Financial Times Sept 28th 2011
Imagine the US economy shrinking by 30% over the past four years, the Chinese economy growing at 2%, not 10%. Imagine UK house prices down 60% and commodity prices sliding back to the levels of the mid-1970s.
This frozen wasteland is not some alternate universe, but what reality already looks like when expressed in the world’s last remaining hard currency, the Japanese yen.
Since the global financial crisis kicked off in 2007, the yen has appreciated significantly against the euro, the pound, the dollar, and commodity-backed currencies like the Brazilian real. When Japan was hit by the triple disaster of earthquake, tsunami and nuclear disaster in March, the market’s reaction was to bid the yen higher. Japan’s position as a trillion dollar creditor nation, coupled with the inertia of its central bank made the yen a safe haven in an era of scary financial climate change.
A strong currency used to be a badge of pride. It was a mantra of Clinton administration officials that a strong dollar was in the US national interest. The Bundesbank was wedded to the idea of a strong Deutschmark, and the ascent of the Euro in the years after its launch was a source of satisfaction to European politicians.
The global financial crisis changed all that. Suddenly policy-makers were plunged into a world of anemic demand and de-leveraging. Currency depreciation became a useful tool for boosting competitiveness and – dare it be said – reducing real wages and real asset prices through imported inflation. Countries that stuck to hard money orthodoxy were on the other side of that trade. Like the countries that stayed on the gold standard to the bitter end in the 1930s, they were importing deflation.
As the dollar and the pound plunged, it seemed at first that the Euro might retain some vestiges of its Deutschmark heritage. Such fond hopes soon evaporated.. With the eurozone facing an existential crisis, the ECB has no choice but to stuff its balance sheet with sovereign eurojunk.
The Swiss franc, like the yen, strengthened through the recent upheavals. Indeed both had been in uptrends since the era of floating currencies started in 1971. So it was a momentous event when the Swiss central bank announced in August that it was drawing a line in the sand at 1.20 francs to the euro. Beyond that no further appreciation would be tolerated. The rationale was the protection of domestic industry. The extent of the Swiss volte face was demonstrated by a Bernanke-esque doubling of the central bank’s balance sheet in following weeks.
Now only the yen remains in the hard money club. How long before it leaves too?
At first sight there’s no urgency. Although the yen-franc cross-rate is roughly the same now as in 1971, the fundamentals of the yen are much better. Corporate Japan has been living with deflation for fifteen years and has learned how to stay profitable by reducing wages and other costs. Switzerland has seen low but positive inflation, so the loss of competitiveness is more severe. Verbier is outrageously expensive; Hokkaido is not.
Yet Japan’s deflation has insidious effects too. The erosion of tax revenues and the stagnation of nominal GDP are the main factors behind the relentless rise in government indebtedness. Young workers bear the brunt of wage deflation and declining job security, while retirees enjoy a lower cost of living. Cash holders get a tax-free carry, while equity-holders take pain.
Japan has long been a serial intervener in the currency markets, but tactically, not strategically. The instigator has usually been the business community. Now there is a new factor to worry the bosses of Japan’s blue chip companies. Korea and Japan compete head-to-head in electronics, autos, shipbuilding and other sectors. Since 2007, the Korean won has halved in value versus the yen, giving Korea’s already formidable manufacturers a huge competitive boost. It was a similar depreciation after the Asian crisis of 1997 that helped propel Samsung Electronics, Hyundai Motors and the rest into the forefront of their industries.
Japan can hardly let that pass. Pressure from the business community to intervene is sure to mount. The recently-formed Noda administration, otherwise bereft of growth policies, will be tempted to accede. But for intervention to be successful, Japan would need to go Swiss and subordinate monetary policy to its currency market goals.
When that happens, the global retreat from hard money will be complete. Politically it is the obvious solution. House prices declining 15% in soft money is always going to be more acceptable than a 60% decline in hard money.