rate under, 12

256 Index

Singapore dollar, fitting into currency geography, 113 Smithsonian Agreement, 41 Solo euro movement, defined, 79; illustrative identification, 102; see also currency geography Solo movement; see currency triangles Solo US dollar movement, defined 79; illustrative identification, 102; see also currency geography Solo yen movement, defined 78; illustrative identification, 80; first example of, 1979, 50; see also currency geography South Korean won, fitting into currency geography, 113 Sterilised intervention in currency markets, ineffectiveness of, 183, 213; Bank of Japan refuses to unsterilise, 1999, 113 Strategic Initiative negotiations with Japan 1989–90, 131–2; see also Bush Administration Sumita Satoshi, ignores bubble markets in conduct of monetary policy, 123; tightens monetary policy in 1989, 124; retires 126; an urbane francophile 126; comparison of his policy during bubble with that of Alan Greenspan, 123 Summers, Lawrence, as US Treasury Under-Secretary expresses concern about likelihood of rise in Japanese current account surplus, Spring 1997, 194; as Treasury Secretary presses for Bank of Japan monetary easing in Autumn 1999, 213 Swiss franc, fitting into currency geography, 111; bubble of, 1978, and its relation to yen, 51; fails to decline as real estate bubble bursts in early 1990s, 135; how the Swiss government burst the bubble of the franc in 1978, 220

Swiss National Bank (SNB), guilty of monetary overkill in early 1990s, 137 Swiss real estate market bubble of late 1980s, currency implications compared with Japanese case, 135, 137, 140 Switzerland, as safe haven during World War One, 17; its huge savings surplus and comparisons with Japan, 64, 68, 135; fiscal reflation following burst of real estate bubble, 137; see also Swiss real estate bubble in late 1980s Taiwan dollar, fitting into currency geography, 113 Tanaka bubble, see bubble economy in Japan, real estate market Tanaka, Kakuei, extravagant reelection campaign 1972, 42–3 Taylor rule, why unhelpful in judging Japanese monetary policy, 125 Tokugawa regime, its fall, 5; Monetary system under, 5–6, 13 Tokyo earthquake 1923, 23; behaviour of yen after, 24–5 Tokyo equities, surge in foreign buying of during first half of 1994, 170; react to Kobe earthquake, 180; see also Tokyo equity market bubble, equity market crash Tokyo equity market bubble 1987–90, 116; optimistic rationalisations of, 122; brief fall of the yen as bubble bursts, 134; yen falls during last stage of bubble, 130–2; real estate and construction companies fall hardest in subsequent crash, 134; see also Zai-tech Trade surplus problem (Japanese), origins of, 63–71; mistaken analyses of implications for

Index 257

yen, 71–6; during First World War, 16; emerges in late 1960s, 35; lack of savings surplus to match trade surplus in late 1960s, 35; in 1972, 41; during 1976–8 52–4; re-appears in early 1980s, 56, 169; reemerges after bubble economy bursts, 149; potential problem in Spring 1997?, 194–8; see also big surplus strong currency myth, Mieno Trade war, in 1930s, 27; Clinton warns of, 166; fears of influence yen in 1994–5, 165 UK real estate bubble of late 1980s, currency implications compared with Japanese case, 135 UK real estate market bubble, in late 1980s compared to Japan, 121; see also real estate market bubble in Japan Unholy alliance between LDP big spenders and Washington mercantilists, analysis of, 3, 70–1, 76; first example of, 1977–8, 53; its emergence in 1990s, 155; see also fiscal policy in Japan US business cycles, recession of 1969–70, 36–7; recession of 1974–5, 47; recovery in 1975, 49; recession of 1980, 56; recession of 1981–2, 56; Reaganomics boom gets under way, 56; end of Reaganomics boom, 59; recession of 1990–1, 146 US dollar devaluations, in 1971–3, 38–45 US dollar bubble, 1983–5, 105 US real estate mini-bubble and burst, 1989–92, 146; implications of for dollar, 146 US Savings and Loans crisis, 146 Volcker, Paul, votes with mercantilists at Camp David,

August 1971, 39; his antiinflation policy copied from the Bundesbank, 45; unleashes monetary shock, 1979, 56; effects of his monetary policy on the yen, 56 Washington, any real power to influence yen?, 75 Watergate affair, 46 Yamaichi Securities, bankruptcy of, 34 Yen, its launch in 1871, 10; fixing of gold parity in 1897, 15; fixing exchange rate in 1949, 28; over-valuation of following First World War, 20; sharp fall after Tokyo earthquake, 24; collapse, 1931–2, 27; fixing of exchange rate in 1949, 28; thirteen phases of motion, 1960–2000, 31–2; real appreciation of in early 1960s, 33–4; real appreciation comes to a halt in second half of 1960s, 35–6; coming of end of fixed exchange rate with dollar, 1969–71, 35–41; could Japan have salvaged fixed exchange rate with dollar in years 1969–71?, 35–41; dollar devaluation and then return to yen–dollar stability, 1971–6, 38–50; unofficial peg to the dollar, 1974–6,47; yo-yo yen is born, 1977–80, 50–6; solo rise in early 1977, 50; peaks in 1978 well before Swiss franc, 51; golden stability of during early 1980s, 62; almost three years of stability against the dollar before Plaza, 56; soars against dollars, 1985–8, 59–62; behavior of during late stages of 1987–90 bubble economy and in its immediate aftermath, 128–36, 140; bizarre surge of in early 1990s, 118, 135–6, 148–51; a view on

258 Index

Yen cont. equilibrium exchange rate in early 1990s, 145; bizarre strength in second half of 1991, 148–50; fails to decline despite Japanese recession in 1992, 151–2; driven up by Washington’s economic diplomacy in 1993, 155; role of US fiscal policy in 1993 yen surge, 159; brief yen surge in early 1994, 166–8; does Washington have any real power over the yen rate?, 167; moves out of limelight from Spring 1994 to beginning of 1995, 170; rises to the sky, Spring 1995, 175–86; big fall from Summer 1995 to early 1997, 189–94; yen shock (surge) in Spring 1997 and its aftereffect, 194–202; from Asian crisis to yen lowpoint of Summer 1998, 202–5; jumps by 20% in one day, October 1998, 206–7; strong rise in Summer and Autumn 1999 related to NASDAQ bubble, 209; yen currency market becomes oneway, 1999, 213; most volatile of major currencies in 1990s, 33; see also Bretton Woods System, carry trade in yen, counterfactual historical analysis, currency geography, Dodge Plan, dollar–yen axis, earthquake risk, exchange restrictions, exchange risk aversion, fixing the yen–dollar rate, floating yen, free float, G-7 intervention, German unification boom, Gold Standard, purchasing power parity, Silver Standard, solo yen movement, Tokyo equity market bubble, yen devaluation, yo-yo yen, yen–euro axis, yen shock of October 1998, yen spike of Spring 1997

Yen bubble 1995, 116; role in Asian crisis, 116, 175–94; Federal Reserve Governor Lindsey’s remarks as catalyst to, 180–3; benign neglect of Greenspan Federal Reserve, 180; role of Kobe earthquake in, 178–9; influence of trade talks on, 182, 185–6; talk of Asian central banks shifting reserves into yen, 183; Asian borrowers repay yen loans, 183; state of market opinion during, 184–5; the bursting of in Summer and Autumn 1995, 186–9; role of Eisuke Sakakibara in the bursting process, 187; risk aversion during 188; growing confidence crisis in Japanese banks as factor in bursting of , 189; see also Greenspan, Clinton, currency bubbles, Framework Talks Yen devaluation, from 1885 to 1887, 13; from 1891 to 1894, 14; as exit from post-bubble depression of 1882–5, 14; in 1931, 27; as possible means for extricating Japanese economy from deflation at the start of the 21st century?, 219 Yen shock, its 20% jump in one day, October 1998, 205–9 Yen spike of Spring 1997, its harmful influence on the mechanisms for recycling Japan’s savings surplus to the rest of the world, 201–2 Yen–Dollar Talks 1983–4, 58 Yen–euro axis dominance, defined, 78; illustrative identification, 80; see also currency geography Yo–yo yen, is born, 1977–80, 50–5; small throw of in early 1980s, 56; violent upward swing following Plaza, 62; as impediment to capital exports from Japan, 69; were its strings pulled by Washington in early

Index 259

1997?, 200; bad for the Japanese economy?, 216–7; lessons for the global economy, 235 Zaibatsu, formation of, 13

Zai-tech, in Japan’s bubble markets 1987–90, 133; as contributor to capital exports, 133 Zero rate policy, adopted in February 1999 by Bank of Japan, 214