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CIAO DATE: 12/03
Depreciate the Yen
On The Issues
April 2002
Japan's Ministry of Finance and the Bank of Japan should continue to purchase foreign exchange—but stop negating the effect of such purchases by selling other assets—and expand money growth until yen deflation ends.
As the world economy moves toward recovery, Japan, the second largest economy, lags behind. After more than ten years of slow growth and several recessions, Japanese officials continue their costly dialogue of the deaf. The Bank of Japan urges the government to reform the financial system and remove the bad loans from the commercial banks' balance sheets. It claims that, until the government acts, monetary expansion is useless because banks will not lend. The government responds by urging the bank to increase money growth.
This stalemate could be broken with a small change in the bank's procedures: ending sterilization of its foreign exchange purchases.
Buying Foreign Exchange
Many outsiders and a former member of the bank's governing board have urged the bank to buy foreign exchange. The bank's management rejects these pleas using a variety of reasons. In fact, the bank buys foreign exchange regularly—as much as $40 billion in 2001 and $200 billion in the past five years. It cancels any expansive effect of these purchases on money growth and the economy by selling other assets.
This is an error that prolongs and deepens Japan's recession, as the markets tell us in several ways. Japan has suffered from deflation for years. Deflation occurs because the public wants to hold more money than the Bank of Japan supplies. The public cannot create its own money, but deflation raises the purchasing power of the money it holds. With housing and stock prices 50 or 60 percent below their peak, and no sign of strong recovery, holding money has proved a safe choice.
Deflation is also the market's way of responding to Japan's overvalued exchange rate and the "hollowing out" of Japan's manufacturing sector. Markets care about the real value of the exchange rate—how much it costs to buy in Asia, the United States, or Europe compared with the cost of buying the same product in Japan. By neutralizing its purchases of foreign assets and keeping money growth slow, the bank forces wages and prices to fall as a way of adjusting the real costs of its exports to prices abroad. Reducing wages and prices is a slow process. Depreciation of the yen would achieve the same result more quickly.
The main objection to purchasing foreign exchange is that Japan would be exporting its unemployment and recession, a repeat of the despised "beggar thy neighbor" policies of the 1930s. This is far from the truth. Markets will adjust Japanese prices one way or another. If yen depreciation does not lower the effective cost of Japanese goods and services, deflation will. Japan's trading partners will find that the continued decline in prices and costs will increase Japan's competitive position.
Faster money growth would give impetus for renewed economic growth, expanding at home and abroad. It is a mistake both to criticize the inevitable reduction in Japan's costs and prices and to ignore the effect of rising Japanese incomes on imports from its trading partners. As output and imports increase, Japan will contribute to growth of Asian and other economies. It will export growth and jobs, not unemployment.
Depreciation of the Yen
For most of the postwar period, depreciation of the yen seemed unnecessary, even unthinkable. Productivity growth was greater than in Europe or the United States. Japanese producers gained competitive advantage in production of cars, electronics, and many consumer durables. After leading currencies floated in 1973, stronger productivity growth and conservative financial policies kept Japan's production costs for many durable goods below the costs of foreign competitors. The yen appreciated, moderating the effects on other countries.
Recession and slow growth in Japan and faster productivity growth in the United States changed the relationship. Japan's relative cost advantages have eroded. My calculations suggest that the United States became much more competitive in the 1990s. The strong dollar partly offset these gains against many countries, but not against Japan. The yen has not depreciated enough to offset higher U.S. productivity growth.
Under pressure from its government, the Bank of Japan has recently flooded the commercial banks with reserves. With little demand to borrow, and short-term interest rates near zero, banks have no incentive to use the additional reserves. They pile up on the banks' balance sheets, giving the illusion of an easier policy, without the substance.
Monetary policy works mainly by changing relative prices of short- and long-term assets or domestic and foreign assets. The Ministry of Finance and the bank should end sterilization of foreign exchange reserves and announce a policy to expand money growth until deflation ends.
Reform of the financial system is important, as the bank insists, but strong growth is important to Japan, its trading partners, and the rest of the world. The bank should not continue holding economic recovery hostage to reform.
Allan H. Meltzer is a visiting scholar at AEI.
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